What does the rate hike mean for online lenders?
Murat Giray Kaya | E+ | Getty Images
The past half-decade has been a gold rush for new online lenders. As banks drown in regulation and the explosion of big data opens up space for more new entrants, a wave of web-based lending companies has emerged in an effort to attract more consumers.
The Federal Reserve’s zero interest rate policy also certainly helped. Yield-seeking investors desperate for fixed-income returns have essentially played the role of bank roll, pouring money into new lending platforms.
Known as market lenders, these companies made nearly $9 billion in loans in 2014, up from about $100 million in 2009, according to venture capital firm Foundation Capital. While some of this money has been funded by banks, the majority comes from private equity firms, hedge funds, family offices and retail investors.
Read moreWhy startups need to start listening to the Fed
Now that Fed Chair Janet Yellen has signaled that the fed funds rate will rise above zero for the first time in more than six years, a key question is whether these investors will return to Treasuries. and corporate bonds, taking the easy money out of tech start-ups. punch bowl.
So far, it’s not happening. Just this week, 4-year-old SoFi, which refinances student debt and offers mortgages and personal loans, said it crossed the $2 billion mark for loans issued. SoFi has enough growth mojo to launch a competition whereby it will forgive a student loan – up to $600,000 – per term.
Read moreDrowning in student debt? Maybe you can refinance
And Upstart, a new entry into the online lending market, won a large vote of support from private equity firm Victory Park Capital, which said it was increasing its commitment to fund $500 million in personal loans. , compared to $100 million.
“Their results give us confidence that this emergence [lending] fills a critical market need,” Tom Welch, director of Victory Park, said in a statement.
Of course, there is no doubt that higher interest rates could eventually hurt these new lenders. Loans are rate sensitive, so prices need to rise to protect margins. But for now, market demand for loans is skyrocketing.
Let’s take a closer look at the potential impact of higher lending rates.
Even though the Fed suggests that rates will rise from zero, the average market participant forecast is that the benchmark rate will hit 0.625% by the end of this year and 1.875% by the end of 2016.
Read moreLendingClub’s silent backer is ready for a windfall
Anything below 2% is really not of concern, says Peter Renton, founder of industry publisher Lend Academy. For lenders who deleverage borrowers at 20% interest and consolidate them into loans at rates of half that amount, the remaining spread offers a lot of profit to investors.
Another reason new lenders may be confident in a higher interest rate market is that they have a backlog of potential customers. SoFi and others are proving they can make money for investors while simultaneously attracting a new generation of borrowers who want to avoid traditional banks.
“I don’t think for next year, if rates go up 100 basis points, it’s going to have a lot of impact on the whole landscape,” said SoFi chief executive Mike Cagney, who is also helping manage a hedge fund. “IIt may affect the industry, but you’re talking about a pretty big backup.” (One percent equals 100 basis points.)
Read moreUpstart: where you can hope to stake the next Zuckerberg
Generally speaking, alternative lenders are one of the main reasons why venture capitalists are increasingly interested in financial technology in general. Venture capitalists injected $1.07 billion into financial services start-ups in 2014, up from $512.1 million in 2013 and $272.7 million in 2012, according to the National Venture Capital Association. .
And LendingClub, the largest of the new class of US online lenders, raised more than $1 billion in an initial public offering and is currently valued at $7.3 billion. Small rival Prosper hit $2 billion in loans issued in October, just six months after topping $1 billion.
Investors in LendingClub and Prosper loans typically see annual returns of 5% to 10% and even more.
Target youth, pre-prime demographic
Other players have entered the lending space in recent years to provide small business loans, payday loans, merchant cash advances, and real estate. Foundation Capital, a funder of LendingClub and commercial lender OnDeck Capital, estimates that this new group of lenders is competing for a potentially trillion-dollar market by replacing many traditional banks.
For new entry Upstart, founded by former Google executive David Girouard, a key strategy has been to target a younger demographic (average customer age 28) who is being harassed by credit card rates and fees. , and place them in consolidated loans at a better price. Girouard describes them as “pre-prime” because data shows they are low risk even without the credit history to qualify as prime borrowers.
Read moreLendingClub IPO to reward Silicon Valley banking approach
As an example, Upstart halves a 20% credit card rate for the borrower, still leaving investors with a return after fees and expected defaults of around 10%.
“On the borrower side, we have 1,000 basis points between the debt they are refinancing and the average loan on Upstart,” said Girouard, whose company has issued about $70 million in loans. “We would be fine if prime rates were to go up 100 to 200 basis points. It could have an effect, but not a catastrophic one,” he said.
Again, Upstart has a monstrous spread even to the Fed’s rate direction, giving the company plenty of leeway to raise prices if needed without hurting borrowers.
Read moreJune or September: when will the Fed raise rates?
The market’s lending space will continue to remain attractive, in part because there are few other lucrative options. Lend Academy’s Renton simply asks: Where are bond investors going?
The 10-year is currently yielding 1.87% and the 30-year is at 2.48%, which aren’t exactly big yields. “Now that’s a very large premium they’re getting over the risk-free rate,” said Renton, who is based in Denver. “That premium doesn’t have to be that big for a lot of people to justify the investment.”
Build a clientele
SoFi has taken a new approach to market lending. Early on, the company raised funds from alumni of universities such as Stanford and Harvard, and used that money to refinance graduate loans from those schools at better rates. The company has since moved into personal loans and mortgages and has a wide range of investors.
Cagney acknowledges that refinancing student debt is Fed-sensitive because existing loans are based on rates that were set years earlier. But it doesn’t matter if those loans become less profitable, because getting recent college grads to trust the brand gives SoFi a huge potential customer base.
In the longer term, it is thought, these younger consumers will eventually seek to marry, own and travel the world, mitigating short-term risks.
“If we didn’t make any margin on student loans, we would still because of the relationship we’re building,” said SoFi’s Cagney.