The Federal Reserve raised interest rates for the second time in a decade this month, increasing the federal funds rate from 0.25 percentage points to between 0.50 and 0.75. But unlike the previous rate hike, the Fed has signaled its intentions to raise rates again in short order. CNN Money reported that many Fed officials predict three or four additional hikes in 2017.
To many, this is a sign that the Federal Reserve has new confidence in the economy, which has enjoyed several years of consistent job growth and a national unemployment rate that has dropped below 5 percent. But not everyone welcomes the move. The lending industry has changed since interest rates first dropped to near zero in the immediate wake of the last recession, and some new online lenders may struggle in this new environment.
How will online lenders acquire the necessary capital?
The challenges of securing financing for their own operations has forced some upstart online lenders to cease loan origination, according to the Wall Street Journal. For instance, Dealstruck Inc. reportedly lost its credit line and stopped issuing new loans. Some hedge funds may not view online lending as a promising investment in a time of higher interest rates.
“To the extent that rate hikes come sooner than anticipated and it surprises the funding market, and then you get funding costs moving up more quickly than the investors had anticipated, that’s when you can see some dislocation,” Eric Wasserstrom, managing director of equity research at Guggenheim Securities LLC, told the Journal.
The type of financing matters
Specifically, those online lenders that rely on hedge funds for their own financing may be hit hardest by rate hikes. The Journal noted that hedge funds often pay higher interest than the federal funds rate, meaning that they seek even higher rates from online lenders.
Even small rate hikes can add up over time. The problem for small online lenders is that they aren’t necessarily competing on a level playing field. The question of their survival hinges on their ability to either absorb the cost of higher interest rates or pass them on to consumers. Larger financial institutions are already better positioned to weather changes in the market, and online lenders that obtain their capital from banks, rather than hedge funds, can often negotiate better deals.
Can online lending succeed by reducing risk?
One advantage that online lenders have is their ability to use innovative underwriting techniques to streamline the lending process and make it easier for small borrowers to obtain credit. Traditional underwriting considers factors such as tax returns, credit reports and bank statements. But as Inc.com noted, online lenders have made great strides in the use of big data. Some look at the results of programs like FreshBooks for an additional angle on a potential customer’s finances. By analyzing individual transactions, they can pick up on patterns that traditional lenders may miss.
“Online lenders that obtain their capital from banks, rather than hedge funds, can often negotiate better deals.”
Crowdfund Insider argued that the online lending industry’s unique approach to underwriting may actually reduce systematic risk, which could help many of these small startups survive.
“Every originator and every lender have their own product structures and credit policies,” Frank Rotman, founding partner at QED Investors, told the news source. “They find ways of originating demand and then say ‘yes’ to some of the applicants. Saying yes to the right customers using the right policies and products should result in a very resilient portfolio of loans regardless of whether you’re holding the loans or selling them downstream.”
If online lenders can do this right, they may be better positioned to succeed despite higher interest rates.