Since Affirm (AFRM -1.34%) went public, it has been drawing attention for its efforts to really bring "buy now, pay later" (BNPL) lending to the masses. The company offers several ways for consumers to buy everyday products with no money down and pay off those purchases in multiple installments. The company's services also help merchants boost their sales. But at the end of the day, Affirm is making lots of short-term loans, which means credit quality can make or break the company. With that in mind, let's take a look at how its loan quality is holding up.
Delinquencies and charge-offs rise
With pandemic stimulus programs now in the rear-view mirror, inflation running high, and savings on the decline, it's not a huge surprise to hear that Affirm has seen delinquencies rise over the past year.
Image source: Affirm.
Affirm's delinquencies moved even higher in July and August, although they were still below levels seen in its fiscal 2019 at that point in the year. Charge-offs, which are debts that the company views as unlikely to be collected, and a good indicator of actual losses, came in at nearly $66.4 million in its fiscal 2022 fourth quarter, which ended June 30. That was up roughly 38% from the fiscal third quarter.
Interestingly, Affirm lowered its allowance for loans on its balance sheet to 6.2% of its total loan book. That's still a healthy buffer, given that the net charge-off rate for loans held on its balance sheet is currently at about 2.7%.
Confusing credit trends
Affirm's credit trends confuse me. Its delinquencies are rising, charge-offs are way up, many think the U.S. economy is headed for choppier waters in the near term, and yet Affirm is reducing its allowance for loan losses. That move is also being made as interest-bearing loans -- presumably made to riskier borrowers because they charge annual percentage rates (APR) of between 10% and 36% -- are ticking up at the company.
Management has tried to explain these policies. Chief Executive Officer Max Levchin said about half of the company's loans are projected to be paid off in four months and about 80% of the book in eight months, giving management a good line of sight into credit trends.
Furthermore, Levchin and Chief Financial Officer Michael Linford talk constantly about how Affirm's proprietary credit underwriting gives it control over how loan delinquencies come in. On the company's February earnings call, Levchin said that by cutting its origination volume by 10%, it could eliminate one-third of all delinquencies, but asserted that doing the same reduction using traditional credit underwriting would only lower delinquencies by 13%. If Affirm lowered loan originations by 30% it would remove 70% of all delinquencies, while under a traditional underwriting model, that same reduction would only remove 36% of delinquencies. But this is all a bit hard to reconcile with outside studies like a Breeze survey that found that 36% of people who have used BNPL to make a purchase have missed a payment or made a late payment.
While Affirm's ability to lower delinquencies would be impressive if true, the fintech company still would have to cut the total volume on its platform in order to lower the credit risk in its portfolio, and investors were already disappointed by Affirm's forecast of $20.5 billion to $22 billion of gross merchandise volume for its fiscal 2023. That implies less growth even at the top end of its guidance range than it achieved in its fiscal 2022, when its gross merchandise volume rose by $7.2 billion to a total of $15.5 billion.
Finally, I also find Affirm's proprietary ITACs credit scoring model hard to understand. The ITACs model grades loans on a scale of 0 to 100, with 100 being the highest credit quality and the least likely to go into default. But almost 90% of the loans on Affirm's balance sheet score above a 90, which one would think is a pretty good score. Yet, 64% of Affirm's loans are interest-bearing, which means they are charging APRs of between 10% and 36%, suggesting that there's a significant degree of risk that these borrowers will default. In my opinion, suggesting that 90% of your loans got a 90 or above out of 100 in terms of credit risk skews the perception of what risk actually is.
How is Affirm's loan quality holding up?
Right now, loan quality across the industry is still holding up quite well. But with interest rates rising rapidly, many experts anticipate that consumer finances could soon start to deteriorate, and the hot labor market will likely start to cool eventually. Affirm saw delinquencies and charge-offs rise last quarter, but also lowered its allowance for loan losses. Reports about BNPL borrowers are not good. Levchin, who was a co-founder of PayPal, is undoubtedly an extremely smart guy, but right now, Affirm's credit trends and policies don't quite add up for me. So when it comes to this stock, I'm staying on the sidelines until I can get better answers to some of my questions.
