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Updated Orchard Index Points to Needed Improvements for U.S. Consumer Online Lending

Orchard Index 2.0

Recently, Orchard re-launched the Orchard US Consumer Online Loan Index (the “Index”). This “new and improved” version of the Index includes performance data from more online loan originators (now five platforms) and substantially more loans (now over $12 billion in loans outstanding and over $40 billion of total historical originations). These enhancements further cement the Index’s role as a benchmark for the online lending industry and as a tool for investors to measure relative performance.

But that is not what I want to write about today.  I want to write about what the Index data says about the current state of unsecured consumer online loans in the U.S.  And, quite frankly, the investment story – based on the Index data – is not as compelling as it has been in the recent past.

Orchard Index Returns

Annual and monthly return data have trended down 2016 saw a nearly 300 basis point decrease in total return from 2015 (3.95% vs. 6.93%), and 2015 was lower than 2014 (6.93% vs. 8.71%) by nearly 180 basis points. So over a two-year period, we have seen nearly 480 basis points of return compression for investors in these loans; that is a meaningful, negative change.  This downward trend has continued into the first quarter of 2017.  

Why has this happened?  Based on other data from Orchard’s most recent Monthly Industry Report on online consumer unsecured lending (view aggregate quarterly reports here), we can see that overall interest rates charged to borrowers declined modestly during 2016.

Online Lending Interest Rates

… and charge-offs (particularly for 2015 vintage loans) ticked up noticeably.

Online Lending Charge-offs

Taken together, those two factors squeezed returns available to investors. Slower industry growth in 2016 did not help either. Orchard’s market data shows the sharp decline in monthly originations during the better part of 2016.  

Online Lending Originations

As the 2015 vintage of loans hit their peak charge-off levels, the materially slower growth also contributed to the decline in the Index’s reported total return number (see the Index Methodology for calculation details).

Relative value for online loans has also declined, placing further pressure on industry growth, as institutional investors compare online consumer loans to other potential income-oriented investments. In the Chart below, we compare the returns available to investors in Online Consumer Loans against two representative income-generating ETFs (with relatively short durations) and 5-year CDs in 2014, 2015, and 2016. The green numbers indicate the total basis points return advantage for consumer loans while the numbers in red indicate the basis points of relative underperformance of online consumer loans versus two of the alternatives. The poor relative return in 2016 – not to mention the decline in the absolute return – helps explain a lot of the decline in the volume of loans originated in 2016.    

 Online Lending Performance Comparison

 * SHYG is the ticker for the iShares short duration high yield corporate bond ETF and BKLN is the ticker for the Invesco PowerShares bank loan ETF; in addition to the total return advantage in 2016 for both of these ETFs, investors would have also been able to enjoy the liquidity of these exchange traded products, something not currently available to owners of online loans. 5-year CD rates from as of January for each year.

So how does this nascent industry get its “mojo” back? According to the Index data above, the most important thing the industry can do, from an investor’s point of view, is to improve the investment returns on the loans being originated. The industry must also return to a robust and sustainable growth trajectory to bring new investors into the online lending ecosystem. To achieve these two objectives, online lenders will likely need to address a variety of issues, including:

Improve Business models

  • reduce stubbornly high customer acquisition costs
  • diversify away from overcrowded and outdated sales channels (e.g. direct mail)
  • originate loans at the point of sale or through corporate partnerships

Diversify funding sources

  • stabilize funding to better weather full economic cycle
  • reduce cost of capital to offer competitive interest rates
  • reduce reliance on one investor type

Broad loan offerings

  • improve ability to cross-sell to existing borrowers
  • reduce dependence on the dynamics of one asset class/borrower set
  • increase interest from a broader group of investors

2017 is shaping up to be another exciting and challenging year in online lending.  As technology gets better, faster, and cheaper and the experience for borrowers improves apace, independent online lenders will continue to face challenges relating to business models, cost of capital, and asset class diversification. But in the end, the data from the Orchard US Consumer Online Lending Index (and other Orchard indexes yet to be launched) will continue to tell us whether the industry rises to meet these challenges or muddles along with weak relative and absolute returns to investors.

We would love to hear from you on this blog post, on how to improve this Index and on what other online lending indexes would be valuable to you.

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  • Charlie Moore

    Thanks for the insights Bill. Part of the challenge remains the operating costs of all the players still short of profitability and relative lack of scale. To achieve those efficiencies required, we are likely to see consolidation the next few years.