Home Product listing Buy Now Pay Later joins the list of subprime losers

Buy Now Pay Later joins the list of subprime losers

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In each down cycle of the market, subprime mortgages appear. It may not take center stage, as it did during the financial crisis of 2007-2008, but it is still surfacing. When times are good, finance companies are happy to ignore the pitfalls of lending to riskier borrowers. When times turn bad, problems arise.

This time, the Buy Now Pay Later (BNPL) phenomenon is carrying the torch. Founded in the ashes of the last recession, the BNPL industry has devised a new way to facilitate consumer lending, swapping revolving credit for fixed installments.

At the top, valuations were pricing in rapid growth. Affirm Holdings Ltd. came to market via an initial public offering with a market capitalization of $12 billion, which peaked at nearly $50 billion (about three times Deutsche Bank AG). Afterpay Ltd. was acquired by Block Inc. (formerly known as Square) for $29 billion, and Klarna Bank AB raised private funds at a valuation of $45.6 billion.

As interest rates rise and recession fears grow, valuations have suddenly reversed. Affirm stock is down 90% from its peak, and last week it was revealed that Klarna was in talks to raise new equity at a valuation as low as $6 billion.

The rapid downgrade reflects many of the problems that subprime lenders have historically faced. Essentially, they are exposed to three cycles that generally overlap, as is the case today.

The first is the credit cycle. Buy Now Pay Later is easy to access but, like all forms of credit, there is adverse selection – the healthiest borrowers generally don’t need it.

Some consumers use BNPL to avoid paying credit card interest, but according to a survey, others use it to make purchases they couldn’t otherwise afford, to borrow money without a credit check or because they can’t get approved for a credit card. . Affirm looks into this. At the time of its IPO, it revealed that it approved an average of 20% more customers than comparable competing products.

The result is a clientele that skews subprime. According to credit bureau TransUnion, around 69% of BNPL users are subprime or near-prime. In a favorable credit environment, the distinction may not show up in earnings, but when the environment changes, defaults – and write-offs – will increase.

Last year was particularly benign for consumer credit. Charges in the United States were lower than at any time since the mid-1980s. Yet even with this tailwind, Klarna’s realized loan losses rose as it continued to grow more fast, reaching 7.7% in the second half of last year at a time when total US consumer losses were less than 1%.

The core skill in the lending business is not so much giving money as getting it back – and that becomes more difficult during a recession.

The second cycle is the funding cycle. With the exception of Klarna, BNPL companies do not raise deposits and therefore rely on capital markets to fund loans. But markets can be fickle, freezing up when you least want it and need it most. Last month, Affirm priced a securitization deal – bundling loans and selling tranches to investors – at a yield of 5.65%, compared with a yield of 4.34% on a deal in April.

Often, conditions in funding markets follow consumer credit conditions, but sometimes they walk at their own pace, confusing lenders who rely on them.

Following the Russian debt crisis in 1998, market turmoil led to a sharp drop in investor demand for risky assets, including subprime securitizations, even before a recession set in three years later. Subprime originators have seen their own borrowing costs skyrocket. In the two years since the crisis, eight of the top 10 subprime lenders have declared bankruptcy, gone out of business or sold to stronger companies.

The third cycle is the cycle of actions. Before BNPL became a buzzword, Klarna was doing just fine. It became profitable within six months of its launch in 2005. But then venture capitalists came along and lured the company with cheap capital to fund faster growth. Since 2019, continuing a meteoric expansion, it has recorded 11.8 billion Swedish kronor in operating losses, or about $1.3 billion. At the same time, its valuation has fallen from eight times sales in mid-2019 to 37 times sales in mid-2021.

One of the challenges any investor faces is discerning a secular trend from a simple cyclical trend. But all loans are cyclical, and with multiple cycles to navigate, the pitfalls are impossible to avoid. With its valuation now just four times lower than earnings, Klarna – like its peers – is starting to reflect that.

More from Bloomberg Opinion:

• Banks prepare for a storm that may never come: Paul J. Davies

• Why India doesn’t like to buy now, pay later: Andy Mukherjee

• Buy now, pay later? You might regret it: Alexis Leondis

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly financial newsletter Net Interest.

More stories like this are available at bloomberg.com/opinion