The Asymmetric Credit Risk for FinTech Companies in Subprime Lending, Specifically in BNPL
Will Subprime FinTech Lending Collapse?
The Asymmetric Credit Risk for FinTech Companies in Subprime Lending
Charlie Martin
Founder and Portfolio Manager
Paradise Divide Capital
Disclosure:
Paradise Divide Capital, or “the Fund”, may maintain positions in the securities discussed in this article. It will be made clear to readers if the Fund maintains a security. This is not investment advice, either long or short, and is purely informational and educational. Do your own research and diligence if you want to take a position in a security!
Introduction:
Over the past few months, investors have had to become acquainted with yet another acronym: BNPL (Buy Now, Pay Later). BNPL offers an attractive value proposition for consumers. A consumer is able to buy their iPhone or favorite pair of sneakers with only a fraction of the price with the promise of paying for the item over a 6 or 12 month period. For example, if you went on Nike.com, you might encounter something in the checkout window that says, “Get you sneakers for only $12 a month”. It is easy to see how this is a big value proposition for the consumer. They are able to get the instant gratification of getting their favorite sneaker without paying for the thing!
BNPL also offers FinTech (Financial Technology) companies with a new and potentially profitable market. With BNPL, they are able to tap into a demographic who would not have previously been able to buy the product that they are buying. We will refer to these people in this article as “subprime” because they represent the greatest credit risk for a lender. They are inherently subprime because they cannot afford what they are buying, hence why they are using BNPL services.
FinTech subprime lending transcends this though. FinTech companies are moving into personal loans, auto loans, insurance, and all sorts of financial services. They are what are being called “neo-banks”. The companies that are leading this charge are companies like SoFi Technologies, Square Inc, and Affirm. The Fund does not have a position in SoFi or Affirm, but it does have a position in Square. They are offering banking services to people who were traditionally underbanked or did not even have access to a bank. These people were typically not banked because of fees associated with a bank account, poor credit, or even no history of credit. But, with some of these services, good credit doesn’t matter and it is as easy to set up your bank as it is a Facebook profile.
Today, or tonight for me, we will be analyzing the viability of these companies, through both high liquidity and low liquidity environments. This could also be referred to as high and low interest rate environments, but it is the inverse, so high interest rates mean generally low liquidity.
Analysis:
We will be mainly focusing on Square today. Mostly Square because I think it is more versatile and will be interesting to look at. Square is a multi-faceted business. On one end of the business, they have the checkout service at many SMB’s (small medium businesses). We won’t be focusing on this today because it has little to do with the asymmetric, subprime credit endeavors that Square is taking on. The other part of their business is the CashApp. Originally just an analog to Venmo, the CashApp now provides a wide array of services with anything from crypto investing to personal loans to BNPL services, but those BNPL services will be available in a couple of months.
It will take a couple of months for those BNPL services to be available because Square announced on August 1st, 2021 that they would be acquiring Afterpay, a BNPL company, in an all stock, 29 billion dollar deal. I won’t waste time on my opinions or the details of the acquisition because it isn't super relevant to the article as a whole.
The direction that Square seems to be going in is to make the CashApp a bank, and they want to make that the majority of the business. From a revenue growth standpoint, that seems like a brilliant idea, but it has many holes in it from an execution standpoint.
Let’s start with BNPL because I have the strongest opinions on it and because I think that it involves the most credit risk for Square. First off, as I mentioned above, the people that are choosing to purchase things through a BNPL service are the worst possible people to lend to. Because they are opting to use a BNPL service, it inherently signals that they are buying something they can not afford. It is not like a family who takes out a mortgage on a house and who has proof of income, proof of credit, and is generating enough cash flows to pay both the principal and the interest on the debt. It is irrational consumers who think they only have to pay 25 dollars to get a pair of Bose headphones. The products that these people are buying are generally in the range of 150-500 dollars and most likely not more than 1000 dollars.
Credit Karma survey reported that over 40% of Americans using BNPL services have missed payments, reinforcing the fact that it is used not with any foresight of paying for the item. And over 72% of people who used these services said that their credit score as a result of using BNPL. But no longer do I want to blame the irrational American, I would like to direct my attention to the irresponsible risk taken by FinTech companies when they do BNPL services.
First off, if we start with the 40% of people who have missed payments, we can rationally assume that at least 15% of that 40% will have defaulted on their loans, or will have never been able to pay off their loans. If we take the high yield credit market in corporate bonds, we will see that today there was an average credit spread, or the spread that investors will pay to incur incremental risk in bonds, of 3.37. That implies a yield of somewhere >4.5%. This is decently low for high yield credit because we are currently in a high liquidity environment. To price these high yield bonds at this, credit investors assume a default rate of 1.5%> and maybe even south of 1%. BNPL will have an expected default rate of somewhere around 6% from my calculations above. This means that investors would demand around 4 times the credit spread to incur the risk of holding this extraordinarily risky credit on their books. That assumes a >13 or 1300bps credit spread for these FinTech companies to make these BNPL loans and incur the risk that comes along with holding something this risky.
To begin, when a consumer sees a greater than 14%, which would be the implied interest rate according to my calculations of credit spreads, markup to use BNPL, they might think twice about using this service. Most FinTech companies will probably want to offload these assets off their balance sheet, so as not to convey that the company is so exposed to risky credit. While this might be easy to do now because of the amount of liquidity in the system, when the liquidity dries up, these high risk credit will be the most unattractive thing possible. It doesn’t even sound attractive to hold right now given the risky and impulsive nature of these loans. When the next downturn occurs, the credit spreads on these loans will skyrocket, as the people most sensitive to a downturn are the most likely people to be using BNPL and the FinTech companies will not be able to get these risky assets off their books because nobody wants high yield credit during a downturn.
The banking services that Square, or the CashApp, offers or will offer similar risk. Since they are serving the people with the worst credit, they will be subject to high default rates and high credit spreads, and they will likely find themselves stuck with all these corrosive assets on their balance sheet. While I can envision lower default rates on personal loans and auto loans than BNPL, it is still extraordinarily risky just out of the people that they are lending to. For this reason, I think that all lending services that these FinTech companies engage in are asymmetric credit risks that could potentially crater the entire business.
One final thing that I would like to talk about is the possible multiple compression that these FinTech companies could face if they do become “neo-banks”. FinTech companies, today, are largely trading on a price/sales multiple. For example, Square is trading at 8 times the last twelve months’revenue to enterprise value. This is decently expensive, but by no means the most expensive stock in the market. On the other hand, banks largely trade on a price/book multiple, which is the ratio between their price and the value of their balance sheet. For example, JP Morgan trades at 1.8x book value and Bank of America trades at 1.3x book value. Square on the other hand trades at 46x book value. So, if investors start to believe that Square is more of a bank than a technology company, there could be quite the wild multiple compression. No, I am not suggesting that Square will trade at 1.5x book value, but if Square trades at 10x book value that means a 75% decline in their share price. What a gnarly decline that would be! So if they want to avoid wiping out 75% of the wealth of their shareholders, maybe they should consider not becoming a bank.
Conclusion:
Wow! This was a long one. Thank you all so much for reading if you got here. It truly means the world to me that you all would take time to read this. I love you all so much <3. If you have any questions, feel free to leave a comment or send me an email. I’m sure I made typos as well, I’ll fix those over the next couple of days. Thank you all so much for reading!!!!!!!!
Excellent article, and I of course agree with your analysis. Recent history offers two examples where uncritical lending to the worst borrowers led to devastating results for society (not just investors): 1. the subprime mortgage crisis - - really, stupid government affordable housing policies through Fannie/Freddie promoted by Wall Street; and 2. the stupid federal student load lending practices to student borrowers (and their parents) for unqualified borrowers to pursue worthless degrees that have led to $1.5 trillion in student loans, most of which are worthless. Are the universities that got this "free" money going to stand behind the product they sold to the unsuspecting students? Perhaps we should confiscate their endowments?