Opinion Alternative Lending

The Rates rise conundrum - good for business?

The single biggest non story of the year has been the US interest rate hike. Countless gazillions of words have been written about the possibly calamitous side effects of the US Federal Reserve’s much delayed decision to raise interest rates by a mighty 25 basis points. Might this momentous move spark a bonds meltdown? Could stock markets crash and burn? Is this crunch time for alternative lenders?

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The reality was always much more mundane, frankly even tedious. The US Fed should probably have raised rates a little earlier in the year – if it hadn’t raised rates in December there would almost certainly have been a financial bloodbath. Now that it’s finally happened should we care?

Stockmarkets certainly seem to have taken the decision in their stride, notching up decent gains in the last few trading days of the year. Bond investors also haven’t panicked, quietly acknowledging that the decision was already baked into the price of most fixed income securities. And what about alternative finance, especially the marketplace lenders? Well, surprise, surprise, there doesn’t seem to have been any great panic so far. In fact there is some evidence that lenders such as Lending Club might actually appreciate an increase in rates. The logic here is simple.

The worst kept secret in finance is that a series of small interest rate increases is a big positive for mainstream, conventional banks. They’ll be quick to raise interest rates to borrowers but investors/savers probably won’t feel any difference until the middle of 2016. In simple terms, rising rates flatters bank margins.

Ordinary consumers might be happy to put up with this form of financial repression but most institutional investors will be determined to hunt down alternative sources of yield. The obvious first home for this yield hungry money is ‘traditional’ high yield credit but this market in the US is looking terrifically wobbly at the moment, if only because the energy sector (a large net borrower) looks to be in dire straits.

Step forward another home for that money – alternative lenders such as Lending Cub who have been quick to raise rates for both borrowers and investors. US investment magazine Barrons explained to its readers what might happen next – the article is here at http://blogs.barrons.com/incomeinvesting/2015/12/23/lending-club-charging-borrowers-more-and-paying-lenders-more/.

According to Barron’s, Lending Club announced that is raising the rates it charges borrowers who use its platform 25 basis points. And, at the same time, investors who use its platform will benefit from the higher rates earned on money lent. Lending Club CEO Renaud Laplanche said in the release: “Our marketplace’s rates will continue to adjust in such a way that borrowers benefit from the same savings against credit card rates, and investors continue to find very attractive risk-adjusted returns compared to other fixed income alternatives. Our ability to compress the spread between these two rates, using technology and low-cost operations, remains unchanged irrespective of the rate environment.”

So, here’s the good news for alternative lenders after the rates rise. They can use their real time marketplace structures to respond quickly to higher rates, tempting in more lenders. Also over in the SME lending space many loans already have flexible rates structures built around benchmarks such as LIBOR – lenders can simply increase rates. And it won’t escape the beady eye amongst you that increased revenues from rates translates through into increased platform lending fee revenues.

Ah, but what about the risk of defaults? Surely higher interest rates is bad news for borrowers, who might find that they can’t pay their interest bill? If rates were likely to raise by 2 or even 3% over the next year, that would indeed be a worry but let’s keep some perspective here – talk to most banking analysts and they think that US interest rates probably won’t peak at much over 1.5%, implying another four quarters of 25 basis points hikes. This is hardly earth shattering for lenders already paying between 6 and 12% (depending on whether the borrower is a business or consumer). Painful yes, but terminal – probably not.

The point here is the destination of rates rises, not the direction. Small incremental moves, well signposted by a central bank eager to be open and honest, should largely be absorbed by borrowers benefitting from relatively robust economic growth. If the end point is 1.5% or even 2% then it’s reasonable to presume that alternative lenders with all their online flexibility might actually benefit. If on the other hand the end destination are rates of closer to 5%, then all bets are off – but frankly if this was the horrific ‘final destination’ (excuse the horror film pun), then we’re all in trouble as the US and the UK economies fall off a cliff. Banks will need rescuing, mortgage borrowers will default and government deficits will balloon.

But there is one last fly in the ointment worth considering – origination. Higher rates might translate through into increased investor volumes but that money needs to be lent out. That requires more borrowers, which in turn requires more expensive stuff like marketing just as the traditional banking competitors take off their gloves and fight back – using their huge branch networks as the competitive edge. And while we’re being a tad cautious, it’s also worth watching the high yield credit market and especially junk bond borrowers in the energy market. There could be some very nasty crashes in the new year and that could spark a retreat from risky ‘lending’ amongst big institutions, possibly hurting alternative lenders indirectly as they take risk off the table. Watch this space.

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