Tough road ahead for US fintech lenders as default risk rises

Jan 13 (Reuters) – U.S. fintech companies that lend to consumers with impaired credit scores face a tough year as rising defaults and interest rates limit the companies’ access to cost-effective debt financing.

“We expect that profitability will be reduced for many firms and that financing conditions will remain challenging, as increased financing costs caused by rising interest rates will not be offset by increases in earnings,” Moody’s said in a report on Thursday. It revised the outlook for such lenders to negative from stable.

During the pandemic, many fintech startups emerged as lenders to borrowers with imperfect credit. Using artificial intelligence, their screening tools were more likely to recommend these loan requests than traditional lenders.

Lenders such as Pagaya Technologies ( PGY.O ) and OneMain Holdings ( OMF.N ) financed themselves by bundling the subprime consumer loans into collateralized securities, or ABS, which they sold to Wall Street investors.

Pagaya declined to comment, while OneMain did not immediately respond to a request for comment.

The lenders’ ABS were among bonds that raised $36 billion in 2021 and 2022 by pooling consumer and market loans, according to FinSight data.

Investors were comfortable buying the bonds as US government stimulus ensured that consumers had money to meet their loan payments.

But as that stimulus faded, loan losses began to rise, Moody’s said. Inflation has hit subprime consumers who spend most of their income on rent, groceries and gas, and they struggle to pay interest on personal loans.

Losses on subprime loans assumed to be bad debts or write-offs rose an average of about 20% by the third quarter of 2022 from 2019 levels, Moody’s said.

Investors in ABS demand higher returns for new deals or avoid them altogether. Funding costs have also increased by as much as 200 basis points in recent months compared to mid-2022, based on FinSight data.

But the lenders’ securities haven’t lost investor appeal yet, said Theresa O’Neill, ABS strategist at BofA Securities.

She said a widening of credit spreads and a deal structure that lowered investor risk through more credit enhancements would continue to secure interest.

“We’re early in the game for what will happen in a recession or an economic downturn for many of these lenders,” said Tom Capasse, founder and managing partner of Waterfall Asset Management.

Reporting by Matt Tracy; editing by Shankar Ramakrishnan and Cynthia Osterman

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