One big warning has always hung over online lenders: The next economic decline, everyone agreed, would be a make-or-break test for these fast-growing upstarts.
Now the long-awaited downturn, brought on by the coronavirus pandemic, has arrived. And already it is more severe than most observers anticipated.
Online lenders, whose borrowers were often bank rejects, are sharply reducing or even suspending new loan originations. They are drawing down credit lines to boost liquidity. And they are cutting costs as much as possible, except in loan servicing, since their chances of survival hinge on their ability to collect payments from customers who have recently become riskier bets.
“Somebody might look like a 700 FICO today. But in reality they’re dropping,” said Brian Korn, an attorney who leads the fintech practice at Manatt, Phelps & Phillips. “And they might look like a 600 FICO after the next payment cycle.”
Many online lenders, particularly those that are privately held, are staying quiet about the challenges they are suddenly facing. But interviews with industry insiders and an assortment of corporate disclosures from the likes of LendingClub and OnDeck Capital revealed some of the damage that the sector has sustained since mid-March.
Because these companies operate outside of the banking industry, they have never been able to turn to deposits as a stable source of loan funding. Instead they have relied heavily on alternative sources of liquidity — securitization markets, hedge funds and other private investors — that skeptics warned were likely to dry up during the next crisis.
That structural weakness has been compounded by the revenue models of many online lenders, which rely on a steady supply of new loan volume to drive growth. With new loans now sharply reduced, companies that are sitting on a big supply of cash will likely try to weather the storm. Others may look to sell, though they could be forced to do so at heavily discounted prices.
“Fintechs are relatively fragile and looking to conserve cash, by and large,” Nigel Morris, a co-founder of Capital One Financial, said during a recent webinar. Morris is now managing partner at QED Investors, a venture capital firm that has investments in numerous online lenders.
“Banks are largely well capitalized and in very good shape to ride this out,” he added. “And it’s a time to consider M&A, to buy assets and capability [they] don’t have. The fintech community is more in the mood to listen.”
What follows is a look at how the coronavirus crisis has roiled online lenders in both the consumer and small-business spheres.
Consumer lenders are battening down the hatches
Many digital consumer lenders built their businesses around the refinancing of consumers’ existing credit card debt. Just between 2016 and 2019, U.S. personal loan volume grew by 58% to $161 billion, according to TransUnion data.
Those existing loans may prove harder for lenders to collect on during the nascent downturn than other types of consumer credit. Unlike mortgages, which pay for a place to live, and auto loans, which finance transportation, personal loans often do not provide any ongoing utility to consumers.
“The pandemic-led unemployment shock may cause consumers to increasingly prioritize other debt payments,” analysts at Fitch Ratings wrote in a recent research note.
Harry Kohl, a Fitch analyst, said that online lenders specializing in subprime loans may have a particularly hard time collecting from their customers. In April, the unemployment rate for Americans with less than a high school diploma rose to 20.9%, versus 8.2% for those with at least a bachelor’s degree.
“These aren’t the people that have the nest eggs and liquidity and cash saved up to make a payment,” Kohl said in an interview. “If they lose their job, they have to start making decisions pretty soon as to which bills they’re going to pay.”
During the pandemic, online lenders have been offering short-term payment relief to cash-strapped consumers, which could have the short-term effect of masking any deterioration in credit performance.
So far, forbearance rates in the industry are around 12% to 13%, according to Ram Ahluwalia, chief executive of the analytics firm PeerIQ. He estimated that losses could ultimately top out at around 20%, though he also noted that much hinges on the future course of the virus.
The securitization market has long been a key source of funding for online lenders, but it has recently become hard, if not impossible, to access.
Against that backdrop, online consumer lenders
All of the bad news for the sector has been tempered to some degree by government stimulus efforts — specifically, the cash payments and expanded unemployment benefits that were part of the Coronavirus Aid, Relief and Economic Security Act — that have enabled many borrowers to continue making their loan payments.
Thus far, the increase in the number of online loans that are either in forbearance or in some stage of delinquency has been smaller than the spike in unemployment, according to a report released this week by the data provider dv01.
“Consumers came into the COVID-19 crisis with healthy debt levels relative to income and wealth, as well as historically low debt service ratios,” the report stated. “It is no surprise then to see credit show earlier signs of recovery, a far different picture than the 2008 crisis.”
Still, questions linger about what dominoes will fall if unemployment remains substantially elevated when government payments to U.S. consumers stop.
In anticipation of what may come, LendingClub increased the size of its collections staff by about 30% by early May. The San Francisco-based company also
LendingClub moved quickly to shore up its liquidity, boosting its cash and cash equivalents by 21% to $294 million as of March 31.
“With our lower expense run rate, we believe we have enough liquidity through the end of 2021 in a variety of stress scenarios,” LendingClub Chief Financial Officer Thomas Casey said during the firm’s May 5 earnings call.
Afterpay, an Australia-based online lender that entered the U.S. market in 2018, is also bracing for an extended downturn, cutting its operating expenses and drawing $97 million in warehouse facility debt.
Unlike online consumer lenders that specialize in personal loans,
Before the coronavirus crisis, Afterpay said that it planned to offer in-store financing in the United States sometime in the coming months. In mid-April, the company said those preparations remained ongoing, but added in a written disclosure, “Timing of our launch will be dependent on the timing of a recovery in offline retail in the U.S.”
Vulnerabilities exposed at online small-business lenders
If anything, the situation is even bleaker for online lenders that extend credit to small businesses.
Many of these firms lend at high interest rates to restaurants and other businesses that cannot qualify for more affordable credit from a bank. Much of this borrowing may have been unsustainable even if the good economic times had continued.
Instead, many small businesses saw their revenue decimated this spring. Discover Financial Services has said that its credit card holders spent 60% less at restaurants in the first three weeks of April, as compared to the same period a year earlier. For travel-related businesses, the decline was 99%.
As in the consumer realm, online small business lenders have seen their traditional funding sources dry up. “It’s like the end of the world is happening,” Ahluwalia of PeerIQ said.
OnDeck Capital, which is one of the largest U.S. online business lenders, has said that approximately 45% of its loans were in some stage of delinquency by the end of April. The New York-based company has paused originations of its traditional products. OnDeck’s loans carry an average annual percentage rate of 44.5%, a rate high enough that even healthy businesses may have a hard time staying current.
“Beginning in the third week of March, we started to see an increase in call volume into our customer service center,” OnDeck CEO Noah Breslow said during the company’s April 30 earnings call. “Our inbound call and email volume peaked at approximately six times normal levels in the second week of April.”
When OnDeck held its initial public offering in late 2014, the company’s shares opened at $26.50. During the first two months of this year, the shares were trading in the $4 range. On Thursday, they closed at 66 cents, giving the firm a market capitalization of just $38.6 million.
It is not just OnDeck that has been hammered. Kabbage, another major player in the sector,
Square, which offers financing to merchants that use its payment services, paused new offers on its core loan product in mid-March, according to a public disclosure. The San Francisco-based company said that adverse changes to economic conditions had strained its ability to correctly identify eligible borrowers.
Some online small-business lenders have sought to carve out roles in the Paycheck Protection Program, the $660 billion federal emergency effort aimed at stopping the bleeding at U.S. small businesses. But investors are not counting on a government lifeline for the lenders.
On Monday, Kroll Bond Rating Agency said that
