Signs of a Turnaround? A Closer Look at Orchard’s 2016 Q4 Report
Please note: Reported origination volumes only include the loans of originators integrated with Orchard’s platform and that are permissioned to be shared publicly. While these numbers do reflect a sizable portion of the industry, certain special lending programs and other sub-segments of the consumer lending industry are not reflected at this time.
Origination numbers fell consistently over the course of 2016, and we have been waiting to see whether that was going to continue or whether we would eventually see an uptick. In Q4, we finally saw an uptick.
Not a huge one. It’s about a 10% increase over Q3 numbers. And that’s still down significantly from the peak last year, about 46% from what we recorded in Q4, 2015. But it marks one of the first signs that things may be beginning to recover. Anecdotally, our business development team has also noted that they’re seeing increased interest from institutional investors in the space. We’re optimistic that, barring any additional surprises from consumer lenders, we’ll see a return to growth in originations in early 2017.
Charge-off Rate Vintage Curves
When you’re looking at data such as this, it’s important to remember that aggregated data tells just a part of the story. While each vintage curve represents the charge-offs of the loans originated during a given period, to paint a more complete picture, you also need to take into consideration other aspects of each vintage.
For example, as the industry grows, newer vintages will include additional lenders and loan products which affect charge-off rates in a variety of ways. Looking at the vintage curves in the chart below, you see that rates are relatively similar across vintages, except for the 2010 vintage, which is a bit of an outlier.
Back in 2010, the size of the industry and the volume of loans originated were pretty small. There were also fewer lenders focused on subprime lending. Additionally, a larger percentage of 2010 loans had a term of 36-months. 60-month loans have grown more in later years. 36-month loans have shown a tendency to charge-off at slightly lower rates.
This introduction of new loan products for lower credit quality borrowers in later vintages—i.e. lower lending standards and longer duration loans—means that the 2010 vintage includes not only fewer loans, but the loans tended to be of a higher credit quality. Given those factors, charge-offs are bound to be lower in the 2010 vintage.
More recent years all stack together pretty tightly, within 1-2% of each other in cumulative charge-offs. However, 2014 and 2015 vintages seem to be charging off at a slightly faster rate, at least, as of this latest report.
There are a few reasons for this.
First, and something we’ve discussed in other papers, is the introduction of more subprime lenders into the space. Subprime lenders focus on issuing loans to people lower on the credit spectrum, and you expect to see those loans charge-off at higher rates. Over 2014 and 2015, subprime lenders became a larger chunk of the industry.
However, that’s not the entire story. If you look at individual lending platforms, like Lending Club or Prosper, for example, you also see that 2014 and 2015 are charging off at steeper rates.
But even that is not the whole story. Steeper charge-off rates in those years could mean a lot of different things. While it could mean, for example, that a platform’s loan quality is deteriorating in general, it could also mean that the platform is expanding to target additional, lower quality borrowers. For example, it’s possible that their core A, B, C, and D grade borrowers are charging off at the same rates as before but that by growing volumes of E, F, and G borrower originations as a proportion of total loan issuance it is contributing to higher charge-off rates.
So, it may not be that they are giving loans to prime borrowers at the same interest rates and seeing higher charge-offs, which is something you would be worried about, it’s that they are also extending loans to lower quality borrowers at higher interest rates to expand their customer base, and are fully expecting higher charge-offs.
Whenever you’re looking at aggregated numbers, you need to look a little deeper. “What’s actually driving what I’m seeing?” The answer could be that it’s an increase in borrower charge-off rates, but it could also be that the current groups of borrowers included in the aggregate are not the same as the groups that were included years before.
Borrower Interest Rates
While borrower interest rates are a different metric, a lot of the same themes we just talked about are manifesting themselves. Since Q2 of 2016 we’ve seen borrower rates fall in both Q3, and Q4 by around 1.2%. And this change is not necessarily what we would expect for a variety of reasons. One, the Fed raised rates during that time period. To remain a competitive investment option, platforms will need to raise rates. And secondly, because of weakening investor sentiment in Q2 and Q3, you imagine platforms would want to raise rates further to attract additional investors. Paradoxically, we see rates falling over this time period
Similar to charge-off rates, you really need to think about the mix of loans in each origination period. What we see is that most of the core prime lending platforms actually did raise rates over this time period for the reasons I just cited, while the subprime platforms cut their originations sharply.
Subprime rates are significantly higher. They’re in the 25-40% range. Whereas the prime lenders are going to be in the 8% to maybe 15-20% range. We end up with a weighted average of ~16%. Now, however, the subprime lenders are a fraction of what they were in prior quarters. This was most likely driven by investor sentiment and general fear in the industry after the well-publicized events of last year. The result, though, is that despite increases in interest rates across most platforms, we actually see a declining average interest rate over this period due to the reduction in originations from subprime platforms.
Borrower Interest Rates by FICO
By looking at FICO, you can see the trend I’ve been talking about. Except for the less than 680 Group, where most of the subprime originators are going to be originating, interest rates increased across all FICO groups. In Q4 you see some declines, although I’d say it’s relatively flat. Q4 is still up from Q2 for all of the FICO groups. What that means is that all originations to non-subprime borrowers (i.e. near prime and prime) are at higher interest rates than before.
The decline we see in the subprime group (FICO <680) is interesting. It’s not really what’s driving the overall decline in interest rates in Q4, but it’s still an interesting phenomenon to explore. I believe what we’re seeing there is a decrease based on the fact that subprime platforms have reduced lending. For example, if a prime lender were to issue a loan to somebody with a 670 FICO, they would tend to issue the loan at a lower interest rate than a subprime originator would. So, prime lenders are still originating loans in those lower FICO groups but at slightly lower interest rates, while subprime lenders have scaled back lending. As a result, we see a decline in interest rates for this FICO band in recent quarters.
Borrower Interest Rates by Loan Size
In Q4 there’s not much of a story here. It’s relatively flat from Q3. The most interesting thing I see in this graph is the notable change in rates for the less than $5,000 bucket over time. There are two factors at play here. First, this segment used to be more dominated by the subprime platforms, where rates were higher. Second, rates at the subprime platforms have actually fallen notably over the last 3 years. So, there are a combination of effects here. First, there’s a shift toward a smaller percentage of loans coming from subprime originators, but also there are lower rates from the subprime originators themselves, which results in this sharp reduction in interest rates for this segment.
Still, the rates are higher for smaller loans. People who are approved for smaller loans have tended to be lower credit quality borrowers. If you went to a loan provider and said, “I want $30,000” and you have a pretty poor credit score or other negative credit qualities, they’re just going to decline you. Whereas, if you apply for, say, $5,000, lenders are more willing to take a chance. Typically, these borrowers are offered these small loans at higher interest rates, and that is what we see in the data.
In a way, it’s counterintuitive. All else equal, you would expect that larger loans would have higher interest rates. However, because larger sized loans are usually only approved for near-prime and prime borrowers, they actually tend to have lower interest rates.
Finally, we see a tightening in all of the bands in the last couple of quarters. If you look back to Q2, there’s more dispersion. Rates ranged from 14% at the low-end to 27% on the high-end. In Q4 the range was 14.2% to 21.6%. That’s a tightening of about 5%. I find it interesting. It probably has to do with additional competition in the industry and just a general tightening regarding pricing, as borrowers have more options. It is something I’m watching.