Exactly a decade ago, in September 2008, I was sitting in my office in Kiev, Ukraine with the CFO and CRO of the consumer lending bank I co-founded two years prior. Lehman just went bust. Global markets were in a meltdown. Who will fall next? We were sitting on a $50M pile of interbank cash after a recently closed equity round. Given the circumstances, “who can we trust” was much more than just an academic question.
Can we trust City? Or Paribas? Who is too big to fail? And which governments will have the staying power to support their national leaders without going bust themselves? For a while, we were kidding around that we should convert all our interbank into cash and gold, put it in our vault, and take turns standing watch by the vault with Kalashnikovs. After a couple more days passed, and the global gloom deepened, this course of action gained considerable appeal. (To find out what we finally decided, I am afraid you will have to persevere to the end of this article.)
Today, Goldman and Morgan are again making headlines with their predictions of an impending bear market. To be fair, we are now in the longest bull market in history, and it doesn’t take a rocket scientist to figure out that, statistically speaking, what goes up must go down, and soon. However, too few of the fintech companies and investors seem to spend any time contemplating the profound cyclicality of the retail lending industry. To understand what lies ahead, let’s take a quick look at the lending value chain.
Defining the Lending Value Chain
The dictionary definition of a value chain is “the process or activities by which a company adds value to an article”. In the context of a lending activity, there are four activities that we should focus on:
- Origination – finding the customer and causing him to apply for a loan.
- Underwriting – evaluating the customer’s credit risk profile and either accepting or declining his application.
- Servicing– a multitude of activities performed while the customer remains on the books, including processing his payments, informing him of his balances, addressing his inquiries, as well as dealing with non-performing loan (NPL) customers.
- Financing – the money lenders of our era have access to a bewildering array of potential financing sources, ranging from deposits and current account balances (what’s referred to as “organic resource”) to various types of “wholesale” financing, such as bank and non-bank commercial loans, bonds, securitizations, and a variety of so-called “P2P” mechanisms (mostly a “catch-all” glorified descriptor for short-term high-yield wholesale securitization lines).
Lending Value Chain Is Hyper Cyclical
In good times, liquidity flows freely. The Financing value chain element is unconstrained. Putting all this free-flowing money to work is where the profit is. In the pre-2008 days, Origination companies used to be called “Credit Intermediaries” or “Loan Brokers”, and clever people made good money building them and selling them at huge multiples to big banks. In the glorious fintech days, we call such companies “P2P Lenders.” Tools of the trade may change, as nowadays more applications are originated online. But the fundamental business model is still the same and is focused on loan origination.
The above happy picture changes considerably once the liquidity cycle turns. The high yield and all other wholesale financing markets are notoriously cyclical and can shut down completely for extended periods of time. This is exactly what we observed in 2008-09 and what brought down such massive institutions as Northern Rock and Lehman Brothers. In this scenario, the lenders that are unable to refinance their liabilities will be caught with their pants down. And in times like these, origination no longer matters. What matters is whether one has access to Money – the raw material for making loans.
What will also matter, of course, is how much attention one paid to the Underwriting and Servicing parts of the Value Chain – as it is the tough times like these that test with a vengeance true portfolio and operational process quality. It is easy to keep NPLs low as a percentage of the portfolio when the portfolio is growing at double-digits month on month. But when the economy is slowing down and portfolio growth turns to negative, the cost of risk tends to spike massively. And as the lender tries to intensify its collection and pre-collection actions against the background of rapidly growing delinquency, operational scalability quality is revealed.
As an angel investor, I lost quite a bit of money when two of my Credit Intermediary investees went bust in the 2008 downcycle. Lost money is a very talented teacher. Student remembers with 100% retention.
Do I hear a popping sound?
The effects of a risk expansion/liquidity compression “double-whammy” event that lies ahead are well illustrated by the graphs below.
US Credit Cards are among the most stable consumer lending markets, with well developed credit models, credit bureaus, and all other consumer lending risk infrastructure. Yet, when the 2008 crisis hit, US credit card delinquencies nearly doubled from their 2006 trough. In the Emerging Markets, the Cost of Risk spikes during the downcycle tend to be much more violent then in the OECD economies, and can reach 3-4x from their “normalized” levels.
During the crisis, the Cost of Risk increase tends to coincide with a severe liquidity squeeze. The most relevant proxy for the type of funding currently attracted by the P2P platforms is Corporate High Yield. As S&P went into correction mode in 2008-09, all high yield markets underwent a shutdown, as the risk appetite of institutional lenders dropped to zero. As a result, Emerging Market high yield bond spreads peaked at over 25%, a whopping 10x increase on the pre-crisis level. New issuance of high yield dropped by two-thirds. And unsurprisingly, defaults skyrocketed, as overextended borrowers found it impossible to refinance their obligations and/or unable to absorb such a massive increase in their Cost of Funding against also mushrooming Cost of Risk and Cost of Servicing.
Were the above trends unpredictable? Not really. As we can see from same graphs, a very similar thing happened in the previous downcycle – the burst of the Great Internet Bubble Of 2000. But when the times are good, everybody is too busy partying to plan for survival during the discontinuity that lay ahead. The “Black Swan” psychological effect of assigning a lower probability to an unpleasant event is a well-documented cognitive bias.
The intensity of a bubble bursting tends to be in direct relation to the size of the bubble. In this regard, we should note the huge expansion of the High Yield Corporate Bond Issuance since the last correction, fueled by the global Quantitative Easing monetary experiment. The bubble is now a multiple of the size that we faced in 2007. Time to get ready for a very loud popping sound.
To draw on a popular song, we are on the verge of experiencing a profound “ain’t no sunshine when she’s gone” moment.
Over the last couple of years, VCs and yield seeking investors have deployed over USD 200M into various P2P/Digital Lenders across Southeast Asia. This number is easily triple or quadruple that if we add India. I think a lot of future losses could be avoided if investors asked a few of the following simple due diligence questions before taking a leap:
- Has the company’s management been in consumer finance long enough to have seen a downcycle?
- Does the team understand and manage product-level profitability drivers proactively: not only on CAC (customer acquisition cost) but also COF (cost of funds), COR (cost of risk) and COS (cost of servicing) levels on a vintage basis?
- Can the teams competently and quantitatively address simple risk questions regarding vintage write offs and delinquency bucket flow rate trends?
- Does the originator have quality Underwriting and Servicing processes? Are there people in their teams who know what they are doing in this department?
- What does the funding strategy look like? Is there enough diversity in the funding sources?
- Are liabilities locked in for the long term or is there a lot of refinancing risk?
I recently saw a LinkedIn post by a CRO of one of the regional digital lenders saying something like: “risk management for unsecured consumer lending is an art rather than a science… discuss.”. I didn’t bother commenting. But I do feel very sorry for his shareholders when the cycle turns.
So how does one protect himself from this downcycle? At FORUM, we have strategically positioned our investment portfolio to have a considerable degree of cyclical resilience.
Our AsiaCollect business (NPL management) is the ultimate counter-cyclical proposition, that will thrive when the cycle turns. CredoLab (alternative credit scoring) should also be able to command much higher fees for its services once the Cost of Risk spikes up. Both of these B2B businesses are focused on the Risk Management (Underwriting/Servicing) part of the value chain, which becomes a bottleneck in crisis times.
As to our B2C balance sheet businesses, AsiaKredit and SolarHome, they are operating in high-spread space, and are already profitable at the product level. Within the next few months, both companies should be cash generative on an unleveled basis. They have proactively brought world-class Consumer Finance Risk Management know-how into their Underwriting and Servicing, with robust risk MIS and well documented, optimized and standardized processes. And they are working on the diversification of their Liabilities to achieve downside resilience, and capture market share when other lenders pull away.
Last but not the least, Homsters is a SaaS business where a significant proportion of revenue is based on acyclical long-term license fee subscriptions.
Who Can You Trust
As promised – our 2008 cash pile story has a happy end. We divided up our liquidity reserve between the Central Bank and the Ukrainian subsidiary of the Bank of Georgia. We figured, as the dominant retail bank in a largely agricultural (and hence not very cycle-prone) country, Bank of Georgia should have a lower-than-average cost of risk spike, and it also has access to a huge latent pool of retail deposits. And, we were joking, if things get so out of hand globally that the Russians annex them – we are arbitraging to a petrodollar-rich Sberbank of Russia.
The trade paid off. Sure enough, the Georgians managed to keep their portfolio risks under control, they raised their deposit interest rates, bolstered their liquidity, and paid us back with a handsome profit.
When the liquidity cycle turns, will your P2P investee be able to do that?
Greg will be the trainer and panelist for the AngelCentral Deep Dive Series Webinar – Early Stage FinTech Investing in the Era of COVID-19: What’s Hot and What’s Not! Join us for the session here
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