Hello FTT faithful, I’m Ryan. Long time reader, second time guest poster.
I’m excited to dive into the second half of this guest post and spill the beans on some very achievable improvements to the consumer lending industry.
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Ryan here again. Last time, I covered some of the basic mechanics of the mortgage industry:
- Mortgages are, at face-value, very risky
- GSEs like Fannie Mae reduce lender risk by guaranteeing liquidity (secondary market)
- Data quality and other standards establish qualifying criteria for those guarantees
So... what problem are we solving?
Increasing liquidity in the consumer lending space by implementing an easily adoptable data underwriting standard (like those that exist in mortgage) will lead to better market outcomes for all, and sustainable growth for lenders.
For consumers, this means easier and eventually cheaper access to capital. There is no shortage of BNPLs, with over 170 current players in the market. This competition allows the companies with the best product, service and terms (i.e. interest rates) to win over the long haul, helping out consumers.
How consumer lenders fund loans
Back to basics. Consumer lenders fund loans in a few different ways:
- Balance sheet lending: When the lender holds the loans on their balance sheets, raising capital through debt or equity financing to fund the loans.
- Marketplace lending: When the consumer lender does underwrite the loan but sells it in the short-term to the secondary market (e.g. banks, funds, insurance co’s etc).
Most BNPLs operate as balance sheet lenders. They raise capital through equity (i.e. venture fundraising) and use that capital to deploy loans. While BNPLs also borrow from banks to fund loans, there is not a robust secondary market. This means BNPLs are keeping those billions of dollars of loans on their balance sheets.
Is that bad? Not inherently. It creates accountability for BNPLs to mitigate risk when issuing loans.
BUT, it does mean that consumer lenders like BNPLs need to constantly raise capital in order to fund loans. That’s not efficient. Lenders are much better suited to do what they do best: underwrite and lend to borrowers at the appropriate risk levels.
The lack of a thriving secondary market for BNPLs and other consumer lenders limits efficiency and overall growth in the space. This is similar to what occurred in the mortgage industry before GSEs created en masse liquidity by guaranteeing the purchase of qualifying mortgages.
Expanding the consumer lending secondary market…
As mentioned in my first post, consumer marketplace lenders have experienced significant bumps in the road in part caused by a lack of standardized criteria that allows secondary buyers to transparently assess risk. Marketplace lenders do not design their business models on holding loans on their balance sheets for long periods of time, relying on a handful of buyers to create liquidity.
When those buyers get spooked, perhaps by a macro-economic downturn, all of the sudden the marketplace lender has limited liquidity to continue issuing loans.
Modern balance sheet consumer lenders (e.g. BNPLs) do not have this problem because they do not rely on the secondary market…
…but they do rely on outside capital (VC fundraising) to fund the loans. While the cost of VC capital is relatively “cheap” at the moment, this will not always be the case. Both BNPLs and marketplace lenders need to build a more robust secondary market in order to diversify their capital sources and increase resiliency to withstand bear markets.
Better data standards
Labels (like the “non-GMO” stickers you see on food) are helpful to buyers because they increase trust between parties. In mortgage, Fannie Mae’s “Day 1 Certainty” label gives secondary buyers confidence that the underlying information used to underwrite the loan met the highest quality and accuracy standards.
Before I get hate-tweeted, let me say that it is extremely unlikely a GSE will step in and guarantee liquidity for consumer loans. There are not the same risk barriers (long loan terms, massive individual sums) as exist in mortgage.
But hear me out. Balance sheet lenders (BNPLs and others) will benefit greatly from a more robust secondary market because it will:
- Diversify capital sources and reduce efforts needed to raise loan capital
- Reduce risk exposure by selling qualifying loans into the secondary
- Allow for continued investment in the technology and distribution channels to underwrite more loans
Establishing industry-wide data standards for consumer lending underwriting is a relatively easy step to start improving the secondary market. This will give buyers confidence that the data used to underwrite the loan, such as employment and income, meets the highest standards possible.
Consumer lenders will create more resilient business models and consumers will continue to have easier and cheaper access to capital, while institutional investors gain risk-mitigated exposure to a growing asset class.
It’s a win-win-win.