Consumer Lending Overview:
Fintechs and Goldman Sachs’ Marcus
Since the collapse of our economy under a decade ago, banks have gotten tighter with their lending. They no longer give out significant amounts of unsecured personal loans, many of which were considered subprime. While the banks became less likely to make these loans, this opened the door for other lenders to step in. Taking this role of providing highly lucrative, but highly risky loans, is the burgeoning fintech industry. These lenders tend to be peer-to-peer lending platforms which aren’t public. Because they are private, this industry is hard to get a pure play in, in the equity space. However, while this is a growth opportunity that most banks are missing out on, Goldman Sachs (GS) has created their own platform to take advantage of this growing industry. Although it isn’t exactly the same system in terms of peer-to-peer lending, there are reasons to believe they will be the eventual leader in the space. At the same time, while this may be a growth driver for them, the debt load in our country and the lack of security for the loans means that this industry must be closely watched for signs of over-stress.
This industry, lead by pioneers such as SoFi, have created a large market for the equivalent of peer to peer lending. This poses interesting opportunities and threats for the banking industry and standard lenders. While the number below includes insurance and payment systems, the growth of fintech lending has also been huge.
The Rise of Consumer Loans:
The first graph I’d like to look at will help understand the increased unsecured indebtedness of U.S. residents as well as the huge increase in the proportion of these loans that came from fintech startups. According to a QZ article in reference to the chart below, “Upstart financial technology companies like Lending Club, Prosper, and Avant account for about a third of this lending, up from less than 1% in 2010.”
The problem with these personal loans is that they are inherently risky. While most bank mortgages are taken out with home equity as collateral, there is nothing to collect if these borrowers can’t pay. These loans are pretty similar to credit card loans except in this case, many of the credit restrictions are lower. While the lack of collateral adds risk, it also is the entire basis for the ability of the industry to function as the lack of collateral makes the process of providing a loan orders of magnitude faster. To show how this has grown, the chart below shows the originator of current U.S. personal loans.
As the same article mentions, “fintechs are aggressively pushing into this space, but banks and credit unions are also ramping up their efforts. Tech upstarts account for about $31 billion of this type of debt, compared with $22.5 billion for banks and $18.7 billion for credit unions, according to TransUnion data. The amount of personal loans outstanding originated by banks has more than doubled since 2010.”
Goldman Sachs’s Marcus Vs. Fintech Lenders:
While banks are seeing the trends and are working hard to enter the industry, none have been successful as Marcus by Goldman Sachs. With the company having had earnings growth struggles, they needed to find new ways to increase their earnings power. As trading revenue remains unimpressive, this business will provide new avenues to growth and has even started as the company posted revenue growth of 19% and earnings growth of 40% YoY in the second quarter.
The company has done the best job of any bank at creating their personal loan program to compete with the fintechs. According to their earnings call, the company has originated over $4B in loans thus far with $3.1B outstanding. Unlike standard mortgages or other secured loans, these loans have much higher interest rates. As Bankrate says, the rates start out at 6.99%APR and can be as high as 24.99%APR. If these loans can remain out of delinquency, they have massive earnings potential. This is helping them increase lending revenues and should allow them to make a meaningful business out of it.
This industry has been pioneered by companies such as LendingClub (LC), Prosper, and Borrowers. However, there are a few differences between these companies and Goldman Sachs’ Marcus that could prove either beneficial or crippling which I will flesh out below. The main difference is that while Goldman Sachs is lending from their own balance sheet, the others are using peer-to-peer (P2P) lending. This means that the fintech companies originate the loans for a fee and then basically sell the notes to individual investors. Another difference is that while Goldman Sachs is backed by a huge balance sheet and the size of a large bank with diversified holdings, the other companies are pure personal loan businesses. The last is that Goldman Sachs has higher restrictions for their lending that make their balance sheet more likely to remain healthy in the long run.
Direct Lending Vs. P2P Lending Pros and Cons:
There are large advantages as well as risks with Goldman Sachs lending from its own balance sheets versus the P2P format that the other companies use. The first advantage is clear: while the peers get the interest income from loans from the P2P loans, Goldman Sachs gets all the income from their loans. This means that the comparative earnings potential is higher for Goldman Sachs. It also means that while other lenders charge origination fees which are their source of income, Goldman Sachs can originate loans for free because their income comes from interest payments. This is a huge incentive for borrowers to use them.
The next advantage is that while the other companies basically put possible loans up for sale before they issue them, which takes time, often up to a week. Goldman Sachs on the other hand, due to their large cash on hand and their lack of need for outside capital, can originate loans in as little as 2 hours. Between the lack of fees and the faster turnaround time, the Marcus business is overall a better experience for consumers and should grow rapidly on those merits alone.
Large Bank Advantage:
The next large advantage is that Goldman Sachs is backed by a huge balance sheet and the overall strength of a huge bank. This may be the biggest advantage of all of them for multiple reasons. The first is that the company isn’t reliant on outside sources. This means that they can originate loans even if they don’t have investors lining up to buy them. The next is that they have been through recessions before and are experienced with recession and risk management. Lastly, the biggest is that if some of their loans fail, it won’t affect their entire business as they aren’t a pure play.
The fact that the company isn’t reliant on other lenders may be the biggest strength of the entire Marcus platform and could also be counted as part of Direct vs. P2P lending pros and cons. When the inevitable recession hits, there will be increased loan delinquencies, less capital to go around, and more fear of investment.
All three of these events will cause for Goldman Sachs to have a huge leg up on their peers. Increased delinquencies and bankruptcies will make investing in consumer loans more risky and less profitable. As that happens, banks have the balance sheet and the fortitude to resist having to pull back, but the fintech companies have no control over their capital. If the investors for the fintech companies start seeing higher risk and higher default rates, they will be less likely to invest in the sector and we could see the fintech capital dry up incredibly fast.
To add on to this, as recession hits, the amount of investable capital to go around decreases. With less total money to go around, there will be a way smaller pool of applicants to invest in personal loans. The fintech companies are reliant on consumers and their sentiment on both sides. If their loans start to sour, they will lose investors who came at the sign of gold and will leave when they see coal. Along with the increased desire for lower risk investments during economic downturns, investors will run for the hills. If they lose their access to large amounts of capital, they will not be able to issue new loans at the same rate. Borrowers will not go to a lending facility that doesn’t have the capital to provide them with a loan and this could ruin the entire fintech industry. When these companies are forced to pull back significantly over this period, Goldman Sachs has the resources to charge ahead and capture a heap if the market share. I wouldn’t be surprised to see consolidation and maybe buyouts during the upcoming recession.
Balance Sheet Strength:
Another huge difference between Marcus and other lenders is the quality of the loans they are putting out. As can be seen from the chart above, LendingClub requires a minimum credit score of only 600 while Marcus requires a minimum score of 700. When the upcoming recession hits, these lower class loans will be the first to fail. Although banks understand the risks and rewards of high yield, low quality loans, investors may not and thus will be likely to back out at the first sign of stress.
As can be seen below, a huge amount of the loans being issued are either subprime or “near prime”. While according to a Business Insider article, Marcus has subprime loans accounting to at least 10% of their portfolio, given the chart below, it is fair to say other companies likely have a higher proportion of subprime loans. Also considering that the Experian definition of subprime is a credit score of 670 and below, that leaves subprime lenders well within the credit requirements of the fintech lenders. This compares to Marcus where according to Michael Douglass of The Motley Fool, “overall portfolio quality through Marcus is very strong. Average FICO score is over 700”.
American Debt and Economic Status:
While these lower quality loans may have higher yields and could be more profitable, there is a lot of signs to suggest that our economy will take a downturn and these debts will go unpaid at a huge rate.
Debt is increasing pretty largely in our country and while a large percent of mortgages have been going to the highest quality borrowers, some other types of loans have not. These borrowers are starting to go delinquent at a higher rate which could point to a turn in the credit cycle and huge losses for issuers of personal loans.
We can see these signs already taking place in the auto industry where subprime loans are growing and delinquencies are rising rapidly. This is largely due to the fact that while the regulations over the mortgage industry have tightened due to the financial collapse, the auto market is much looser.
While unlike mortgages, these loans won’t cause the whole market to fail, they are telling. These tend to be smaller loans with less value tied to their collateral as, unlike homes, vehicles depreciate instead of appreciate. Similar to personal loans, cars can’t be bought and if repayments can’t be made, sold for more money to repay the loan. However, different than personal loans, cars can be repossessed. To miss car payments has an even larger direct consequence than missing personal loans and there is still huge delinquency rates. This could be a sign that similar trends will affect the personal loan industry.
Current Fintech Lender Success:
However, even in our good market, the fintechs are struggling. As an article by Tayana Macheel states “The announcement follows a gloomy earnings season for online lending companies, whose personal loans rival Marcus’. Lending Club has reported losses exceeding $200 million over the last six quarters; Prosper has lost $210 million since the start of 2016, despite various cost-cutting measures, and lost its unicorn status. Even OnDeck Capital, which focuses on small businesses, is struggling to become profitable, having reported losses over eight consecutive quarters.”
Conclusion and How to Invest:
The likelihood of struggles for the industry actually has some upsides. While most of the fintech companies will either struggle or fail through an economic downturn, Goldman Sachs can capture a large portion of their market share. However there is definite downside for Goldman Sachs as well. While everyone will see increased delinquencies, Goldman Sachs has to foot the interest income loss, while fintechs pass those losses onto noteholders.
While this will cause short term losses, the increased market share is worth it. Currently, the personal loan industry is very small. According to a Quartz article linked before “Despite rapid growth, the size of the personal loan market is relatively modest. About 6% of American consumers have an open loan, according to TransUnion data, compared with 29% for auto loans and 60% for credit card loans. ‘We believe there is a lot of runway,’ Laky said.”
As personal loans are often a great way to consolidate debt for credit card loans, we will likely see a large shift from credit card debt to personal loans. Especially for those who can’t immediately pay their debt, personal loans are much cheaper than credit cards. There are a whole host of positives for consumers to get personal loans as shown in this forbes article and we are likely to see this industry grow rapidly and create huge value for its leaders.
We will likely see Goldman Sachs do well in the short term until a downturn comes. When it does we will see increased delinquencies and huge decreases in earnings from this sector and a lot of talk about the risks Goldman Sachs took and how they shouldn’t have invested heavily into an inherently risky industry. Then, when the market turns back up, Goldman Sachs will be the leaders in a growing an profitable industry and in a better position than they started. To invest, follow the economy. Invest until we start seeing loan delinquencies then go to cash until the economy starts to pick back up. This is a large long-term growth opportunity and we are still in the early stages.
The main competition Goldman Sachs could see to long term industry leadership would be the stepping in of some of the other banks. While many others such as Wells Fargo (WFC) and J.P. Morgan (JPM) are more known for their lending portfolios, they may see this as a space where they could compete and win. As Michael Douglass said: “Of course, the flip side of that is, now a lot of other folks are looking to get involved. Citigroup (C) has started making noise about it, JPM as well. There’s a lot of interest, and other folks building increasingly strong digital presences to try to combat Marcus’ success.” These are risks to watch for.
Goldman Sachs Trading Value:
Even so, as Matt Frankel said “Goldman Sachs is trading for right around 1.2X book, which is less than all of the Big Four banks except Citigroup. And, Goldman Sachs has significantly underperformed the banking sector in 2018. So, Goldman Sachs is trading like a pretty cheap bank right now. If you think that consumer banking especially is going to be a big future catalyst, then Goldman Sachs looks like a pretty compelling value right now.”
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.