Heads I Win / Tails You Lose: Rising US Interest Rates in 2015 & Their Potential Impact on The Marketplace Lending Industry
Over the last few years, many experts have forecasted the imminent rise of interest rates in the United States and the consequent bond market rout, but it has not materialized. However, a strong consensus has emerged (based on economic data and expert interpretation of those mysterious words released by the Federal Reserve Open Market Committee in December of 2014) that the first of a series of US Fed Funds rate rises will likely begin around June of 2015.
Why is this relevant to Marketplace Lending? Because one of the most commonly asked questions about the rapidly growing Marketplace Lending Industry is: “what will happen to this industry when interest rates start rising again?”
In fact, this question is often posed not so much as an intellectual curiosity but as a knock on the industry itself – as if the whole marketplace lending industry will come crashing down as interest rates in the US rise to historical norms. The question itself assumes that these historically low interest rates are the main or only reason for the rapid growth of the industry and ignores the significance of many other key factors, such as:
- technological advances,
- a growing internet oriented “crowd finance” movement,
- superior borrower experiences offered by marketplace lenders,
- inexpensive and ultra-fast access to personal and credit-related data,
- improved underwriting processes and algorithms,
- development of large and rapidly growing individual and institutional investor bases for marketplace loans,
- high and seemingly capricious costs of consumer and small business credit offered by traditional financial institutions and
- enormous amounts of data transparency made available to all marketplace lending participants
I wanted to try to tackle the subject of rising rates in the Orchard Blog and to take (what I hope is) a relatively objective look at the consequences, if any, of higher rates on the Marketplace Lending Industry, an industry growing at extraordinary rates, attracting thousands of new lenders and borrowers weekly and billions of dollars of growth equity and venture capital.
Chart 1.0 below is a graphical representation of the yields on the 10-Year US Treasury Bond and the Fed Funds rate since 1962. It shows quite clearly just how low rates are today and just how unprecedented such low rates are in the last half-century.
Let’s break down the potential consequences of higher rates on the Marketplace Lending industry into three main buckets: 1) the performance of marketplace loans; 2) the volume of loans originated and 3) the profitability of marketplace lenders themselves. (eg. LendingClub, Prosper and many others).
1) Loan Performance
To look at the potential impact of rising rates on loan performance, I turned to some historical data to try to get a handle on what might happen. Specifically, I have looked at consumer loan delinquencies and charge-offs during two periods of rising rates since 1990 (Jan 1994 – Sept. 2000) and (July 2004 – Sept. 2006). The charts below are illustrative.
During the more sustained period of rising rates in Chart 1.1 above, it is clear that as the Fed Funds rate rose during this so-called “Goldilocks” economy, charge-offs and delinquencies of consumer loans in the US rose too. The Fed Funds rate rose by 350 basis points during this 7-year period and delinquency rates rose by about 60 basis points to approximately 3.7% while the charge-off rate rose by about 75 basis points to 2.25%. Of course, both of those numbers would peak in the next year or so as the recession of 2001 impacted borrowers more severely – and by then the Fed was reversing course, cutting the Fed Funds rate to stimulate the economy. Chart 1.2 tracks what happened during other period of rising interest rates in the last three decades. This chart is not as conclusive. While delinquencies and charge-offs were certainly trending up in 2006, the overall change during this period of rising rates is basically negligible. Again, as before in the 1990s, delinquencies and charge offs would peak later – after the Fed had begun to cut rates – during the recession and global financial crisis of 2008-2010.
Based on these charts, there is not much of a conclusion to draw regarding the impact of rising rates. If the Fed does indeed raise rates in 2015, based on the graphs above we can expect some modest deterioration in credit quality (maybe). However, I would be much more worried about the next time the Fed starts to contemplate reducing the Fed Funds rate – in order to respond to the prospect or reality of the next recession. Until then, current credit quality trends will likely remain intact and high delinquency and charge-off rates will likely not rear their ugly heads and materially impact investment returns on marketplace loans. (Whether the Fed will have any “rope” to work with at such time of the next recession – meaning, will Fed Funds rates be even high enough to cut and have an economic impact at that point in time – is a topic raging amongst economists around the world today, but let’s not go there in this blog post).
2) Loan Volume
To look at the potential impact of rising rates on marketplace loan volume, I looked at the same periods above and compared the Fed Funds Rate over those two periods to Total Consumer Credit Owned and Securitized as tracked by the Fed.
There are many observations one can make regarding Chart 2.0 above. The first one is obvious: but for one period over the last 20-plus years, consumer credit has grown consistently in the United States. That one period was during and shortly after the Global Financial Crisis (July 2008 to October 2010), during which time consumer credit outstanding in the US went down from a peak of about $2.7 trillion to about $2.5 trillion. The decline in volume started AFTER the Fed started to cut rates, not while rates were going up and amounted to about a 4% decline over a 28-month period. During all of the 1990s and even the during the recession of 2001, consumer credit outstanding grew. Again, I would draw a similar conclusion to the one drawn from the Charts 1.0 and 1.1 – that a recession, and not rising interest rates, is more likely to cause some harm to the Marketplace Lending industry.
3) Marketplace Lending Platform Profitability
To look at impact of rising rates on the platforms themselves, I looked at two different topics – 1) how did a select group of consumer finance company equities perform during times of rising rates and 2) what would be the pro forma estimated net interest income impact of higher rates on the current income statements Lending Club and Prosper.
During the two periods of increasing rates noted in the charts above, I looked at the stocks of American Express, Bank of America, Wells Fargo and Capital One. This is not an exhaustive list but representative of the types of companies and sensitivities we are trying to analyze.
|US Consumer Finance Stock Prices|
|During Recent Periods of Rising US Interest Rates|
|Periods of Rising Rates|
|1/94 – 9/00||6/04 – 9/06|
|Bank of America||89%||36%|
|Data for Chart 3.0 from Yahoo Finance.|
If we judge success and value creation by stock market prices, then a rising rate environment is clearly a good thing for companies engaged in consumer finance. While the longer period of rising rates in the 1990s saw spectacular stock price appreciation, the shorter 2+ years of rising rates in 2004 to 2006 also showed price appreciation across the board for these four companies.
It should be noted that LendingClub acknowledges the risk of interest rate fluctuations (not rate rises per se) in its S-1 filing: “Fluctuations in interest rates could negatively affect transaction volume. All personal and small business loans facilitated through our marketplace are issued with fixed interest rates…If interest rates rise, investors who have already committed capital may lose the opportunity to take advantage of the higher rates. Additionally, potential borrowers could seek to defer loans as they wait for interest rates to settle…As a result, fluctuation in the interest rate environment may discourage investors and borrowers from participating in our marketplace, which may adversely affect our business.”
In fact, rising rates could be seen as a real positive to the bottom lines of Marketplace Lenders. First, as we saw above, rising rates and increasing volumes of consumer credit go hand in hand. That means more origination and servicing fees (both core revenue sources) for originators.
But even if we hold growth and credit quality relatively constant, rising rates can still be helpful to the bottom lines of these origination platforms. How? Free credit balances. Every day, cash sloshes through a marketplace lender’s platform, whether such cash is i) proprietary (eg., cash owned by the marketplace lender and sitting in a bank account) or ii) the cash is owned by a lender and waiting to be deployed into loans but controlled by the marketplace lending platform. In either case, higher short-term interest rates mean higher net interest income for the marketplace lending platform. LendingClub currently has approximately $1.0 billion in short term investments and cash accounts (on account of its highly successful IPO). Every 25 basis points of increase in interest yield would equate to $2.5 million dropping directly to pretax income. Even with a quaint 15x multiple (quaint versus its current pretax income multiple), that equates to $37.5 million of incremental market capitalization. So if rates ever normalized at around 3%, we could see substantial gains in net interest income, profits and valuations for origination platforms.
A word or two of caution. Consensus investment predictions can often be dead wrong. So it has been with interest rate forecasts over the last several years. Howard Marks, CEO of the venerable Oaktree Investments, recently wrote a memo on his firm’s website about “The Lessons of Oil .” In discussing the recent collapse in crude oil prices he points out the fallacy of the near-unanimous consensus on interest rates. “While this has nothing to do with oil, I mention it to provide a reminder that what “everyone knows” is usually unhelpful at best and wrong at worst.” So take the whole premise that “interest rates will rise in 2015” with a lump – not a grain – of salt. Marketplace lenders may in fact enjoy this favorable and historically low interest rate environment for longer than the experts expect.
Head of Capital Markets, Orchard Platform
Note: Unless otherwise noted, the charts above were created from data and charting capability of the Board of Governors of the Federal Reserve System (US), retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/