When a consumer goes to borrow, whether it be a credit card or loan, there is a basic assumption that the lender will be ready with funds. The application goes to a bank, credit union, or fintech who specializes in lending money.
However, there is more to it than just a licensed lender having a marketing process. In the case of a credit card, the financial institution must stand ready to cover the borrower’s demand for the credit line, and in the instance of an installment loan, the financial institution must be ready to deliver the funds at closing.
To make the funding process works, financial institutions must have the funds available on their balance sheets or have access to a warehouse line of credit. If the funds are from the balance sheet, it will decrease a bank’s liquidity, by moving cash into an account which will increase as the funds consume the credit line. If the funding comes from a warehouse line of credit, the financial institution or fintech will use those funds to support the borrowing.
These actions are transparent to the borrower, except when the funds tighten. To manage loss reserves, financial institutions must calibrate their lending requirements with their available cash to ensure the lending function is fluid. A lot more goes into the process than the typical borrower expects.
What top institutions and many fintech lenders do is originate the loans, age the loans to season the account, then package the loans for an asset-backed securitization (ABS). The ABS process allows the financial institution to move accounts from their balance sheet into an investor pool, which frees up cash for additional lending. This way, lenders can keep reinvesting into new borrower accounts.
Lenders such as American Express, Bank of America, Barclaycard, Chase, Citi, Discover, and Wells Fargo are examples of leading lenders that deploy the ABS strategy. All rely on using the FICO Score as a measure of asset quality. Institutional investors, such as the California Teacher’s Retirement Fund, or portfolio managers, such as Vanguard will take positions in ABS offerings to increase their yields beyond the level of government securities. A few basis points make a difference when you are responsible for investment yields.
The ABS process works well for large lenders because investors require critical mass. The strategy is not effective for lenders with less than $5 billion in loan books because the volumes are usually insufficient for institutional investor needs.
Some fintech lenders use alternative scoring, and it looks as though some new lenders are less rigorous about the FICO Score. Instead, the fintech may use their proprietary score, either throughout the entire process or only at origination. And this brings us to today’s story from the Wall Street Journal.
The headline screams, “Investors Turn Cautious on Consumer Debt,” and explains how “demand softens for bonds backed by loans from riskier borrowers.”
Buyers of bonds backed by subprime car loans or credit cards are demanding the highest premiums over interest-rate benchmarks since mid-2020. Meanwhile, investors have punished shares of some financial-technology companies that helped fuel a recent surge in consumer borrowing, such as Affirm Holdings and Upstart Holdings.
Clayton Triick, a portfolio manager at Atlanta-based Angel Oak Capital Advisors, said he is particularly wary of debt owed by people with low credit scores. Angel Oak has been “eating around the edges” when purchasing so-called consumer asset-backed securities in 2022, he said, buying smaller amounts of new bonds.
Wall Street’s enthusiasm for consumers’ debt has helped finance a surge in lending. About $900 billion of loans to individuals that were packaged into tradable bundles and sold to investors as bonds was outstanding last year, Moody’s data show, supporting record borrowing for homes, cars and even electronics. Debt owed by households topped $15 trillion for the first-time last year, according to the New York Federal Reserve.
For more info on fintechs seizing installment lending volume, see this recent Mercator report titled Installment Lending: Fintechs Gaining Ground on Loans Forecast at $212 Billion.
This year, investors have sold bonds broadly, driving up yields, which rise when prices fall. But consumer-debt yields are rising even faster, a sign that traders believe the relative risk is increasing. Bonds backed by the most-traded category of subprime auto loans have recently yielded 1.45 percentage points more than standard benchmarks, according to data from JPMorgan Chase & Co., up from a 0.9-percentage-point premium, or spread, at the start of the year. Yields also have climbed for bonds backed by credit-card debt and other types of consumer debt.
But, for fintechs, the market is not so rosy.
Rising costs in the bond market prompted at least one consumer lender to cancel a new financing in recent weeks: Affirm, which specializes in “buy-now-pay-later” loans for online purchases, pulled a $500 million bond backed by the loans in March after a large investor demanded a higher interest rate on the deal, according to a hedge-fund manager.
“We made the decision to hold off on issuing the refinancing transaction given the extreme pricing volatility due to heightened macro uncertainty,” a spokesperson for Affirm said.
A spokesperson for Upstart declined to comment. Upstart Chief Financial Officer Sanjay Datta said on a call with analysts in February that the company is not expecting meaningful problems from rising defaults.
Ouch, the downstream effect is costly.
Shares of Affirm and competitor Upstart have each lost about 75% since November when late payments started to rise, according to FactSet. Short interest as a percentage of shares outstanding has tripled for Upstart to about 15% and almost doubled for Affirm to 6%, according to data from S&P Capital IQ.
Remember, the economy may feel good, but there are bumps ahead.
Late payments for several types of securitized consumer debt are on the rise. In February, the share of subprime auto loans that were more than 60 days delinquent was 4.77%, up from 3.74% a year earlier and the highest level since April 2020. Delinquencies on credit-card payments also have ticked higher from lows reached last year, though at a more moderate pace.
And a portfolio manager from Lord Abbett sums things well:
“It’s incumbent upon an ABS investor to be vigilant about where underwriting standards go from here,” Mr. Castle said.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group