Of all the sectors out there, the fintech sector has been among the worst performing over the past few years. Rapidly rising interest rates have harmed just about every financial business, especially newer fintech companies perceived as unproven and unprofitable.
Among fintechs, personal-loan provider LendingClub (LC 1.00%) doesn't seem to get much respect even relative to its competitors. In fact, LendingClub was the rare example of a fintech that maintained its profitability over the past few years, even as higher-valued competitors inked hefty losses.
After LendingClub beat expectations for revenue and profit in the fourth quarter, I had the opportunity to speak with CFO Drew LaBenne about how LendingClub achieved this feat, as well as the massive growth opportunity that lies ahead when interest rates come back down.
Why LendingClub took a hit from rate increases but was able to maintain profit
LendingClub improved its business model exactly three years ago, when it bought Radius Bank, giving the lending company a banking license and access to its own deposits. Today, LendingClub can now toggle between selling its attractive high-rate, short-duration personal loans to outside investors, or holding those loans on its own balance sheet.
While LendingClub's underwriting has done rather well over the past few years, rapidly rising interest rates have caused all sorts of turmoil for regional banks, which previously made up the majority of LendingClub's customer base for loan sales.
As those regional bank customers fled the loan marketplace to deal with their own problems, that left LendingClub with fewer customers to sell to. And while LendingClub did put more loans on its balance sheet, the company only had so much room.
In addition, LendingClub was under tighter regulatory restrictions for three years following the Radius acquisition. LendingClub was required to retain higher Common Equity Tier 1 (CET1) risk-weighted capital ratios than similarly sized banks for three years following the acquisition, constraining its capital even further.
So LendingClub had to originate fewer loans, leading to declining revenue and profit -- not because of demand from borrowers or anything wrong with its underwriting, but rather because of the problems at other banks.
LendingClub CFO Drew LaBenne. Image source: LendingClub.
But LendingClub adapted
Even though LendingClub's total net revenue declined by 8% quarter over quarter and 29% year over year last quarter, the company has been able to maintain profitability. Strikingly, despite the quarter-over-quarter declines in revenue, the company's profit increased, doubling relative to the prior third quarter.
LendingClub has come up with interesting ways to free up capital and attract more asset-manager investors to replace some banks. Two big innovations have been structured certificates, and extended seasoning loan sales.
First, extended seasoning is exactly what it sounds like. According to LaBenne, the main advantage of these loan sales are when LendingClub wants to sell a loan portfolio to an investor, but that investor wants to pay too low a price out of fear around loan performance. After a certain amount of time, say, the first six months of a loan portfolio, early delinquencies and chargeoffs give a big indication of future performance. That allows LendingClub and investors to come to a better agreement on price, and LendingClub is able to earn interest income for the early months until the loan is sold.
But what has really been a game-changer is the new structured certificates. These new certificates are quite an ingenious way for LendingClub to continue earning high returns with little to no credit risk, and with lower capital requirements too.
LaBenne explained the certificates to me this way: Say LendingClub originates a $100 prime loan at, say, a 13% coupon. In a structured certificate arrangement, an asset manager would buy $15 of that $100 loan. That $15 then has the right to earn an outsize 6%-7% of the yield, but takes on all the risk of first losses. LaBenne explains asset managers can earn up to a high-teens return on that small portion of the loan. Meanwhile, LendingClub still gets about a 7% yield on its $85, a little more than half the coupon, but with almost no credit risk.
While the ultimate return on equity for structured certificates is a tad lower than holding whole loans on its balance sheet, the advantage for LendingClub is that it doesn't have to take any CECL loss provisions against those loans. Moreover, those securities only have a 20% risk weighting, whereas whole loans have a 100% risk weighting.
Image source: LendingClub.
Since all banks' capital is generally measured according to the risk-weighted value of assets, LendingClub can hold five times as many structured certificates on its balance sheet as whole loans for every dollar of equity. So the structured certificates are actually the highest return on risk-weighted capital.
Of the $1.1 billion in loans held on LendingClub's balance sheet, 75% were structured certificates last quarter. The increased proportion of these new securities resulted in lower revenue than the prior quarter, given the lower yields on structured certificates. But they're also why LendingClub recorded higher net profits, as it didn't have to reserve against them.
Q1 should be the bottom, with growth on the horizon
The first quarter is typically a low seasonal quarter, and LendingClub forecast flat originations to Q4, along with lower pre-provision net revenue. But that net revenue is probably affected by an increasing proportion of structured certificates. Importantly, LendingClub forecast net profit again, maintaining its impressive streak through this downturn.
But Labenne said in our conversation that the first quarter should mark the bottom in all of these metrics, as long as interest rates don't go higher from here.
Since LendingClub has to wait a bit after rate increases to reprice its loans higher, returns are less attractive for banks when short-term rates rise rapidly, as their deposits move instantly higher with the Federal Reserve. While asset managers have come back to LendingClub's marketplace given lower yields on two-year Treasury Bonds, banks probably won't return until short-term interest rates come back down.
But when that happens, LendingClub would have a huge tailwind, and aggressive growth could follow. And this is doubly true because LendingClub's restrictive three-year agreement with the Office of the Comptroller of the Currency just ended literally on Friday. That means LendingClub's new minimum CET1 capital ratio should now be 7%, in line with other banks. But with LendingClun's current CET1 ratio a super-high 17.9% at the end of December, the company now has tons of excess capital it's now free to deploy.
Meanwhile, U.S. consumer credit recently surged to a record high $1.3 trillion, with the highest credit card interest rates in generations. Since the main use for LendingClub's personal loans is to pay off higher-rate credit card debt with a lower fixed-rate loan with monthly payments, that gives LendingClub a massive addressable market. Given that LendingClub is a leader in the space but only serviced $14.1 billion of loans between its own held-for investment loans and those sold to investors last quarter, that's just over 1% of the total market opportunity.
Image source: LendingClub.
The best way to play lower rates?
LendingClub trades at only 0.8 times book value today, which is quite something when you consider the company is still growing that book value even through this downturn.
As long as a recession is avoided, when the interest-rate regime turns and rates go lower as many expect, LendingClub may be the highest-upside way to play the economic recovery.
