For years a high growth segment of the debt market has been the so- called sub-prime housing market. Sub-prime refers to the credit rating of the consumers who are borrowing to buy homes – their ratings are sub-prime meaning that they have a weak to poor history of making debt payments. Of course, risk and reward go together, so the lenders thought that if they made loans to sub-- prime consumers, they would make more money by charging a higher interest rate, closing fees, etc.
This predicament has always struck me as odd—lenders charging more money to the very people who can’t afford it in the first place. But that’s what happens. In the early stages of sub-prime lending all goes well. Lenders make loans and charge fees, consumers buy houses and everyone is happy. Overall loan balances at the lender grow fast because competitors are slow to catch on. This looks like a good business, and, in the early years, it is. It usually takes a couple of years for things to go wrong on a scale that affects the whole company.
Growth covers up a lot of mistakes and companies who tap into new markets usually grow pretty quickly, allowing them to take care of whatever defaults do happen and make it all look good. It’s when the growth rate slows down that they start to see the default rate as a percentage of total static assets rise to levels that don’t work very well.
There are good slices of this market and bad slices. Good slices make money because the good consumers who have real jobs and can manage their payments well make it work. Perhaps they wound up with a poor credit rating because of the financial consequences of some adverse life event such as an illness or other one time problem. Bad slices of the market lose money because the consumers who make up this slice really can’t handle the burden. Their credit ratings are accurate and ignoring it was a mistake that can’t be corrected with higher fees.
The problems with sub-prime lending arise when too many people get into the market thinking they can all have the good slice. They start competing as if every customer was a good customer mislabeled as a bad one. They aren’t and there are not enough of the good ones to go around to make up for the bad ones. It’s that simple.
Recently lenders have been discovering that there is no defying the laws of financial gravity forever. For a while maybe, but not forever.
What does this mean for the markets and our space in particular? You can expect a lot of people to start looking harder at the risk they have taken on loans and other financial arrangements. In some cases, lenders with direct exposure will pull back their lending activities, tighten credit standards and in extreme cases, stop lending altogether. Some may even fail or be taken over by larger financial entities.
This kind of thing happens all the time—remember Long Term Capital Management? It was anything but long term. They bet the wrong way on Russian bonds and other volatile instruments and lost a bundle. They were then taken over by a consortium of banks.
What does this mean for ISOs? Well, put simply, it means that it’s likely that money will be harder to come by. Merchant processing and ISOs in particular have been hard to bank in the best of times and the last five years have been just that. Expect money to become harder to find and probably more expensive from here.
Lenders will expect more from their borrowers in all respects, collateral valuations, reporting and debt performance convenants.
Lenders will probably expect more collateral for the same loan just to make sure everything is locked down.
This adjustment period will likely take several years, and then the market will reach a new period of stability marked by tighter credit standards. Bottom line: Credit standards won’t return to the free and easy days of the early part of this decade for at least ten years.
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