The boom in online lending is a sign of the next credit bubble

bubble burst

Hanser Alberto #2 of the Texas Rangers blows a big bubble as it bursts during an MLB game against the Toronto Blue Jays on May 4, 2016 at Rogers Center in Toronto, Ontario, Canada.

Tom Szczerbowski/Getty


Debt is fine. More debt is better. Financing consumer spending with debt is even better – that’s what economists have been preaching – because the goods and services consumed disappear after being added to GDP, while debt, which GDP ignores, stays up. ‘until it’s repaid with future earnings, or until it blows up.

Companies too have been on a borrowing spree. Unlike consumers, they have no intention of repaying their debts. They issue new debt and use the proceeds to pay off maturing debt. Financing share buybacks and dividends with debt is ideal. This is called “unlocking the value”.

The debt must always grow. To this end, the Fed manipulated interest rates all the way down. In fact repay and reduce debt bears the terrible nickname, widespread during the financial crisis, of “deleveraging”. It is synonymous with “The end of the world”.

At the institutional level, “debt” is replaced by a more politically correct “leverage”. More leverage is better. Especially if you can borrow short-term at near zero cost and bet the proceeds on risky and illiquid long-term assets, such as real estate, or securities that become illiquid without warning.

Derivatives are part of this institutional equation. The notional value of derivatives in the US banking system is $190 trillion, according to the Office of the Comptroller of the Currency. Four banks hold more than 90%: JP Morgan ($53 trillion), Citibank ($52 trillion), Goldman ($44 trillion) and Bank of America ($26 trillion).

More than 75% of these derivative contracts are interest rate products, such as swaps. With them, heavily indebted institutional investors who borrow short-term to invest in illiquid long-term assets protect themselves against fluctuations in interest rates. But Treasury yields and mortgage rates have moved violently in recent weeks, and somebody came out a lot of money.

These credit bubbles always burst to the surprise of these institutions and their economists. When they collapse, the above “end of the world” scenario of orderly deleveraging turns into forced deleveraging, which can get messy. Assets that were previously taken for granted are either revalued or simply evaporated. But they had been given as collateral. As a result, the warranty no longer exists….

In amount, a lot of money can be made on this debt, in multiple ways, including in interest and fees taken directly from consumers, and in fees taken by Wall Street, for example by repackaging consumer or corporate debt. risky into a highly rated asset. – backed by securities which are then distributed to institutional investors who use the proceeds of the leverage effect to acquire them. But no problem; it’s just OPM (other people’s money).

Then there is the peak. It is marked by “totally crazy loans”. We saw this peak. One sign: White-hot online peer-to-peer lenders, or rather subprime consumer lending “platforms.” These were Silicon Valley inventions that would revolutionize lending and bankrupt banks. They operate proudly regardless of risk. They borrow from individual and institutional investors and provide unsecured personal loans to consumers. They are also repackaging consumer loans into bonds and selling them to overenthusiastic institutional investors.

There are several such platforms, including Lending Tree, CircleBack, LendingClub, LoanDepot, and Avant.

Avant provides unsecured personal loans up to $35,000, ranging from 2 to 5 years. It targets subprime borrowers with credit scores as low as 580 who want to consolidate their debt, i.e. turn their credit card balances into a personal loan so they have the flexibility to borrow more on their credit cards.

It is expensive debt. There are fees, including an origination fee between 0.95% and 3.75% of the loan amount. According to Nerdwallet, who reviewed Avant’s loans, annual percentage rates range from 9.95% to 36%!

Person, much less a struggling subprime borrower, will repay a loan over five years with an annual interest rate of 36%. Or heck, even 26%. These usurious rates on unsecured personal loans practically guarantee that the borrower will have to default.

Still, borrowers typically receive funds the same day, according to Nerdwallet, though it can take up to a week in some cases. And investors were eager to buy these loans, which is the definition of “totally crazy loans”. It marked the peak of the bubble.

Then it started to unravel. Amounts can be small in the multi-trillion dollar scheme. But these are red flags that soothsayers actively ignore.

Citing unnamed sources “knowledgeable about the matter,” Bloomberg reported that many of these subprime consumer loan-backed securities, which were issued last year, are already spoiling:

Delinquencies and defaults are reaching key levels known as “triggers” for at least four different sets of obligations. Exceeding these levels will force lenders or underwriters to begin repaying bonds sooner. Avant Inc. and its underwriters, for example, are going to have to start repaying three of its asset-backed notes….

The four deals totaled more than $500 million, or nearly 20% of the $2.8 billion in online consumer loan-backed securities sold in 2015. But securitized loans only account for a small portion loans arranged by online lending platforms, which in 2015 reached $36 billion. Bloomberg:

Online lending showed other signs of weakening. Last month, LendingClub Corp. raised interest rates and tightened standards for at least the second time this year after seeing an increase in delinquencies among its customers, especially those with the most debt.

Online lenders settled only a small portion of the $3.7 trillion in outstanding non-mortgage consumer debt, mostly student loans, auto loans and credit card balances. While credit cards are still holding up, student loans have terrible delinquency rates, and subprime auto loan delinquencies have soared to their highest in six years.

LoanDepot began providing unsecured online consumer loans last year. In September of this year, according to Bloomberg, losses on its consumer loan-backed securities exceeded limits set by its underwriters. Other online lenders are just trying to hang on:

Chicago-based Avant cut its monthly lending target by about 50% this summer and decided to downsize accordingly, while Boca Raton, Fla.-based CircleBack Lending stopped granting new ready earlier this year.

Several lenders have changed direction this year. LendingClub’s Laplanche left in May and on Monday, Prosper Marketplace said its CEO Aaron Vermut would step down in December.

Given the amount of the central bank


liquidity

flowing through the system, the dismantling of the credit bubble will likely be a slow and protracted process starting in these sorts of pockets here and there.

The online lending debacle isn’t the only red flag. There are others. And now we have this: it is the “risk-free” bonds that have bloodied investors. Read… Bond Carnage Hits Mortgage Rates. But this time it’s real


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David A. Albanese