Buy Now, Pay Later (BNPL) Securitization: Increasing Risks Amidst Increasing Demand

In our first issue on Buy-Now-Pay-Later we focused on potential consumer over-indebtedness, on the value added for merchants and on the regulatory backdrop for these relatively new types of loans.

But one question remained unanswered - what’s in it for private market investors? The answer lies in how BNPL firms finance their loan writing.

BNPL companies initially used to raise money by selling short-term bonds to investors. It made sense in the “zero rates” days, but it is no longer possible since central banks in the developed world have raised the cost of money.

More recently, BNPL firms have been resorting to financing their loan writing through securitization, which offers access to relatively plentiful - if more expensive - sources of capital. It is also a good opportunity to unload risk from their balance sheets.

Securitization is not a new practice in consumer loans - quite the opposite. But BNPL securitization works differently for a number of reasons.

First of all, BNPL companies write very short-term, non-recurring loans (unlike credit cards or auto loans). Moreover, BNPL loans are also not interest-bearing. Rather, revenues are generated by fees paid by merchants, which creates an interesting conundrum when it comes to identify who has more “skin in the game” (hint: Not the BNPL issuers…)

How Does BNPL Securitization Work?

While traditional balance sheet lending is structured so that revenues are derived from the interest and fees collected on loans (i.e., net interest margin minus provisions for losses), BNPL platforms instead rely on a fee (typically 2%-7% of the purchase amount plus, in some cases, a small flat fee) paid by the merchant in advance.

In the days of very low interest rates, BNPL companies such as Affirm and Zip financed their loan writing by issuing convertible bonds - which could be turned into shares at maturity, and they often were, given the appeal of BNPL firms’ stocks - or short-term bonds with 0 coupons. In Europe, Klarna was also issuing commercial paper.

As this era came to an end two years ago, BNPL providers searched for new funding sources.

Enter securitization.

Recently, Affirm has issued $2.4 billion in loan-backed securities, while Klarna has sold loans to private market investors. PayPal signed a deal with KKR to sell packaged European loans. Finally, in Australia, Zip offered ~$2 billion in consumer loans-backed securities.

It is crucial to say that securitization is still not as pervasive in the BNPL space as it is for other types of consumer lending, but it is gaining traction as BNPL growth has plateaued and the macroeconomic environment has become more challenging - consumer spending has tapered, and, with higher rates, funding for BNPL has become harder to obtain and more expensive.

But several challenges have been highlighted - notably by rating agencies - on the sustainability of securitization for BNPL firms.

For starters, it is hard to ascertain BNPL companies’ creditworthiness, as they have grown very quickly, and are just about to get tested in an unfavorable market cycle - one of higher rates and slower growth. Loan default rates may also potentially mount due to consumers with lower credit scores increasing reliance on these types of short-term loans, instead of credit card debt.

Additionally, compared to traditional consumer loan securitization - namely credit card receivables and auto loans - BNPL providers may have less “skin in the game” than traditional lenders, which can potentially affect underwriting standards and loan quality. It is not inconceivable to think that a retailer may prefer to work with BNPL lenders with laxer underwriting policies, which would boost sales, but also mean low quality asset-backed securities may potentially find their way to investors portfolios. 

This happens at a crucial time for the BNPL sector. We have thoroughly analyzed, in our first BNPL piece, the increasing dichotomy between strong borrowers, with prime credit scores, who use BNPL for convenience, and weaker ones who rely on BNPL because - and this is the key issue - BNPL loans do not require credit checks and come with a much easier approval process overall.

The combination of BNPL sector growth, increased skew towards lower credit scores and a potential economic slowdown can have a disruptive effect on these securities.

But there’s more. Given their revenue structure - their reliance on merchant fees rather than interest payments - BNPL firms may not be as aggressive in pursuing defaulted borrowers, which would leave investors less protected.

BNPL-backed Securitized Loans: Credit, Regulatory and Operational Risks

First of all, the short track record of BNPL firms makes it difficult to assess long-term risk. In other words, there simply isn’t enough data to assign a credit score to these ABS.

Moreover, calls for stricter regulations, especially with regards to enhanced consumer protection - which we have highlighted in our previous newsletter - are likely to impact BNPL firms’ profitability. These newer companies with rapidly growing origination present a bigger challenge when it comes to formulate loss proxies (i.e. figure out potential loss provisions in a balance sheet).

As we already mentioned, these companies are also untested in a negative credit cycle, when consumer activity dwindles, and higher unemployment means - at the same time - that more consumers with lower credit scores may be utilizing BNPLs to get by.

A predicted surge in consumer loan defaults was staved off during the pandemic by government-issued stimulus checks. These financial injections provided temporary relief for millions of consumers, allowing them to service debts and avoid falling behind on payments. BNPL lenders benefited from this influx of liquidity, as borrowers were able to meet their installment obligations despite a turbulent economy.

However, this dynamic also created an artificial safety net that may have masked the true level of consumer financial health. As a result, the BNPL industry has grown rapidly under the assumption that credit performance was to remain stable.

With inflation now higher - albeit stable - amidst higher rates, the risk of consumer defaults could escalate. Many households are now feeling the squeeze of rising living costs, from groceries to housing. The erosion of disposable income, coupled with accumulated debt from BNPL services, leaves consumers increasingly vulnerable to financial strain.

Let’s not forget: BNPL loans are often chosen by households with lower credit scores.

This raises serious concerns for lenders, as the weakened purchasing power and diminished financial support could trigger a spike in missed payments and loan defaults, ultimately impacting the performance of BNPL portfolios and putting investor returns at risk.

Operational risk may also arise from BNPL lenders' lax underwriting practices and fast credit approval processes, which may expose end investors to greater potential losses. Retailer-driven pressure to increase acceptance rates and ease underwriting standards can compromise the quality of the asset pool.

Increasing Demand for Consumer Loans-backed Debt

Despite the risks associated with BNPL, demand for consumer loans-backed debt more broadly is expected to remain strong.

As the private credit sector experiences significant growth, with core allocations increasingly directed towards direct business loans and commercial real estate (CRE), investors are turning their attention to consumer loans to fill in the "opportunistic" bucket of their private market portfolios.

These allocations provide managers with diversification potential, not to mention the ability to take advantage of secular disruptions - which we are currently experiencing in consumer behavior. It is worth reminding that the consumer economy represents between 70% and 80% of the US economy, and is generally under-allocated.

It is premature to project the growth of the BNPL securitization market, which remains small for now, but can potentially grow at the expense of credit card receivables lending. Indeed, evidence shows that less wealthy segments of the population are increasingly using BNPL instead of credit cards.

Major hurdles to BNPL securitization growth are regulatory uncertainty, particularly in Europe, and a realistic assessment of non-performing loans - and whether a market for these eventually forms. To date, no BNPL securitization deals have been rated in Europe, largely due to regulatory and operational risks.

With regards to the regulatory environment, concerns over compliance with consumer protection laws and evolving credit practices are prompting regulators to closely scrutinize BNPL companies, which may limit the market’s ability to scale.

The introduction of new regulations could cap potential ratings on these securities, making them less attractive to institutional investors seeking stable, high-rated investments. As a result, the growth of the BNPL securitization market could be significantly slowed by these headwinds, particularly in regions where regulatory frameworks are not yet established.

On the question whether a secondary market will emerge for non-performing loans (NPLs) from BNPL companies, BNPL firms often operate on relatively thin margins, and their portfolios may be more susceptible to defaults, particularly in an economic downturn.

If a market for NPLs from BNPL providers were to develop, it could provide an additional liquidity outlet for these companies and allow them to offload risk from their balance sheets. This would mirror similar trends seen in traditional consumer finance, where NPL markets have become an important aspect of credit risk management.

While the BNPL market is expected to be worth $700bn by 2028, it is hard to project how large the non-performing slice of this market is likely to be. Investors’ uptake will be a factor of the risks associated with these assets, which could be significantly higher than those in more established asset-backed securities markets. The creation of a robust NPL market for BNPL debt may ultimately depend on how well the sector can manage defaults.

Conclusion

Securitization has the potential to provide a lifeline to BNPL firms in a high-interest-rate environment.

But as rating agencies clearly recognized, this may pose significant risks to investors, as a result of potentially higher default rates - due to increasing base rates - and regulatory headwinds that would erode profitability.

The problem is - years of very low interest rates have created artificial pockets of growth for certain markets, to the extent that it is at this stage hard to figure out if the BNPL industry exists only because of a combination lower rates and no regulation. It could as well be a transitional “alpha” opportunity that is fast closing.

Borrowing cheap from investors and collecting fees from merchants has been a successful business model, but as rates increase, either merchant fees will have to increase, or BNPL firms will be unable to extend the same favorable terms they have been extending since inception - meaning potentially the era of no-interest short-term loans to consumer is over.

Meanwhile, regulatory standards are catching up and are no longer ignoring BNPL, closing the gap with credit card regulation and limiting BNPL companies profits.

All this is happening while investor appetite for private credit is growing at breakneck pace, with consumer lending securitizations being identified as a potential “opportunistic” allocation within increasingly larger private market portfolios.

The risk is that of a mismatch between increasing investor appetite for private credit opportunities and deteriorating credit quality for BNPL-backed securities, which could negatively impact private credit investment portfolios down the road.

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