Are Subprime Consumer Lenders Heading for a Settlement?

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Banking executives are confident their consumer loan portfolios are holding up, but non-banks lending to Americans with lower credit scores are starting to see cracks.

Worsening credit is prompting investors to be more cautious of certain lenders and is already contributing to funding problems for at least one company. Upstart Holdings, a digital consumer lender, said last month that the market in which it sells consumer loans to investors was “funding constrained”.

Other lenders that focus more on borrowers with credit scores below prime – offering products such as car loans, personal loans, credit cards and short-term loans buy now/pay more late – also starting to see more people falling behind on their payments. Higher late payments increase the risk that borrowers will not repay their loans, and lenders will have to charge them.

Affirm, Upstart and Afterpay, all of which offer credit to borrowers with scores below prime, have reported rising delinquency rates in recent months.

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“I don’t think we’re at the red flag stage,” said Michael Taiano, senior director at Fitch Ratings. “Maybe it’s starting to yellow a bit.”

The situation is different for banks, where CEOs were largely positive about the health of their higher credit-scoring customer bases in recent earnings calls. The lending industry “definitely sees a bifurcation” in credit quality, Taiano said, with those who lend to people with stronger credit profiles doing better while non-preferred lenders report rising delinquencies.

Credit deterioration is still in its early stages, and its extent will largely depend on continued strength in the labor market, Taiano said. Jobs ensure borrowers have enough income to repay their loans.

But high inflation puts the United States in “uncharted territory,” Taiano said, since Americans had much less debt in the 1980s, the last time inflation was around 9%.

Late payment rates on credit cards and auto loans for low-income borrowers are departure approaching pre-pandemic levels, the Federal Reserve Bank of New York said Tuesday.

Weakening credit quality is also occurring in the unsecured personal loan industry, which is somewhat more focused on borrowers with lower credit ratings than the credit card market.

The percentage of personal loan borrowers who were at least 60 days behind on their bills rose to 3.37% in the second quarter, according to credit reporting firm TransUnion. While this percentage remains somewhat lower than historical averages, the 60+ day delinquency rate has risen above its pre-pandemic level by just over 3.10%.

Late payments are becoming more common, in part because lenders earlier this year began offering more loans to non-preferred borrowers, whose delinquency figures are typically higher, said Salman Chand, vice-president. president of credit reporting agency TransUnion.

The trend also reflects the waning effects of aid at the start of the pandemic — such as stimulus checks, loan deferrals and increased unemployment benefits — that helped keep many consumers afloat, said Chand.

Firms that reported an increase in delinquencies include subprime installment lender OneMain Financial, where the rate of delinquencies over 30 days rose to 4.88% as of June 30, from 3.12% a year earlier. Net charges reached almost 6% in the quarter, compared to 4.41% a year earlier.

“It is clear to us that there has been an increase in early delinquency in the non-priority space over the past two months,” OneMain CEO Douglas Shulman told analysts last month.

OneMain has significantly tightened its underwriting criteria over the past two months to focus on lower-risk customers, whose credit performance has been “very much in line with our expectations,” Shulman said.

Credit also deteriorated among buy now/pay later lenders, which exploded in popularity during the pandemic as consumers spent more money on goods on retailer websites that offered payment options. deferred.

At Affirm Holdings, a publicly traded U.S. lender, the 30-plus-day default rate rose to 3.7% of loans at the end of March, from 1.4% a year earlier. Afterpay, a recently acquired subsidiary of To blockreported an over-60 delinquency rate of 4.1% in the first quarter, compared to 1.7% in the second quarter of 2021, when the company last filed its annual report.

Other major buy-it-now and pay-later companies operating in the United States include Sweden’s Klarna, Minneapolis-based Sezzle, and Australia-based Zip. Last month Zip terminated a previously planned merger with Sezzle following a sharp drop in valuations of buy now/pay later companies.

While these companies have seen substantial growth, their newness means their underwriting models haven’t “really been tested through a tough cycle,” Fitch’s Taiano said.

“We’re probably entering a period where you’re going to see a separation between those who are relatively good underwriters and those who aren’t,” Taiano said, recalling Warren Buffett’s famous line that you don’t know who swam naked. until the tide goes out.

Another challenge faced by some non-bank lenders is the increase in funding costs. Banks and fintechs with banking charters, such as Sofi Technologies and loan clubare able to accept deposits and use them as a lower cost source to fund their loans.

But other fintechs rely more on selling their loans in places like the securitization market, where individual loans are bundled into securities for investors to buy chunks of.

Growing recession fears have made investors in these securities “a bit more cautious,” said Ray Barretto, chief asset-backed securities trader at Mitsubishi UFJ Financial Group. As funding doesn’t dry up, investors are looking for more compensation for taking on risk, Barretto said. This revised calculation comes on top of interest rate hikes by the Federal Reserve, which are also driving up funding costs.

Taiano, the Fitch analyst, cited a recent Affirm securitization deal as an example of how the funding environment has tightened. Affirm is paying investors a 5.65% return for a recent $371 million securitization, Taiano noted in a report last week. That rate is up from the 1.08% yield in a $320 million deal last year.

Analysts are also watching for comments next week from San Mateo, Calif.-based Upstart, which says its artificial intelligence underwriting models allow it to lend to a wider population.

Defaults and charges on the company’s loans have increased faster than expected, which analysts say helps loan investors in its market to exit from buying its loans.

In a press release last month, Upstart attributed its funding constraints largely to “concerns about the macroeconomics among lenders and capital market participants” and said its loans had “outstanding performance”.

The upstart executives will discuss their results — which the company previewed a month earlier through unaudited earnings — on a conference call after the market closes on Monday.

The company’s funding constraints show the downsides of relying on third-party lenders rather than deposits, according to Wedbush Securities analyst David Chiaverini.

“We are concerned that weakening delinquency and loss trends, combined with macroeconomic and geopolitical risks, could lead to a decline in the appetite of Upstart credit buyers and the securitization market,” wrote Chiaverini in a note to customers. “The biggest risk to Upstart, in our view, is its reliance on third-party financing, and this risk tends to increase during recessions.”

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