At the root of ongoing challenges facing the marketplace lending industry is – investors are beginning to lose confidence in the promise of returns by non-bank online lenders/originators primarily in the Above Prime: Refinance: Debt Consolidation credit purpose segment, that funded ~$10BN in loans in 2015.
Why is this happening now and why not any earlier?
Among other aspects, a few observations and inferences from news, white-papers in the media are as below:
- Executives at certain marketplace lenders have been incentivized to achieve top-line growth in an increasingly competitive market
- Consequently, between 2013 and 2015 while average FICO’s in this credit purpose segment have been declining, average interest rates on these new loans have also been trending lower, on the pretext that credit models have been getting smarter. This has helped to generate incremental volumes whilst keeping acquisition marketing costs within budget.
- It typically takes between 18-24 months for losses to peak; the decrease in returns from an increase in actual defaults suggests that credit risks may have been under-priced and originators in this credit purpose segment are now increasing rates.
Unlike credit cards, where you can increase and decrease APR’s to manage credit risk on a real-time/ monthly performance basis, in the unsecured, installment loans business getting pricing ‘right’ at the outset is critical to ensure promised returns to investors.
Furthermore, under-pricing credit risk for installment loans will reduce investor returns (as currently observed) and overpricing credit risk attracts ‘adverse/ negative selection’. The latter increases ‘bad-good ratios’ and makes the dollar losses from most risky loans even greater than originally budgeted for. Where should lenders draw the line between ‘pricing credit risk’ and outright declining applicants with probability of defaults that are higher than tolerance limits?
In addition to solving for credit risk, lenders could also consider building a pricing framework that is ‘Risk and Returns’ based as against pricing purely based on credit risk + funding costs and competitive pressures.
This approach will deliver differences in results (especially in lower FICO bins) depending on the variable chosen to measure target Returns. Some more commonly used measures for Returns on investing in installment loans include:
- Return on Average Assets,
- Return on Equity and
- Net Present Value of expected cash-flows (similar to pricing a bond)
So then, what should be the most preferred measure for Returns – for the purposes of pricing?
This would depend on the investor:
| Investor | Banks (Whole Loans) | Non-Banks (Whole Loans) | ABS Investor |
| Measure of Returns | ROE? | ROA? | NPV? |
If the investors are FDIC insured banks (buying whole loans), governed by strict risk reserve requirements, pricing that is based on Risk adjusted Return on Equity targets are probably the most suitable. Conversely, less risk averse investors such as Hedge Funds and Self-directed individuals could benefit more from pricing that is linked to Return on Average Assets that may or may not be adjusted for reserves for losses. Moreover, as these loans become more liquid and trade through ABS in a secondary market, target NPV’s could be the most suitable basis for pricing these loans?
Some additional questions to consider for devising a great unsecured installment loan pricing strategy include:
- Should the choice for measuring Returns (ROE, ROA or NPV) vary by Risk Grade?
- Do the shapes of loss curves and prepayment curves significantly vary by term and risk grade and how do these impact the calculation of returns and pricing?
- To what extent should one consider ‘competitor pricing’ in the scheme of things?
- Among other aspects.
Disclaimer: The views and opinions expressed in this article are solely those of the author. Examples of analysis performed within this article are only examples. They should not be utilized in real-world analytic products as they are based only on very limited and dated open source information.
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