In every downmarket cycle, subprime rears its head. It might not take center stage, like it did in the 2007-2008 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 (IPO) with a market capitalization of US$12 billion, which peaked at almost US$50 billion — about three times Deutsche Bank AG). Afterpay Ltd was acquired by Block Inc (formerly known as Square) for US$29 billion and Klarna Bank AB raised private funding at a valuation of US$45.6 billion.
However, as interest rates rise and recession fears mount, valuations have suddenly reversed. Affirm stock is down 90 percent from its high and last week it was revealed that Klarna is in talks to raise new equity at a valuation as low as US$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 do not 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 could not afford, to borrow money without a credit check or because they cannot get approved for a credit card. Affirm leans into this. At the time of its IPO, it disclosed that it approves on average 20 percent more clients than comparable competitor products.
The result is a customer base that skews subprime. According to credit reporting agency TransUnion, about 69 percent of BNPL users are subprime or near prime. In a favorable credit environment, the distinction might not show up in earnings, but when the environment changes, defaults — and writeoffs — would 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 realized loan losses increased as it pursued faster growth, reaching 7.7 percent in the second half of last year at a time when aggregate US consumer losses were running below 1 percent.
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.
However, markets can be skittish, seizing up when you least want them to and most need them. Last month, Affirm priced a securitization deal — bundling loans together and selling slices to investors — at a yield of 5.65 percent, up from a 4.34 percent 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 securitizations, even before a recession took hold three years later. Subprime originators saw their own borrowing costs skyrocket. In the two years following the crisis, eight of the top 10 subprime lenders declared bankruptcy, ceased operations or sold out to stronger firms.
The third cycle is the equity cycle. Before BNPL became a buzzword, Klarna was chugging along just fine. It became profitable within six months of its launch back in 2005.
However, then venture capitalists showed up and seduced the company with cheap capital to fund faster growth. Since 2019, pursuing breakneck expansion, it has booked 11.8 billion Swedish kroner (US$1.12 billion) of operating losses. At the same time, its valuation rose from eight times trailing revenue in mid-2019 to 37 times trailing revenue in the middle of last year.
One of the challenges any investor faces is discerning a secular trend from the merely cyclical.
However, all lending is cyclical, and with multiple cycles to navigate, the pitfalls are impossible to avoid. With its valuation now just four times trailing revenue, Klarna — like its peers — is beginning to reflect that.
Marc Rubinstein is a former hedge fund manager. He is author of the weekly finance newsletter Net Interest.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Merida Industry Co (美利達) has seen signs of recovery in the US and European markets this year, as customers are gradually depleting their inventories, the bicycle maker told shareholders yesterday. Given robust growth in new orders at its Taiwanese factory, coupled with its subsidiaries’ improving performance, Merida said it remains confident about the bicycle market’s prospects and expects steady growth in its core business this year. CAUTION ON CHINA However, the company must handle the Chinese market with great caution, as sales of road bikes there have declined significantly, affecting its revenue and profitability, Merida said in a statement, adding that it would
RISING: Strong exports, and life insurance companies’ efforts to manage currency risks indicates the NT dollar would eventually pass the 29 level, an expert said The New Taiwan dollar yesterday rallied to its strongest in three years amid inflows to the nation’s stock market and broad-based weakness in the US dollar. Exporter sales of the US currency and a repatriation of funds from local asset managers also played a role, said two traders, who asked not to be identified as they were not authorized to speak publicly. State-owned banks were seen buying the greenback yesterday, but only at a moderate scale, the traders said. The local currency gained 0.77 percent, outperforming almost all of its Asian peers, to close at NT$29.165 per US dollar in Taipei trading yesterday. The
RECORD LOW: Global firms’ increased inventories, tariff disputes not yet impacting Taiwan and new graduates not yet entering the market contributed to the decrease Taiwan’s unemployment rate last month dropped to 3.3 percent, the lowest for the month in 25 years, as strong exports and resilient domestic demand boosted hiring across various sectors, the Directorate-General of Budget, Accounting and Statistics (DGBAS) said yesterday. After seasonal adjustments, the jobless rate eased to 3.34 percent, the best performance in 24 years, suggesting a stable labor market, although a mild increase is expected with the graduation season from this month through August, the statistics agency said. “Potential shocks from tariff disputes between the US and China have yet to affect Taiwan’s job market,” Census Department Deputy Director Tan Wen-ling
UNCERTAINTIES: The world’s biggest chip packager and tester is closely monitoring the US’ tariff policy before making any capacity adjustments, a company official said ASE Technology Holding Inc (日月光投控), the world’s biggest chip packager and tester, yesterday said it is cautiously evaluating new advanced packaging capacity expansion in the US in response to customers’ requests amid uncertainties about the US’ tariff policy. Compared with its semiconductor peers, ASE has been relatively prudent about building new capacity in the US. However, the company is adjusting its global manufacturing footprint expansion after US President Donald Trump announced “reciprocal” tariffs in April, and new import duties targeting semiconductors and other items that are vital to national security. ASE subsidiary Siliconware Precision Industries Co (SPIL, 矽品精密) is participating in Nvidia