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.
‘SWASTICAR’: Tesla CEO Elon Musk’s close association with Donald Trump has prompted opponents to brand him a ‘Nazi’ and resulted in a dramatic drop in sales Demonstrators descended on Tesla Inc dealerships across the US, and in Europe and Canada on Saturday to protest company chief Elon Musk, who has amassed extraordinary power as a top adviser to US President Donald Trump. Waving signs with messages such as “Musk is stealing our money” and “Reclaim our country,” the protests largely took place peacefully following fiery episodes of vandalism on Tesla vehicles, dealerships and other facilities in recent weeks that US officials have denounced as terrorism. Hundreds rallied on Saturday outside the Tesla dealership in Manhattan. Some blasted Musk, the world’s richest man, while others demanded the shuttering of his
Taiwan’s official purchasing managers’ index (PMI) last month rose 0.2 percentage points to 54.2, in a second consecutive month of expansion, thanks to front-loading demand intended to avoid potential US tariff hikes, the Chung-Hua Institution for Economic Research (CIER, 中華經濟研究院) said yesterday. While short-term demand appeared robust, uncertainties rose due to US President Donald Trump’s unpredictable trade policy, CIER president Lien Hsien-ming (連賢明) told a news conference in Taipei. Taiwan’s economy this year would be characterized by high-level fluctuations and the volatility would be wilder than most expect, Lien said Demand for electronics, particularly semiconductors, continues to benefit from US technology giants’ effort
ADVERSARIES: The new list includes 11 entities in China and one in Taiwan, which is a local branch of Chinese cloud computing firm Inspur Group The US added dozens of entities to a trade blacklist on Tuesday, the US Department of Commerce said, in part to disrupt Beijing’s artificial intelligence (AI) and advanced computing capabilities. The action affects 80 entities from countries including China, the United Arab Emirates and Iran, with the commerce department citing their “activities contrary to US national security and foreign policy.” Those added to the “entity list” are restricted from obtaining US items and technologies without government authorization. “We will not allow adversaries to exploit American technology to bolster their own militaries and threaten American lives,” US Secretary of Commerce Howard Lutnick said. The entities
Minister of Finance Chuang Tsui-yun (莊翠雲) yesterday told lawmakers that she “would not speculate,” but a “response plan” has been prepared in case Taiwan is targeted by US President Donald Trump’s reciprocal tariffs, which are to be announced on Wednesday next week. The Trump administration, including US Secretary of the Treasury Scott Bessent, has said that much of the proposed reciprocal tariffs would focus on the 15 countries that have the highest trade surpluses with the US. Bessent has referred to those countries as the “dirty 15,” but has not named them. Last year, Taiwan’s US$73.9 billion trade surplus with the US