One of the great unknowns about online lending is how individual lenders will perform in the downslope of a credit cycle. We’ll soon know the answer.
The online lending story will play out in a three parts, beginning with credit fundamentals and funding availability and ending with servicing and collections efficiency.
Let’s start with credit. Credit deterioration in the sector likely won’t be visible in the numbers for a month or two. Look for the first signs of stress in the performance of small business loans from businesses directly affected by coronavirus “social distancing” and the tourism/travel crash (signs of stress related to the tariff wars are already evident). Then expect to quickly see delinquency issues with nearprime/subprime consumer loans as layoffs drive delinquency for LMI borrowers who are already on the razor’s edge. Prime and superprime online lenders will see smaller and later losses than the first two categories but are still at significant risk depending on the length and depth of the downturn.
Borrower utility prioritization suggests that consumers will pay on credit cards and auto loans first and let online installment loans slide. Consumer behavior around new things like online POS loans are harder to predict. The lenders I’ve spoken to are trying to be more selective on credit and to avoid chasing volume. That’s laudable but practically possible only for those online lenders that use their balance sheet to generate spread income from loans and can reduce volume while still remaining viable. Online lenders without recurring revenue from balance sheet loans — i.e., pure marketplace lenders — will find it nearly impossible to hit the brakes. They are stuck on the origination hamster wheel because they depend on new originations to generate virtually all revenue.
Funding availability is a derivative of perceived future credit risk, which means that the impact on lenders will be much more immediate. Take a look at market pricing on existing online lending securitizations and filter out the noise from falling rates to see if credit spreads are widening for the lower tranches. I suspect they already are (but lack a Bloomberg terminal to check). Those wider spreads will be reflected in future financing costs in both direct loan sales and securitizations, and lenders will have little room to raise interest rates to compensate.
Online lender gain on sale margins have always been thin due to business models that give too much control to loan funders. A spike in funding costs will put enormous strain on lender profitability and business viability. Again, those with balance sheet capacity will be better off than those who have to take the Street’s pricing.
Finally, as delinquencies rise, operational capability will come to the fore. Online lenders will suddenly be faced with the costs of servicing large volumes of delinquent loans and collecting defaulted loans. Scaling a servicing and collections capability efficiently is difficult in the best of times and darn near impossible in hard times. We all saw how unprepared the mortgage industry was for the credit crash of 2008, which overwhelmed understaffed collections employees and made a mockery of the cost assumptions underlying servicing valuations. Expect to see the same with many online lenders.
Who will the winners be? My money is on the online lending companies with three characteristics:
- They have material recurring revenue from balance sheet loans;
- They are prime/superprime lenders; and
- They are stocked with experienced operators who are veterans of the 2008 crisis, have seen some version of this story before and know where the levers are. This last characteristic — separating the men (and women) from the bros — may be the most important of all.
[For a collection of essays on FinTech, consumer financial health, banking and related topics, go to Broadmoor Consulting Here or Medium.] [For papers on FinTech alternatives to short-term, small-dollar credit, go to Here and Here.][For videos of my public programs at Columbia Business School go Here.]