This Isn't an Investable Trend for the Average Retail Investor

Because the buy now, pay later business model relies upon unsecured consumer credit, it is especially vulnerable during economic downturns, making these companies highly risky investments right now. In this segment from "The Future of Fintech," recorded on Feb. 3, Motley Fool contributors Matt Frankel, Jason Hall, and Danny Vena share their reservations about the buy now, pay later space in general.

Matt Frankel: With Buy Now Pay Later, this is just more of a discussion of the industry trends in general, because Buy Now Pay Later has exploded worldwide over the past few years. Buy Now Pay Later volume throughout the world is expected to be over $250 billion in 2021 when we get all the numbers, 250 billion. It's very popular in the Asia-Pacific region. A lot of people don't realize that, US is late to the party of Buy Now Pay Later. In a lot of places around the world, it is much of a bigger deal.

Afterpay that Square just acquired is based in Australia, which is Asia Pacific. That's where most of their members are. Affirm is the leader in the space, at least in the United States. They recently have announced partnerships with both Amazon and Target. They started as the exclusive financing partner of Peloton. When Peloton bikes took off, you were able to get interest refinancing for, I think 24 months. That was Affirm. Affirm's customer base grew 124 percent year-over-year in the most recent quarter just to give you an idea of how much this is blown up.

PayPal has its own Buy Now Pay Later services, it's in eight international markets around the world so far. Just one quick statistic, 20 percent of US adults have used Buy Now Pay Later in the past 12 months and of that 20 percent, 70 percent say that they plan to use it again in the future. It's expected to grow 61 percent year-over-year from that high level already in 2022. I'll tell you my biggest concern is what's going to happen when the economy isn't full of stimulus and full of consumer optimism and things like that? I think Jason shares my concern, right Jason?

Jason Hall: Oh, yeah.

Matt Frankel: Let me ask you this question, it's a little bit more specific than the last one. Affirm reported on its last quarterly report that it is setting aside a credit loss allowance that's equal to 6.8 percent, so a little under seven percent of its balance. Is that going to be enough?

Jason Hall: [laughs] That is a huge pile of money. Matt, do you remember what, say, Bank of America, what they set aside?

Matt Frankel: It's less than one percent, I think.

Jason Hall: Less than one percent. The best that I've followed consistently, Axos Financial used to be BMI holdings, set aside like 0.1 percent last quarter. Do I think it's going to be enough? Here's the thing, and this is what you're getting at. This is why I don't think that for the average retail investor this is an investable trend, is because this is the riskiest part of lending. This is unsecured consumer credit. This is where there are always the biggest losses when we have economic downturns. Is that going to be enough when we do see the eventual hiccup happen that sends the economy into a little bit of a downturn? No. [laughs]

Matt Frankel: In the financial crisis, a lot of credit card issuers, standard credit cards, saw default rates in the double digits. I think American Express was above 6.8 percent at the peak of the financial balance statement.

Jason Hall: That's a cream of the crop.

Matt Frankel: They're very affluent cardholder base. I don't think that's going to be enough if the worst happens. We haven't seen a sustained downturn since the buy now, pay later industry has been a thing. Even if you count the COVID downturn, how much stimulus was being issued in 2020 and 2021 to prop up the market? How many lenders were just willing to put payments on hold for whoever decided to call them and ask for it? It has not been a normal market hiccup, I guess you would say.

Jason Hall: Yeah. I want to point out some positive things about buy now, pay later and why it's interesting. Because I think for the average person on the street, it's like this is just another credit card, this is just another loan, another payment. What makes it different? One of the things that's really interesting about it for merchants is they get a little bit more of a peek about the information about the spender. Then Afterpay, and these other buy now, pay later companies are building up a book of data too so they can figure out how to better leverage the opportunities.

If you're just using Visa or Mastercard, one of their banks, they're issuing banks to do something like this, and of course, they're going to want to take a cut and make money and that kind of thing. The access to data is not as good because of the way it travels across those rails. That's the one thing about it that is supposedly one of the things that makes it more appealing and more interesting. I think broadly, it's probably good for the e-commerce companies. Because it's a plug-in, it's an extra button, it's an easy way to have a promo, a little bit easier way to incent to sell more merchandise. But I think depending on who the recourse belongs to, and generally that recourse is going to be at the lender at the end of the day, it's just not an investable area, I think.

Danny Vena: I've got similar reservations about the buy now, pay later space in general. This has actually been around for a long time in various forms, it's just now got the buy now, pay later label to it. But I think the issue here is going to be that I don't see these buy now, pay later companies as stand-alone businesses over the long term. I think what you're going to see happen is the first time there is a recession, and default rates go through the roof, and the stock prices of these companies plummet, they're going to become snap-on businesses to larger lenders. I've looked at these, and I just can't get myself over that wall of why are you better at lending than somebody who has a lot more money, a lot more experience, and a lot less risk?