One of the biggest financial service disruptions in recent memory has been the transformation of the payday lending industry - originally published on Citizen Tekk.
A new breed of technology companies has begun to displace traditional and expensive lenders by using data and technology to build scalable, profitable businesses that deliver meaningful change for borrowers. As a financial technology investor that believes social impact can be an economic multiplier, I am particularly excited about this same model migrating to other industries. I believe that the subprime auto market is that next great opportunity for entrepreneurs.
As a whole, auto lending is a massive and highly fragmented market composed of banks, “captive” lenders, finance companies and Buy Here Pay Here (BHPH) lenders in which many consumers are unable to identify the best financing options available to them. For all but the best customers, the result is often a less-than exceptional buying experience made worse by high interest rates, unnecessary fees, and poor loan terms.
On top of this, a not-so-subtle market shift is underway towards servicing the growing subprime auto market. Lenders are drawn to this market because many buyers that sat out the recession are now shopping for cars in substantial numbers, and subprime loans offer attractive margins. Historically, this population is even more vulnerable because of a lack of compelling loan choices and misaligned financial products. However, much like the payday loan industry of five years ago, the prevalence of mobile phones and big data has the potential to dramatically reshape this trend and the larger auto industry by putting control back in the hands of the borrower.
Just as payday lending evolved to better meet the needs of the underbanked, so will auto lending change to meet the needs of subprime customers. Today’s subprime customers can pay as much as 10 times more to get a car loan, with BHPH lenders charging rates as high as 30% with no un st as payday lending evolved to better meet the needs of the underbanked, so will auto lending change to meet the needs of subprime customers. Today’s subprime customers can pay as much as 10 times more to get a car loan, with BHPH lenders charging rates as high as 30% with no underwriting. But the combination of new technologies and increasing government regulatory attention means that buyers can expect dramatically lower costs and much more efficient ways of buying a car in the very near future. At the same time, this change presents an enormous opportunity for current auto lenders and entrepreneurial thinkers as buyers search for the best deal in a newly transparent marketplace.
Over the next five years, I expect to see five new trends help completely transform this market in a way that significantly improves the borrower experience and delivers them a better deal.
First, new alternative risk scoring technologies and mobile underwriting tools will cut the cost of the highest subprime loan rates by 50%. The payday loan industry provides the clearest precedent here with companies like L2C and Zest Finance using Big Data and alternative scoring methods to significantly drop the price of borrowing. Some people (rightly so) may take issue with the structure of these loans, but no one can argue the impact on interest rate. I expect to see a similar impact when you consider the current, inflated auto lending rates and the high number of BHPH loan originations. Technologies such as big data, neural networks, and machine learning will put the tools in the hands of consumers to seriously undercut this legacy network.
Second, Internet sales and new retail channels will transform auto finance distribution, and Wal-Mart will be the nation’s biggest auto financier by 2018…with Costco and Sears close on its heels. We have only to look at cell phones, electronics, gas, or hundreds of other products to find examples of how this will upend the market dynamics in favor of consumers. Cellphones in particular have moved from a manufacturer-controlled network to a far-flung distributed sales channel that includes prepaid cellphones at corner stores. With Wal-Mart already successfully dipping its toe in the bank branch model, and as the largest check casher in US, auto finance is a natural extension. The end result will be more and lower cost loan choices for car buyers.
Third, improved loan servicing will reduce repossessions by 80%. One of the most disturbing elements of the payday industry isn’t always the front-end loan pricing, but rather the resulting debt treadmill that occurs with multiple renewals and fees. Similarly, in the auto industry, late payments and repossessions can become the larger and unexpected financial impact. New technologies that allow car owners to avoid repossessions through POS payments are already making a difference and additional education will help borrowers understand the long-term implications of non-payment. Eventually, cars will become like utilities that can be shut off for late payments. The net-net will be cheaper upfront borrowing costs because of reduced back-end risk for loan holders.
Fourth, collaborative consumption will influence loan terms for 10% of loans. The rise of transportation alternatives like ZipCar and Uber have some worried about the future of auto purchases. I believe that new, alternative lenders will see the silver lining here and leverage those opportunities to turn your car into a source of income by structuring lower cost loans tied to collaborative consumption trends. The greater ridership for your vehicle, the more reasonable your loan terms. It might sound counterintuitive to some, but it will encourage people to purchase vehicles as an economic opportunity.
Finally, the ubiquity of smartphones will inform a majority of auto purchasing behaviors and will change the point of interaction between customers, dealers, and lenders. By this, I mean that you will have better access to insider pricing information and will no longer be constrained by your physical location when securing an auto loan. Instead of having to divorce your purchase from your loan, or tie the two together by securing on-site financing – borrowers can close over their smartphone in a dealership, or even use their phone to find the best financing deals nearest them. Instead of information asymmetries where more than 10% of BHPH customers are prime and super-prime, we will find a better-aligned marketplace.
Overall, I think we are heading towards a golden age of subprime auto lending that will trickle up into the larger auto loan industry and bring us all compelling choices and benefits. While there will certainly be resistance by some of the entrenched players, we have already seen a willingness by more traditional finance institutions and newer alternative lenders to push the envelope. The result will be a changing and evolving industry – much like payday – that is better suited to the financial conditions of the consumer.
In my last post, I made the case that the financial product no one talks about - auto finance - is actually the single largest spend category in financial services for the un- and underbanked. (Read it)
Today’s subprime customers can pay as much as 10 times more to get a car loan, with Buy Here Pay Here lenders charging rates as high as 30% with no underwriting. This industry is not just large and growing, but it's also ripe for disruption. In fact, I believe that the next five years will transform auto finance in much the same way that the last five years have transformed payday lending.
Over the last half-decade, payday lending has evolved from a marketplace dominated by legacy, largely brick and mortar payday shops into one that is pioneering lower cost and better structured credit from a new breed of technology and data-driven alternative lenders.
Five years ago, payday was largely the same as it was 20 years ago. Online payday options at the time looked a lot like their traditional counterparts, neon lights and all. The high fixed costs from physical locations were simply replaced by high variable cost from lead generation. And high loss rates both on- and off-line kept costs high. From a consumer perspective, a combination of bad habits, financial desperation and information asymmetry kept people coming back to payday.
While in many ways that consumer premise remains true today, payday itself has evolved to offer many alternatives, new players and significant advances. Five years ago, there was no LendUp, or ZestFinance, or BillFloat. Players like Progreso Financiero and Think were still in relative nascency. While many can (and do) take issue with these players and others, it is undeniable that they represent a vanguard of new and improved solutions.
What's behind these improvements? Better disclosures have led to better informed buying decisions; use of big-data and better risk scores have resulted in lower losses and better terms; new channels like merchants and mobile phones have both forced and allowed for better economics; and great design has created long term brand loyalty.
Soon, we will see similar technology, data and mobile advancements drive a parallel evolution in the subprime auto industry. While there are very few startups in Silicon Valley today focused on non-prime auto finance (NeoLoan is an exception), we do see compelling startups in the broader auto space (for example: TrueCAR, CoverHound, Tesla, Uber, Lyft and Side-car) and prime-targeting financial institutions like Chase are beginning to explore new finance methods. This, together with the size and growth of subprime auto finance, paves the way for innovation moving down-market.
For my next post, I've got some smok'n auto finance predictions that we'll put our money on. Wait for it!
No one who reads my blog will be surprised to learn that 1 in 4 Americans are underbanked. But I do see quite a few raised digital eyebrows when I point out that these 80 million consumers spend almost $80 billion on fees and interest for the most basic of financial services every year. While most would assume that these enormous fees are generated primarily by check cashers and payday lenders, the actual amount is quite small at $1.7B and $4.8B, respectively. In fact, the lion's share of these fees derive from subprime auto lending.
Emerging Middle Class Americans paid $27 billion in interest and finance charges for their cars in 2011. $27 billion! That's over one-third of all financial services expenses incurred by those with imperfect credit or those that rely on alternative financial services. Back of the napkin math works out to just over $300 per person per year. As a point of reference, I pay only one-fifth of that amount.
Is this population, as a whole, really five times more risky than me? While some individuals may be, I would argue that most are not. And I believe this will have dire repercussions for many of today's subprime auto lenders.
Over the course of this week, I'm going to write a three-part series on this hidden but giant industry within consumer finance. This first post makes the obvious point that it's large and growing. In the next, I'll argue that subprime auto lending is the new payday lending - in a good way. And finally, I will make some predictions about how the industry will change in the next five years.
But first, chew on this: auto finance, in its entirety, represents a $55 billion spend category (Experian, 2012). Sub-prime is about half of that and it's growing fast. The industry is quite profitable: 32% net margins overall, and as high as 40% for "buy here pay here" lenders. After a dip in the recession, consumer demand is up. Big players like JP Morgan are showing renewed interest in the category. And the secondary market is interested.
All of this – a large, growing but highly fragmented market with a poorly designed consumer product – leads me to believe that the technology transformation evidenced in the payday industry over the past five years will likewise transform the subprime auto market, which today operates basically as it did 20 years ago. I'll make the case why in my next post.But it's curious to note that this giant industry is made up only of small players. No one company commands greater than 6% of the total industry (Wells Fargo leads, Ally - formerly GMAC - is close second). Credit unions, who have long staked their raison d'etre on their great auto finance terms, are 21% of the market. But that's across 7,000 credit unions. Not even the largest credit union has more than 1% of the total market. Can you say super fragmented?
All of this – a large, growing but highly fragmented market with a poorly designed consumer product – leads me to believe that the technology transformation evidenced in the payday industry over the past five years will likewise transform the subprime auto market, which today operates basically as it did 20 years ago. I'll make the case why in my next post.
The past two years Core Innovation Capital has issued a national challenge for who makes the most innovative product or service serving the emerging middle class, aka the un- and underbanked, the cash-preferred, the credit underserved. Sign up here at corevc.com/megachallenge.
This year, we're improving and expanding. It's not just a Challenge; it's a Mega Challenge. Instead of four finalists, we'll pick 10-12. Instead of the last day, we'll feature finalists on the first day of the Underbanked Forum. Instead of one hour, this Mega Challenge will last three hours, in front of the largest group of industry experts ever assembled.
At stake are fun, fame and fortune. A live demo before 800+ executives is pretty exciting for even the most seasoned entrepreneur. National recognition for being the most innovative product for the underbanked in 2013, as determined in real-time by senior leaders in retail, banking, payments, alternative finance, regulation and consumer advocates. And $10,000.
Nominate your company - whether large or small - at www.corevc.com/megachallenge. We've had finalists as large as FIS, or as small as the one-man Juntos Finanzas, who won by a land-slide).
The Challenge has introduced mobile check cashing for the underbanked, payroll-based short-term loans, social media-based underwriting, better sub-prime auto lending, SMS-based financial planning, and micro-investments.
We're eager to see what financial innovation is being cooked up in 2013. We've seen some glimpses and it's pretty exciting!
So if you're working on something great that serves the emerging middle class, whether in payments, in credit, in planning or saving - and if you're able to show a live demo by June, nominate your product or service. It's free, will take 5 minutes and could offer unprecedented exposure: corevc.com/megachallenge.
Goal and resolutions? Too personal. Predictions for this coming year? Too much pressure. Post mortem on last year? Too boring. So, instead, here is my wish list for our industry for the year of the Snake.
An Iconic Brand. Confidence in banking is at historic lows. Perception of alternative financial services are even lower. I would like to see a Great consumer finance brand emerge. And with Great I mean: aspirational to its customers, trusted to manifest the Golden Rule, able to scale. Keep your eye on Progreso Financiero.
Big Bank Backoffice Leadership. With a couple notable large (Chase), medium (Regions), and small (Carver) exceptions, I've long believed most banks shouldn't try too hard to serve the underbanked: oil and water. Instead, I think the best way banks can serve this customer is to serve businesses who serve this customer. Bank great Money Service Businesses. Provide debt to great short-term lenders. Sponsor great remitters. Lobby for non-bank innovators. Partner closer with retailers. I'd love to see a big bank fund and create such a line of business. There's a billion dollar opportunity for someone to go big.
A Short-term Lending Leader. Payday is an ancient game: 1.0. Since around 2010, some new tech players have created the next generation, 2.0, marked by better underwriting, greater transparency, online distribution, and more liberated loan structure (think Zest, BillFloat, LendUp). I'm holding out for 3.0 of short-term unsecured lending, based on my TRUST principles: even better underwriting, risk-based pricing, clear rewards for on-time repayment, lower customer acquisition cost, even lower default rates, the ability to scale big, and solid, mature leadership in this fractious business. It could be one of the above...
Mobile Remote Deposit Capture. Mobile? Talk to the hand! Banks have been rolling out MRDC the past couple years. Last year, it was all the rage to promise it to prepaid card customers. The big deal is that MRDC gets cash onto the phone, which you'd otherwise have to do at a retail location (in which case why use the phone if you can just do everything else at that same retail location?). The big difference is that MRDC for the cash-preferred customer needs to clear immediately, not over 5+ days. The big problem is that comes with a ton of risk. Cool companies, like Chexar, have solutions. I hope this year of all checks "cashed", more than 5% will be "cashed" onto a mobile phone.
Regulatory Clarity. I don't exactly blame your garden variety entrepreneur for starting anything but a financial technology company. It is highly regulated, complexly regulated and unclearly regulated. That Dood Frank? Office of the Comptroller Who? CFP-Why? When and what will they do to me? Fortunately, the CFPB is quite progressive. I hope they will lay out clear principles this year, even before they write the rules, on things like credit reporting, prepaid, short-term lending, and remittances.
New Lingo. The language of unbanked and underbanked has run its course. We need something new. The old lingo is limiting - it assumes banking status is the most important determining factor. It's inaccurate - underbanked suggests people should be banked, which for many in this population is not and will never be the case. It's a bummer - people aren't inspired to dig out from under something. Instead, building towers in the sky is the currency of the entrepreneur (and intrepreneur). At Core, we're trying to re-invision this market in entirely new ways and by the end of this year, I hope we'll have the beginnings of a new lingua franca.
What's on your list?
People generally assume serving the underbanked is a noble thing to do. And it is, if you do it right. You can make an incredible difference in the lives of a quarter of the US population by providing them with better tools with which to spend, borrow, plan and save. Check out CFSI's Compass Principles if you're looking for a roadmap on "doing it right."
But I am not noble. I'm a capitalist. And for the third year in a row, I've been tracking the size of the underbanked opportunity. We all know it's a lot of people (but then, many people have brown eyes). We all know their lives aren't easy (so they should help themselves, or charities can help those who can't help themselves). We assume that in aggregate they earn and move lots of money (over $1 trillion, in case you were curious). We hear immigrants send tens of billions abroad and cash billions of checks. But how much do people who rely primarily on alternatives to banks actually spend on fees and interest for basic financial services is the final measure of whether there is a market here. The answer, of course, is yes, big time.
About $78 billion was spent in 2011 by members of the American emerging middle class - also known as the underbanked - on fees and interest on basic consumer products. Together with my partners at CFSI (and thanks to the sponsorship from Morgan Stanley and Herculean efforts of CFSI's Summer Associate Eva Wolkowitz), we updated last years' study entirely. We took out some stuff, added in some stuff, mined all the best research out there, validated it with public data and insider insights. The result is impressive, I think. You can download it here.
Rather than regurgitate what you can read in the Knowledge Brief we've made for your reading enjoyment, I will instead focus on my point of view about all this. $78billion - so what?
First of all, it is a lot. To put it in perspective, this means that a quarter of the US population spends about 7% of their hard-earned paychecks just to conduct their financial lives. Ignoring management fees on securities and such, I would estimate I personally spend about negative 1-2% on my financial life. Right, I earn money to house it somewhere, pay my bills, service my credit and purchase the things I need.
Second, this is just scratching the surface. We left out costs associated with long-term debt like mortgages and education, any kind of insurance, or any costs associated with the small businesses millions of people run to stay afloat.
Third, it's incredibly inefficient. A huge amount of this relates to high losses and high fixed-overhead. The Digitization of Everything has yet to arrive here at scale. Just look at subprime auto-lending here - $26 billion in fees and interest here alone. This is a securitized loan. But imagine the cost to go repossess a car if someone fails to pay. Better, smarter underwriting - like that of innovator Neo Loan - along with a $5 widget that would turn off the car when a payment is missed, would dramatically decrease defaults and program management costs.
What if we could drive efficiencies that offer more people better service and cost them only $39 billion in fees and interest, in a way that yields better gross margin and puts $39 billion back into the economy? This is no Herculean task. Ping Core if you're working on it. You can be noble and capitalist.
The FDIC updated its 2009 figures (based on 2008 Census data) of who uses what kind of basic financial services and released them yesterday. It's not just any four years later, but marks a period that represents significant change in the economy and individual American's lives. What did we learn? Basically, there are more people who underutilize traditional financial institutions (banks and credit unions) and rely more significantly on alternative financial services (check cashers, payday lenders, etc) - but not dramatically more, 2011 vs 2008.
"More than one in four households (28.3 percent) are either unbanked or underbanked, conducting some or all of their financial transactions outside of the mainstream banking system."
We're talking about 68 million people. Honestly, this is smaller than I would have expected, but perhaps doesn't yet fully reflect some of the regulatory changes that were introduced in the wake of the financial crisis. Certainly, bankers like Jamie Dimon, who have been crying foul that they will be forced to let go of their low-end customers as a result of draconian new rules seem overly dramatic. And the growth in prepaid and anger in banks, while real, are not as exaggerated as I had expected. I think this is good news for people who think of this segment as "underserved." Relative to the dramatic times in which we live, even lower income people are maintaining a relative equilibrium in how - and with whom - they manage their day to day finances.
We will soon share an update on Core and CFSI's market size for fees and interest charged to the underbanked, to show how the industry is changing at a more granular level.
Download the FDIC report here, if you're interested.
Today's WSJ headlines with a story on how even the mass affluent are struggling with student debt. Our summer associate, Aaron Mercurio, has been working on a private student lending investment thesis for us, and opines the following:
We know student loans are important and we’re often reminded that they’re big business: The student lending market recently exceeded total credit card outstandings by surpassing $1 trillion in debt on the heels of $110 billion in new debt issued in 2011. Meanwhile, tuition increases don’t seem to be slowing down.
If students and parents are voting with their wallets, then federal loans are the preferred means of borrowing both for students and the universities that push them. 93% of new debt in 2011 was issued by the Department of Education under the Federal Direct Student Loan Program. But federal student loans come with a myriad of challenges:
Overview of Terms of a federally student loan issued after July 1, 2012 (simplified for brevity):
|Type of Loan:||Subsidized and Need Based (Stafford, Perkins):||Unsubsidized (Stafford, Direct, PLUS, Parent-PLUS)|
|Loan Amt. Limit||$3,500 - $6,500 / year||Based on school tuition + expenses|
|Interest Rate||3.4% - 5% Fixed||6.8% Fixed|
|Origination Fee||0% - 1%||Up to 4% (w/ 1.5% rebate)|
|Collections||Cannot be discharged in bankruptcy, wage garnishment allowed|
Source: Department of Education, Direct.ed.gov website
The average student has $25,700 in debt, including graduate school debt, according to the Department of Education. While subsidized Stafford/Perkins loans are attractive – students need to qualify and it may only cover a small amount of tuition.
Key issues with Federal Student Debt today:
- Not all loans are created equal: Fixed, flat rate loans are inefficient; don’t account for risk, macro-environment, or student/university performance
- Lack of price competition: Up to 4% origination fees and fixed-rate loans in a market where prime has remained flat at 3.25% since Jan, 2009
- Extreme collection practices: Defaulters are almost never able to discharge loans in bankruptcy and co-signers credit is impacted
- Inconsistent borrowing caps: Like the rates, desire for simplicity creates inefficiency in terms of meeting students’ individual borrowing needs
The silver lining? Major problems drive major opportunities, and this market is ripe for innovation. With start-ups like Fynanz creating a platform for credit unions to aggregate lending power to compete, SoFi connecting alumni with current students to create lower cost opportunities, and Tuition.io providing sophisticated software for managing student debt and repayment, I’m excited to see if these and other companies can drive the PSL market and compete head-on with federal loans.
I try to avoid eating food that "may or may not" contain some ingredient, especially if it's not even clear what that ingredient is (milk product?). Barclay's new Ring credit card, I'm afraid, looks tremendously tasty and innovative, but while poking through their Terms of Service over lunch just now, proved themselves no better than a Twinkie. In fact, far worse, because Twinkies don't pretend to be healthy.
Barclay's pitches the Ring credit card as "crowdsourced" and "community powered." They're keeping it "simple" and touting unprecedented candor: "For the first time ever, we're going to give you a look at our profit and loss statement, which shows you how we make money from Barclaycard Ring. And with Giveback™, you'll even get to keep some of the profits for yourself." This is cool stuff! If they would actually share their (card's) P&L statement, it would be a historic first. I love the idea of being a customer and an owner, and if they do it right, I might actually choose features or economics that aren't strictly in my myopic self-interest.
They keep their promise with low, flat rates, a clear fee schedule, even beyond the basic Schumer box requirements. The Terms of Service is easily accessible, plain English, short and to the point. But reading past the fee schedules and basic disclosures, comes my tremendous disappointment:
This profit sharing feature is not based on the actual profits of the program. Instead, the Giveback™ program contains a transparent calculation that is used to determine what will be shared with the community members and which may or may not approximate actual profits. The Giveback™ program and the profit sharing features are offered at our sole discretion. We may discontinue the program at anytime.
They will "transparently" disclose what amounts to a deceitful claim. They will not share their P&L. They may give something back, but it may or may not approximate actual profits. It could be a lot less than your garden variety non-social, non-transparent credit card. They may, in fact, give nothing back, at their discretion. But the fact they promote this as the vanguard of transparency, the epitome of modern, youth oriented social media savvy strikes me as incredibly cynical.
Why not actually disclose the P&L, even if just for a particular product? Why not actually share a portion of the profits that could amount to more than the perfunctory "2% cash back"? Why not actually open source functionality? Why not actually use our social media networks to strengthen our financial agreements? Why fake it, Barclays?
My partner in crime, Jennifer Tescher, who runs the Center for Financial Services Innovation, is leading a bold movement to increase quality in consumer finance. High time! Here's what she has to say:
Given the high level of consumer confusion and distrust, the Center for Financial Services Innovation (CFSI) set out in 2011 to create a higher bar for the financial services industry. With feedback from providers, consumer advocates, policy makers, regulators, and other experts in the financial services marketplace, we created the Compass Principles – a set of guidelines outlining the qualities and features financial institutions should consider, as they create and sell basic financial tools. The Principles are a force for change. They define how the industry can work toward a vision for the future in which financial services are safe and actively contribute to improving people’s lives.
The Principles are comprised of four main guidelines:
- Embrace inclusion by responsibly expanding access;
- Build trust by developing mutually-beneficial products that deliver clear and consistent value;
- Promote success by driving positive consumer behavior through smart design and communication; and
- Create opportunity by providing options for upward mobility.
The Principles aim to inspire a race to the top by encouraging financial services providers to take a proactive role and think creatively about how their products can better serve both their customers and their institutions. The Compass Principles help providers think about how to serve customers in ways that are fair and inclusive. As financial services providers make a “Compass Commitment”—a pledge to proactively and fairly serve their customers and the industry—we will see real examples of products and services that exemplify the Compass Principles. This framework will foster a healthy competition among organizations across the entire landscape to provide safer and more innovative products for their consumers—and we’re looking for those organizations right now. To learn more about the Compass Principles visit www.compassprinciples.com.