Financial manufacturers including banks, factors and all manner of secured and unsecured lenders must prepare for accelerating uncertainty in 2016. Global economic turbulence, a rapidly shifting lending landscape full of FinTech start-ups, and the looming presidential election could stand in the way of more champagne and caviar. There are plenty of reasons to ignore Einstein’s famous adage now: prepare at once for war and peace.
There is also much good to toast come December 31. Lenders that kept their foot on the accelerator over the past five years are enjoying record originations and rising valuations. And the party is likely far from over.
ECONOMIC UNCERTAINTY ABOUNDS
The global economy is flagging by all reasonable measures. Demand for raw materials cratered over the past 18 months, leading to an implosion in emerging markets currencies and demand for products from industrial conglomerates like Caterpillar and Komatsu. Caterpillar’s stock is now down almost 40% from its peak.
Oil prices recently plunged more than 50%, aided by the US fracking boom’s disruption of global supply. Terror and political upheaval in Egypt, Israel, Iraq and Syria can’t seem to bring the oil industry patient back to life. That points to a serious demand problem. The US and Germany remain the only real bright spots left in the world. China’s economic engineering has so far placated investors, but there is no doubt that scary blend of central planning and free markets is fraught with risk for unhappy surprises next year.
Domestically, the credit cycle may be getting long in the tooth. Loans tracked by the Federal Reserve Bank of St. Louis are at all-time highs. Commercial bank loan volume charting demand from prime business borrowers increased from $1.2 trillion in 2010 to $1.9 trillion today. That compares to a pre-recession peak just under $1.6 trillion.
Amazingly, commercial loans have caught up to real estate loans on banks’ balance sheets. This is as much a sign of easy credit for midsize and large companies as it is the aftermath of regulatory reaction to the housing bubble.
The US economy remains resilient, with a combination of strong consumer spending continuing to rebound from the depths of the recession, and productivity gains fueled by the most innovative technology sector in the world.
Stocks are broadly flat so far in 2016, but could easily reach new highs at year-end. Fear of heights is never a good reason to walk away from a financial strategy. Behavioral finance teaches us charts have little in common with actual mountains.
Although publicly available corporate earnings have grown far faster than GDP since the recession ended, the media remains skeptical about the health of America’s small businesses.
To gauge small business performance, we look to the Equipment Leasing and Finance Association’s (ELFA) MLFI-25, an index tracking lending activity across 25 popular lenders to credit-worthy small businesses. The MLFI-25 new volume index grew 8% in 2014 while 2015 was trending at 3-4% over the first three quarters. In a sign of caution, new business now seems to be stalling.
Business investment has been criticized during this economic expansion. Big corporations take public heat for stockpiling cash and using it to buy their own shares, instead of investing in new projects and equipment. But the contraction in capital spending is truthfully related to the plight of the US energy sector. Remove oil firms from the equation and capex is growing nicely.
FINTECH IS EATING YOUR LUNCH
Arguably, the growth of traditional small business finance originations would look a lot better if alternative lenders weren’t taking so much market share. The internet’s supposed democratization of lending feels new. But FinTech companies are spending hundreds of millions on radio, direct mail and TV advertising. There is nothing new about that. FinTech’s business lending leadership comes in the form of CAN Capital, On Deck Capital and Lending Club. Publicly traded On Deck saw originations rise by 50% year-over-year so far in 2015, but costs are up 100% and its new business growth rate is falling.
The firm’s ability to sell nearly $500 million in capital each quarter surpasses most independent business lenders with far longer track records by a mile. But even as their originations are becoming profitable, the plunging stock prices of On Deck and peers like Lending Club reflect investors’ increasing skepticism in the “Tech” portion of “FinTech.”
For now, FinTech is a moniker reserved for any firm with a fancy website, taking business from traditional lenders and credit card companies. The credit methodology used is of little consequence and largely ignored. Any black box will do, so long as it issues an approval. This is reminiscent of 2007. Default rates are low now, so keep the pedal pinned to the floor, they say. There is still plenty of room for more suicidal risk-taking.
Small businesses are inundated with marketing offers from lenders offering short-term unsecured loans based on sales, not profits. The lenders are all betting that small businesses with under $5 million in sales can pay 5-10% of said revenues back over 6-18 months with a daily or weekly payment that carries an APR of 30-50%. Keep the term short enough and the default risk contains itself for now.
What begins as a conversation about short-term needs and an expensive bridge loan, quickly engulfs equipment and may act as a substitute for factoring and credit cards. The product is quick and convenient. And banks are not interested in filling this immense gap in a toxic regulatory environment brought about by the Dodd-Frank Act.
A business with $1 million in revenue can get $100,000 wired into its bank account in a matter of hours. The business owner views the loan as paying back $1.20 for every dollar borrowed. That’s quick math of 20%. But the APR is closer to 35% if payments are made monthly, or 38% at 21 daily payments per month.
The power of this market is evidenced by the entry of equipment finance veterans into the space. Ascentium Capital, Pawnee Leasing and Marlin Business Services have all entered the marketplace with short-term, unsecured loan products now growing much faster than their equipment lending businesses.
For now, if you can’t beat them, join them. Growth is good, but new entrants must manage both costs and risk very carefully. Acquisition costs and third party originator payouts are peaking. Even a small uptick in defaults can be devastating with enough leverage.
The good and bad news is it doesn’t take a genius to create an unsecured loan portfolio with an average term at or below 12 months. A college freshman can create a basic model to analyze the components of a bank statement and apply a few basic rules to back into a term and loan amount using personal credit reports on ownership and business credit data from a source like Experian.
DANGER: LOOSER UNDERWRITING AHEAD
Unsecured business loans are rapidly moving to 24-36 month terms for businesses with relatively healthy bank statements. Some lenders offer loan sizes equal to 15-20% of annual sales.
It’s hard to imagine things won’t push further in 2016 towards lower rates, longer terms and easier credit for borrowers that don’t deserve it. That will surely make any future downturn more painful, but it can’t be stopped as competition heats up.
But for now, lenders offering monthly payments and APRs under 30% are also employing greater underwriting scrutiny that translates into longer approval times. These lenders are mostly having trouble securing significant funding and market share.
DON’T FEAR THE FED
Lenders’ access to capital should be generous throughout 2016. The Federal Reserve has shown no willingness to raise interest rates and private investors have few options in a search for yield. Even a December rate hike is not a sure thing. Any minor blip in US or even global markets and the Fed takes its finger off the trigger. The truth is that raising interest rates far or fast is not politically feasible.
The Fed works for the administration and the Democrats want to be reelected. To make sure that happens, the punch bowl must not be taken away. The party must not end until the new guy or gal, as the Democrats hope, takes office. Monetary stimulus keeps markets primed and should provide a nice, final leg up in this massive bull market and economic expansion.
THE ELECTION IS NOT A THREAT
We are past the summer stock market correction with the economy intact. The fourth year of the presidential cycle is positive 75 percent of the time, only outdone by the third year we are in now. The reasoning is simple and basic. Politicians are focused on one thing – getting reelected.
That means no major legislation and nothing drastic in terms of proposed policy changes. This is amplified in a lame duck period where the president has cemented some legacy over seven years that will be reinforced by keeping his party in power. That means keeping the Fed on task, providing stimulus and keeping legislation away from Congress, which already stands in stark opposition to the White House.
The stock market loves this scenario. Losers hate losing about twice as much as winners like winning. Behavioral finance pioneer and Nobel Laureate Daniel Kahneman’s teachings on loss aversion are as applicable to politics as they are to investing. A quiet Congress means fewer legislative losers among corporations and individual investors. Forecasts are anybody’s guessing game, but the current expansion should have one more leg up to defy everybody’s expectations.
STAY CONSERVATIVE IN 2016 OR GET THAT WAY FAST
2016 is a pivotal year: the presidential election, Fed policy and the rapidly shifting landscape for small business lending products will dictate how it affects everyone’s bottom line. IPOs, mergers and new rounds of capital in the lending space will also play a role in how the year shapes up. We remain optimistic that the market has another leg up remaining.
US mergers and acquisitions stand at a record near $2 trillion this year, over 40% higher than the previous 2007 record. And US deal volume accounts for half of global M&A, the highest share since 1999. Not surprisingly, Technology M&A is over 50% higher than its previous 2000 record.
IPOs in Q3 2015 were down 43% year-over-year to 34 deals. For the first time since 2011, average IPO returns were negative four percent and more IPOs ended the quarter below their offer price than above it.
All of a sudden, ludicrous private valuations of technology firms like Square and Dropbox are being called into question before they go public. Coupled with On Deck and Lending Club’s revaluations once public, these are not great signs for FinTech companies rearing to go public soon like CAN Capital and BFS Capital.
Ownership and investors looking for exits will find 2016 the right time to buy a sailboat and make like Eddie Murphy and Dan Aykroyd in the finale of Trading Places. Lenders sticking around should maintain their course of growth, albeit a conservative one with reasonable leverage. The clock is ticking on the punch bowl. It could be taken away any time.