Buy now pay later joins list of subprime losers

In every down market cycle, subprime rears its head. It may not take center stage, like it did in the 2007-08 financial crisis, but it always surfaces. When times are good, finance companies are happy to ignore the pitfalls of lending to the riskiest borrowers. When times turn bad, the problems emerge.
Carrying the mantle this time around is the Buy Now Pay Later (BNPL) phenomenon. Founded in the ashes of the last downturn, the BNPL industry devised a new way to facilitate lending to consumers, swapping revolving credit for fixed installments.
At the peak, valuations discounted rapid growth. Affirm Holdings Ltd came to market via an initial public offering with a market capitalisation of $12 billion, which peaked at almost $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 funding at a valuation of $45.6 billion.
As interest rates rise and recession fears mount, though, valuations have suddenly reversed. Affirm stock is down 90% from its high, and last week it was revealed that Klarna is in talks to raise new equity at a valuation as low as $6 billion. The swift derating reflects many of the issues subprime lenders have always faced. In essence, they are exposed to three cycles that typically overlap, as they have 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 don’t usually need it. Some consumers use BNPL to avoid paying credit-card interest, but according to one survey, others use it to make purchases they otherwise couldn’t afford, to borrow money without a credit check or because they can’t get approved for a credit card. Affirm leans into this. At the time of its IPO, it disclosed that it approves on average 20% more customers than comparable competitor products.
The result is a customer base that skews subprime. According to credit reporting agency TransUnion, about 69% of BNPL users are subprime or near prime. In a favourable credit environment, the distinction may not show up in earnings, but when the environment changes, defaults — and writeoffs — will rise.
Last year was an especially benign one for consumer credit. Charge-offs in the US were lower than at any time since the mid-1980s. Yet even with that tailwind, Klarna’s realised loan losses increased as it pursued faster growth, reaching 7.7% in the second half of last year at a time when aggregate US consumer losses were running below 1%.
The core competence in the lending business is not so much giving the money away but more in getting it back — and that becomes harder in a recession.
The second cycle is the funding cycle. With the exception of Klarna, BNPL companies do not raise deposits and so depend upon capital markets to fund loans. But markets can be skittish, seizing up when you least want them to and most need them. Last month, Affirm priced a securitisation deal — bundling loans together and selling slices to investors — at a yield of 5.65%, up from a 4.34% yield on a deal in April.
Often, conditions in funding markets track conditions in consumer credit, but sometimes they march to their own tune, confounding lenders that rely on them. Following the Russian debt crisis in 1998, market disruption led to a steep fall in demand among investors for risky assets, including subprime securitisations, even before a recession took hold three years later.

—Bloomberg