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Are Fintechs Pennywise & Pound crazy?

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When a consumer goes to borrow, whether it is a credit card or a loan, there is a basic assumption that the lender will be ready with funds. The request is made to a bank, credit union, or fintech that specializes in lending money.

However, there is more than just an approved lender with a marketing process. In the case of a credit card, the financial institution must be prepared to cover the borrower’s request for the line of credit, and in the case of an installment loan, the financial institution must be prepared to deliver funds at closing.

For the funding process to work, financial institutions must have the funds available on their balance sheets or have access to a warehouse line of credit. If the funds come from the balance sheet, this will reduce a bank’s liquidity, moving cash into an account that will grow as the funds consume the line of credit. If the funding is 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 funds tighten. To manage loss reserves, financial institutions need to calibrate their lending needs with their available liquidity to keep the lending function running smoothly. A lot more goes into the process than the typical borrower expects.

What major institutions and many fintech lenders do is originate the loans, age the loans to season the account, and then condition the loans for asset-backed securitization (ABS). The ABS process allows the financial institution to transfer accounts from its balance sheet to a pool of investors, which frees up liquidity for additional lending. This way, lenders can continue to reinvest in new borrower accounts.

Lenders such as American Express, Bank of America, Barclaycard, Chase, Citi, Discover and Wells Fargo are examples of leading lenders deploying the ABS strategy. All rely on the use of the FICO score as a measure of asset quality. Institutional investors, such as the California Teachers Retirement Fundor portfolio managers, such as Avant-garde will take positions in ABS offerings to increase their yields beyond the level of government securities. A few basic points make a difference when you are responsible for investment returns.

The ABS process works well for large lenders because investors need critical mass. The strategy is not effective for lenders with loan portfolios below $5 billion, as volumes are generally insufficient for the needs of institutional investors.

Some fintech lenders use an alternative scoring, and it seems some newer lenders are less stringent when it comes to FICO scoring. Instead, the fintech can use its proprietary score, either throughout the process or only at the origin. And that brings us to today’s story from the wall street journal.

The headline screams, “Investors are getting cautious about consumer debt” and explains how “demand is easing for bonds backed by loans from riskier borrowers.”

Buyers of bonds backed by subprime auto loans or credit cards are demanding the highest premiums over benchmark interest rates since mid-2020. Meanwhile, investors punished shares of some fintech companies that have helped fuel a recent surge in consumer borrowing, such as Affirm Assets and Assets received.

Clayton Triick, portfolio manager at Atlanta-based Angel Oak Capital Advisors, said he was especially wary of debt incurred by people with low credit ratings. Angel Oak “ate on the edges” when buying so-called consumer asset-backed securities in 2022, he said, buying smaller amounts of new bonds.

Wall Street’s consumer debt craze helped fund a surge in lending. About $900 billion in consumer loans that were bundled into tradable lots and sold to investors in the form of bonds were outstanding last year, Moody’s data showed, supporting record borrowing for homes, cars and even electronics. Household debt topped $15 trillion for the first time last year, according to the New York Federal Reserve.

For more insight on fintechs capturing installment loan volume, check out this recent Mercator report titled Installment Loans: Fintechs Gain Ground on $212 Billion Loan Forecast.

This year, investors have bonds sold overall, driving up yields, which increase when prices fall. But consumer debt yields are rising even faster, a sign that traders believe relative risk is rising. According to data from JPMorgan Chase & Co., against a premium or gap of 0.9 percentage point at the start of the year. Yields also 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 new financing in recent weeks: Affirm, which specializes in “Buy now, pay later” loans for online purchaseswithdrew a $500 million bond secured by the loans in March after a large investor demanded a higher interest rate on the deal, according to a hedge fund manager.

“We have made the decision to suspend the issuance of the refinancing operation in view of the extreme price volatility due to heightened macroeconomic uncertainty,” an Affirm spokesperson said.

A spokesperson for Upstart declined to comment. Upstart’s chief financial officer, Sanjay Datta, said in a call with analysts in February that the company does not expect significant issues from the increase in defaults.

Ouch, the downstream effect is costly.

Shares of Affirm and its competitor Upstart have each lost about 75% since November, when late payments began to mount, according to FactSet. Short interest as a percentage of shares outstanding tripled for Upstart to around 15% and nearly doubled for Affirm to 6%, according to data from S&P Capital IQ.

Remember, the economy may be feeling good, but there are bumps ahead.

Late payments for several types of securitized consumer receivables are on the rise. In February, the share of subprime auto loans more than 60 days past due was 4.77%, down from 3.74% a year earlier and the highest level since April 2020. Delinquencies on credit card payments credit also rose from the lows reached last year. , although at a more moderate pace.

And a Lord Abbett portfolio manager sums it up nicely:

“It is incumbent on an ABS investor to be vigilant about changing underwriting standards,” Castle said.

This is where we believe the FICO score comes in. The inclusive strategies found in exclusive scoring can help open the sales funnel, but ultimately where investors need consistent measurement, the FICO score provides a risk-based perspective for a wide variety of consumer borrowing, from auto loans to credit cards, consumer loans, and even timeshares. A 720 FICO score means something to the investor, as does a 600. A homeowner score used beyond loan booking can be attractive, but when it comes to assessing risk, many variables can create a cloudy environment for investors.

Preview by Brian RileyDirector, Credit Advisory Services at Groupe Conseil Mercator