“It was the best of times, it was the worst of times...” -Charles Dickens, A Tale of Two Cities
Charles Dickens' famous starter to A Tale of Two Cities, as it turns out, is a pretty good way to sum up the year 2018 from the view of the alternative financial services segment.
There were plenty of tailwinds that pushed the segment forward: A strong economy, healthy consumer interest in credit and advances in credit scoring technology were all instrumental in pushing more consumers into the market, particularly in the first half of the year. However, as 2018 wore on, headwinds started to blow back on the segment, most especially in the form of rising interest rates.
That means that on the brink of 2019, it remains uncertain whether the next year will look more like the best of times or the worst of times when it comes to providing consumers and small businesses (SMBs) with access to financial services — both in and outside the traditional bank-backed channels. While we can’t comprehensively say what’s next, we can say to keep watching, because some of 2018’s top stories are certain to keep unfolding, even after the ball drops on 2019.
The Two Faces Of Consumer Credit
“The economy is definitely humming, but most people are still living paycheck to paycheck and facing financial stress.” -Karen Webster, Why Household Finances Under The Hood Don’t Look So Good
Depending on where and how closely one was looking at consumer credit health in 2018, it is possible to take a positive or negative view of the situation.
There is undeniably a lot of good news. Unemployment is at historic low levels (below 4 percent) and wages have been on the increase. According to the PYMNTS/Unifund Financial Invisibles Report, 81 percent of participants said their financial situations have either remained stable or improved since last year, and the number of consumers seriously delinquent on debt dropped 11 percent between Q4 2017 and Q2 2018. The average consumer credit score hovers between 694 and 706, depending on which source one prefers.
However, under the hood, household finances may not be quite as solid as the macro-economic data figures might have indicated. About a third of consumers are seriously behind on their bills, at the same time that American consumers are racking up debt. According to the Federal Reserve, U.S. consumers owe roughly 26 percent of their annual income to debt, up from 22 percent in 2010. That amounts to $13.2 trillion, up 18.5 percent since 2012.
Most alarming, Webster noted, are the large swaths of consumers who appear financially stable outwardly, but may not be when taking a closer look.
“They don’t look like they’re in trouble,” she said. “They have good jobs. They wear nice clothes. Their kids probably go to summer camp, and they take family vacations. Walking by them on the street or working in the cube next to them would never foreshadow the stress of their daily financial situation.”
These secretly vulnerable consumers, Webster noted, often use debt to make ends meet, either on credit cards or through alternative vehicles like online lenders. That may be OK right now while credit is fairly abundant, but as 2018 was heading into its final stretch, there were some indications that credit in some quarters would be harder to come by. Capital One and Discover have both announced that they will be tightening their underwriting standards in the new year, and Goldman Sachs has gone from plans of expanding its online consumer credit product Marcus to plans of reining it in somewhat next year.
“Unless we sort this out as a payments financial services ecosystem, we’ll be talking about things a lot more serious than a bunch of consumers feeling stressed out about paying their bills, but [about] managing to pay them somehow, some way, even if they’re late in paying them,” Webster said.
Concerns about consumer finances under the hood are only becoming sharper, as interest rates have been on the incline in 2018. In the last three years, the Federal Reserve has raised the federal funds rate nine times — after a decade of keeping at near zero. Four of those increases have been in the last 12 months, with more are expected in 2019.
The rising rates have not only made debt more expensive, but they have been a weight on loan growth across both bank and FinTech lending platforms in the back half of the year.
Despite predictions of blockbuster loan growth in late 2017 and early 2018, and some early signs of strength by the actual numbers, 2018 was a fairly modest year overall — topping out at a little more than 5 percent growth. That’s better than it was in 2017 (when it didn’t clear 5 percent), but still well below the double-digit increases that were on display a few years ago.
“For a while now, we’ve been waiting for loan growth improvement, and it’s been slow,” said Barclays Analyst Jason Goldberg. He also noted that continued uncertainty over trade policy and higher interest rates represented two culprits holding back more activity.
High interest-rate arresting activity, as it turned out, was a theme throughout the year’s stories as well — even in segments where activity was, overall, quite innovative.
Resetting Mortgage Services
“This is a frugal generation [millennials] that realizes that a mortgage with tax payments and insurance included is still much lower than paying rent, especially in desirable markets. They are becoming homebuyers.” -Caroline Watteeuw, EVP Chief Information Officer, Caliber Home Loans, Moving Mortgages Into The Mobile Era
For years, we were promised by think pieces that millennials — too burdened by student debt, too gun-shy because of the Great Recession and too enamored by avocado toast to save up for a down payment — were never going to buy houses. They were going to rent, or possibly live with their parents, forever.
As millennials grew up and entered their 30s, the adults they became weren’t quite the people forecasted by analysts, according to the PYMNTS Connected Consumer Report. Those older millennials between the ages of 30 and 40 have earning power, are well-educated and are settling into more stable careers. They're getting married, having children and trying to buy houses — though how they are buying them is evolving.
The majority of mortgages underwritten in the U.S. today are backed by non-bank lenders, Watteeuw noted. Caliber is the fourth-largest non-bank mortgage lender in the U.S., and she told PYMNTS that millennials are increasingly edging toward being Caliber's majority buyers — as of this year, they made up 40 percent of loan originations.
For that up-and-coming class of borrowers, she noted, a mobile app-centric approach is necessary. There will always be high-touch elements of mortgage underwriting, but the ability to easily upload and transfer documents via smartphone — or easily contact their loan officer via the app — drastically speeds up and improves the process for younger borrowers.
“We are trying to build around our borrowers a virtual community of people who are digitally enabled, so that we can get the buyer into their home,” said Watteeuw.
Even more digitally enabled firms like Caliber, though, are missing a swath of interested millennial proto-homebuyers — those locked out by down payment requirements. According to data from Redfin, affording a down payment was the leading concern among millennials looking to purchase a home in the last 12 months, with 50 percent of millennial respondents noting down payment woes.
This is where startups like HomeFundIt come into play, with a platform that allows homebuyers to crowdfund real estate down payments and other associated costs of home purchasing from friends and family members.
As part of a conventional financing agreement with a bank or mortgage lender, consumers can receive cash gifts toward a down payment, but the circle of eligible gift-givers is very limited — and those gifts must be carefully (and sometimes arduously) verified. HomeFundIt allows consumers to take crowdfunded gifts from a wider range of their friends and family network, which, on average, helps users raise about $2,500 toward their down payment costs. CMG — HomeFundIt’s parent firm — also offers users some access to match funds with grants to further boost their down payment amount.
While HomeFundIt is a relatively small startup as of the end of this year, it may be the exact type of outside-the-box solution necessary in 2019 for millennial buyers and potential homebuyers in general, particularly as there will be fewer mortgage lenders available to originate loans.
The rising rates environment of 2018, according to the Conference of State Bank Supervisors (CSBS), has been pushing non-bank mortgage lenders out of business — as their numbers declined by about 3.5 percent between the end of 2017 and the middle of 2018. The ranks of mortgage loan originators at those firms declined by 7 percent, or by about 11,000 workers.
Though some are noting that this may foreshadow a crisis in mortgage underwriting, others like Dan Gilbert — chairman of Quicken Loans, the largest non-bank lender and one of the largest mortgage providers in the U.S. — told PYMNTS that, though there might be a market correction in mortgage lending, there are no signs at present that there is any 2008-like calamity around the corner.
“Rising rates are headwinds to us,” he said, according to industry rankings. “When rates go low, those are tailwinds. But either way, the plane has to fly.”
While large players like Quicken may continue to fly, smaller non-bank lenders may struggle to keep the wind beneath their wings in the new environment. Unlike banks, these lenders have neither deposits to fund themselves nor (in most cases) other lines of business to buoy them through a slow housing market. Instead, they often rely on short-term bank loans — now at a more expensive rate, unfamiliar territory that lenders will almost certainly have to navigate for at least the first half of 2019.
Credit Scoring Gets An AI Reset
“It’s easy to lend money. The trick to successful financing is getting it back and making more money off what you provided. That’s why it’s time to advance the existing solution to bring in the new types of data that are available.” -Dr. Akli Adjaoute, CEO, Brighterion, Can AI Kill The FICO Score?
FICO was not a huge hit when it was first introduced in the 1950s, as banks didn't initially trust the automated credit scoring system designed by engineer William Fair and mathematician Earl Isaac. However, after years of refinement and a boost from a few pieces of legislation, it has become the dominant credit scoring model in the United States over the last nearly 70 years.
Yet, whether it will hold on to that dominance is perhaps an open question.
Of the 247 million Americans eligible for credit, 57 percent are thick credit file consumers — with five or more active tradelines into which the FICO score can dig. On the whole, this group of consumers can fully participate in the financial system. On average, they tend to be older, more affluent and more likely to have multiple credit cards or lines of credit — and tend to have credit scores north of 700.
The other 43 percent, or about 106 million people, with thin credit files are nearly invisible to FICO — and either have no score or a low score. That population included Brighterion CEO Dr. Akli Adjaoute when he first moved to the U.S. in the early 2000s and found it hard to get approved for a mobile phone plan in the U.S., despite operating a successful firm in Europe.
“Additional data fields prove to deliver a more complete view of today’s credit consumer. For the credit invisible, the data can show [that] lenders should take a chance on them. They may suddenly see a steady payment behavior that indicates they are worthy of expanded credit opportunities,” said Paul DeSaulniers, Experian’s senior director of Risk Scoring, Trended Data and Collections in a PYMNTS interview earlier this year. “Alternative credit data can take the shape of alternative finance data, rental, utility and telecom payments, and various other data sources.”
It seems FICO has heard the rumblings, and is concerned about being challenged as the primary credit scoring game in town as it is rolling out a new scoring system. Called the UltraFICO Score, it is designed to give thin-file consumers credit by factoring in how consumers manage the cash in their checking, savings and money-market accounts, which could serve as an indication of how likely they are to repay their debts.
FICO explained that consumers with at least $400 in their accounts — who have had the accounts for a while, make regular transactions and don’t overdraw — are likely to see their scores rise. In addition, applicants will be able to choose which accounts they want to use to recalculate their scores. FICO has estimated that 7 million applicants will see their scores improve under the new system, with an estimated 4 million seeing a boost of at least 20 points.
Furthermore, FICO is “very focused” on its “ability to separate future good borrowers from bad borrowers,” said David Shellenberger, FICO’s senior director of Scoring and Predictive Analytics. He also noted that the new system will help screen out consumers who are more risky than their previous scores indicated.
To see how well the system works, and whether it fends off the various FinTech challengers to FICO’s crown, we will have to wait for 2019. The change will be one of the largest shifts in both the FICO scoring system and credit reporting in general over the last 30 years.
It was, as PYMNTS noted, a seesaw year in the alternative lending world. Consumers, the numbers indicated, are looking for credit and are increasingly comfortable seeking it in various forms, bank-backed and not. Default rates remain low, while employment figures remain encouraging. Not to mention, the market is pushing hard toward greater inclusivity to the point that even FICO is concerned about protecting its credit scoring monopoly — enough to get with the times that alt lenders kicked off a decade ago by using a wider range of data streams to evaluate whether or not a consumer can be counted on to pay.
However, rates are set to continue rising in 2019, and many of the alternative financial services startups that have entered the scene in the last decade are new to that environment, which continues to fan concerns.
As Karen Webster and Affirm Founder Max Levchin discussed in a late December 2018 podcast, the conversation about consumer credit itself is changing and evolving. Consumers are increasingly interested in credit tools that don’t just expand their buying power, but help them better manage their financial lives as a whole.
That means that as wild a ride as 2018 was in the segment, it may have been merely a warm-up for the truly fast time to come in 2019. We look forward to riding through it next year.