Tough road ahead for U.S. fintech lenders as default risk rises

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A man walks his dog without wearing a face mask during the coronavirus disease (COVID-19) pandemic, while the Empire State Building and New York skyline are seen from Weehawken, in New Jersey, U.S., April 2, 2021. REUTERS/Eduardo Munoz

Jan 13 (Reuters) - U.S. fintech companies that lend to consumers with impaired credit scores face a tough year as rising defaults and interest rates limit the companies' access to cost-effective debt financing.

"We expect profitability to be depressed for many firms and funding conditions to remain challenging, as increased funding costs brought on by rising interest rates will not be offset by increases in revenue," Moody's said in a report on Thursday. It revised its outlook for such lenders to negative from stable.

During the pandemic, many fintech startups emerged as lenders to borrowers with imperfect credit. Using artificial intelligence, their screening tools were more likely to recommend these loan requests than traditional lenders'.

Lenders like Pagaya Technologies (PGY.O) and OneMain Holdings (OMF.N) financed themselves by pooling the subprime consumer loans into asset-backed securities, or ABS, which they sold to Wall Street investors.

Pagaya declined to comment, while OneMain did not immediately respond to a request for comment.

The lenders' ABS were among bonds that raised $36 billion in 2021 and 2022 by pooling consumer and marketplace loans, according to FinSight data.

Investors were comfortable buying the bonds as U.S. government stimulus ensured consumers had the money to meet their loan payments.

But as that stimulus faded, loan losses started rising, Moody’s said. Inflation has hit subprime consumers who spend most of their income on rent, groceries and gasoline, and they are struggling to meet interest payments on personal loans.

The losses on subprime loans that are assumed to be uncollectible debt or charge-offs rose on average by some 20% by the third quarter of 2022 from 2019 levels, said Moody's.

Investors in ABS are demanding higher yields for new deals or avoiding them altogether. Funding costs have also risen by as much as 200 basis points in the last few months compared to mid-2022, based on FinSight data.

But the lenders' securities have not lost investor appeal as yet, said Theresa O’Neill, ABS strategist at BofA Securities.

She said a widening of credit spreads and a deal structure that lowered investor risk through more credit enhancements would continue to ensure interest.

"We’re early in the game for what will happen in a recession or an economic slowdown for a lot of these lenders,” said Tom Capasse, founder and managing partner of Waterfall Asset Management.

Reporting by Matt Tracy; editing by Shankar Ramakrishnan and Cynthia Osterman

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