Bank earnings came in stronger than expected this quarter, driven by improved fixed income trading revenues and lower legal fees. Delinquency rates remain at decade-lows and credit quality is high, although a re-normalization of credit performance to historical levels is expected going forward.
ROEs for major banks remain mired in the 7 to 9% range—well-below pre-crisis mid-teens targets due to post-crisis capital and liquidity rules.
Source: WSJ; PeerIQ
Indeed, the Institute of International Finance published a study showing that since 2010 banks across the US, Japan, and EU are, on average, earning less than their cost of capital.
In this newsletter, we argue that banks can improve their ROE position by funding or financing whole loans from marketplace lenders, and that most banks will choose to partner with marketplace lenders rather than compete.
Case-Study on Discover: The Case for Owning Whole Loans
Discover (NYSE: DFS) is a publicly traded bank holding company offering banking products and payment services.
Discover’s asset-mix consists of credit card receivables ($57 Bn outstanding at end of Q2), personal loans ($5.7 Bn), and student loans ($8.7 Bn). Discover funds its assets primarily through deposits (55%), borrowings and securitization (32%), and stockholder equity (13%).
We analyze Discover’s public financial statements to estimate the ROE on their personal loans business. The goal of our analysis is to illustrate that under reasonable assumptions the ROE potential for banks funding personal loans is significantly higher than the average ROE for banks today. We conclude that Discover’s ROE on the personal loan business is in the low-20s.
We share our methodology below and note that significant assumptions are required due to the lack of segment-level P&L data. ROE can be estimated by calculating net income generated by the personal loans business (e.g., interest yield less provision expense, financing costs, operating, marketing costs), and dividing by the level of equity capital required to fund the business.
We proceed accordingly through each component.
Personal Loans Business
Source: Discover Financial Services; PeerIQ analysis
We observe that Discover loans generate a Net Yield of ~9% before financing costs:
- Discover’s Net Yield compares favorably to the loss-adjusted return expectations of several unsecured installment marketplace lenders which range from 6 to 7.5%. Note, however, that we have not adjusted for credit risk and are not performing a static pool comparison.
- Delinquencies have increased a modest 31 bps, and Discover is increasing reserve rates accordingly.
- Discover continues to invest in their personal loans business. 2015 originations were ~$3 Bn and ending loans increased 10% YoY to $5.7 Bn outstanding at the end of Q2. Discover has fewer loans outstanding than LendingClub ($8.9 Bn) and is somewhat larger than Prosper ($4.3 Bn) for the same period.
Financing Costs
We can estimate Discover’s funding costs by taking the quotient of the interest expense to total liabilities:
Source: Discover Financial Services; PeerIQ analysis
We observe a consistent funding cost of approximately 1.74% to 1.78% over the last four quarters.
Several observations:
- “Borrowings” consist primarily of Discover’s master trust securitization program ($16.6 Bn) which have experienced a steady borrowing cost of 198 to 206 bps over the last several quarters. Discover has a long history of participating in the ABS markets.
- Discover’s direct-to-consumer deposit rates are lower at 122 bps. By contrast, we note that term CDs offered by GS bank are priced at 105 bps (not surprising given the much larger deposit base for GS).
- Certificates of Deposit feature prominently as a funding tool for Discover. CDs are an attractive source of funding for installment loans due to Basel III regulatory capital controls,in particular, net stable funding ratios and liquidity ratio tests.
Operating Costs
Discover’s annual operating costs (staff, marketing, technology, office & equipment, etc.) are approximately $3.6 Bn. These operating costs support Discover’s deposit, lending, and payments businesses.
Since Discover does not provide a segment P&L for the personal loans business, we roughly allocate operating overhead to the personal installment loan business based on the pro-rata share of outstanding balances of the personal lending business and estimate $205 MM in applicable operating costs.
Capital Charges
Discover’s various lines of business face varied funding costs and capital allocations (for instance, Discover’s ABS programs funds only revolving credit card receivables).
Nevertheless, we simplify for our purposes and assume capital is pro-rata allocated to the personal loans business. We also add an arbitrary 20% capital surcharge to this figure to account for the higher capital set-aside requirements for CCAR purposes given the likely “first-to-default” behavior in unsecured personal loans (as compared to student or credit card receivables).
Based on the foregoing approximations, we estimate Discover generates a peak-ROE of 24% through their unsecured consumer installment loans. We note that the ROE figure is biased upwards since the analysis is based only on financial data from the last 12 months rather than a complete credit cycle.
Cooperate or Compete?
Having established the attractive ROE potential, banks have a choice: cooperate/acquire or compete.
In recent quarters, we have seen Goldman Sachs, PNC Financial, and American Express enter the installment lending business.
At the same time, we observe other banks–Union Bank, Regions Bank, SunTrust, BBVA–have elected to cooperate by incorporating their technology, funding loans, and extending credit facilities.
We identify key decision-making drivers below:
Source: PeerIQ analysis
A decision to originate whole loans requires a significant investment in marketing, technology, servicing, and risk management.
On balance, we predict most banks to cooperate with marketplace lenders to marry their low-cost funding profile with low-cost operations of marketplace lenders.
Marketplace lenders that evidence deep capabilities in risk management and analytics, quality underwriting, robust servicing, and apply bank-level compliance and control standards stand to benefit in a post-crisis low-ROE environment.
Conferences:
- Money2020 on October 23-24 in Las Vegas. Send us a note if you’d like to connect.
- Bloomberg Radio: Bloomberg Markets (10/20/16) Hosts Pimm Fox and Lisa Abramowicz discuss Goldman Sachs’ Marcus and LendingClub’s 8-K with PeerIQ CEO, Ram Ahluwalia.
- Led by Student Loans, Marketplace Lending Securitization Volumes Soar (Forbes, 10/21/16) Nick Clements argues that a group of increasingly sophisticated marketplace lending investors are emerging.
- Ron Suber, President of Prosper Marketplace, Delivers Keynote at Context Summits Alt Lending 2016 (ContextTV, 10/10/16) Ron Suber, President of Prosper Marketplace discusses the new phase of growth for Marketplace Lending, and PeerIQ’s role in providing transparency on ABS.
- LendingClub Street Wrap: Valuation Concerns, Signs of Stacking (Bloomberg First Word, 10/17/16) Lack of “consistent valuation framework” and independent valuation methods, may expose some hedge funds to legal risk and investor fairness concerns.
- Who’s Afraid of Goldman’s Marcus? (FT, 10/17/16) PeerIQ cited for cautioning MPL participants on dismissing prospects for GS Marcus.
- Lending Club Adjusts Loss Expectations, Tightens Credit Policy (AltfiNews, 10/17/16) As of 10/14, Lending Club has updated its loss forecasts based on recent increases in delinquencies.
- Are We Seeing the First Signs of the Next Recession? (LendAcademy, 10/21/16) CEO, Ram Ahluwalia, concludes that increased loss-rates are not a sign of an impending recession over the next 6 months.
- Private Offerings Frustrate Reg AB Project (AB Alert, 10/21/16) Investors in Rule 144A transactions are sacrificing transparency for yield, a false trade-off.
- Bank Legal Costs Cited as Drag on Economic Growth (WSJ, 10/20/16) Fines on banks translate into $5 Tn of reduced lending capacity.
- How OCC Will Assess FinTech Firm for Charter (American Banker, 10/14/16) The drive to create an OCC charter is coming from industry participants.
- Online Lenders Seek to Shape Industry Before Regulators Do (NYT, 10/20/16) Self-regulatory efforts such as the Marketplace Lending Association are emerging.
- SoFi, an Online Lender, Is Looking for a Relationship (NYT, 10/19/16) SoFi is developing community and an on-going relationship with their clients.
- Lending Club Tightens Credit Policies in Fight to Keep Investor Demand (FT, 10/16/16) Lending Club tightens credit policies in response to rising delinquencies among lowest-ranked loans.
- Third Quarter Data Reveals Continued Peer-to-Peer Growth (p2pfa.info, 10/19/16) Figures show strong and sustained growth in the sector.
- CircleBack Cuts Off Loan Production (AB Alert, 10/21/16) CircleBack turns over $300 million servicing portfolio to a backup servicer.
Lighter Fare:
- How Vector Space Mathematics Helps Machines Spot Sarcasm (MIT Technology Review,10/13/16) A mathematical approach to linguistics could allow computers to detect sarcasm.