LendingClub: When Headwinds Turn To Tailwinds (NYSE:LC)

You probably couldn’t imagine a much worse macro setting for a digital market bank like LendingClub (New York stock market :CL). The headwinds are currently remarkably strong and are almost single-handedly attributed to rapidly rising interest rates.

This both affects market origins and causes significant NIM compression for LC’s existing portfolio. The good news is that these headwinds are temporary in nature and should ease over the next two quarters.

The business model remains extremely attractive and the TAM has never been greater with outstanding credit card balances topping the $1,000,000 mark.

In this article, I will explain the nature of headwinds, when these will turn into tailwinds, and how that will translate to the stock price reaction.

The business model summarized

Investors may recall that LC income primarily comprises NII from unsecured held-for-investment (“HFI”) securities income from personal loans and market fees from the sale of loans initiated to partners and investors (which include banks and asset managers).

Since becoming a bank in the first quarter of 2021, LC has significantly grown its HFI portfolio, as these offer a very good return on equity. The market revenue generated supported its profitability and enabled it to generate organic capital which was immediately deployed to grow the HFI portfolio. This created a virtuous cycle of increasing profits and growing book value. It is important to note that maintaining loans on the balance sheet requires recognition of lifetime expected losses under the CECL accounting standard. This effectively means that by retaining the loans, LC generates an accounting loss in the quarter while income will be recognized in future accounting periods. So, in other words, it is only a time difference, but requires LC to pre-finance the capital in advance. As I explained in my previous articleLC has always been capital constrained while its binding capital constraint is the Tier 1 leverage ratio.

Headwinds

The rapid increase in interest rates by the Fed created a number of significant headwinds for the economic model.

First, the loans issued by LC are generally fixed rate loans while the cost of funding is based, in large part, on high yield deposits which instantly revalue when the Fed raises rates. This invariably leads to significant net interest margin (“NIM”) compression which affects LC’s profitability. This is a very different result from the typical business model of a bank which generally benefits from a rising rate environment.

NIM compression is clearly evident in the following slide:

The second headwind concerns market earnings. Similarly, the rapid rise in rates has completely changed the economics of investors (especially asset managers) for the worse, as their funding costs have risen parabolically as asset returns revalue with a lag. . It should be noted that investors generally finance loans with rates based on yield curves longer than 18 months, which naturally incorporate the future rise in rates. Additionally, some cohorts of originations that were previously popular with investors (e.g. prime loans) are clearly experiencing rapid credit normalization and as a result investor appetite for these loans is currently very limited. So, the combination of the above results in significantly lower revenues in the market.

Importantly, borrower demand remains exceptionally strong but investors are currently on the sidelines due to these factors (i.e. yields are lower due to higher cost of funds and concerns about the credit performance of certain cohorts).

The third headwind is a manifestation of the two preceding headwinds. Lower profitability due to the compressed NIM along with lower market earnings results in lower GAAP net income impressions for LC and, in turn, he has less capital to redeploy to keep loans on the balance sheet ( i.e. disrupts that virtuous circle I discussed above). In other words, under current conditions, it will be difficult for LC to grow its balance sheet as it is capital constrained and maintaining loans requires LC to pre-finance the associated capital.

These headwinds above translated into the first quarter guidance provided by LC management.

LC needs to slow balance sheet growth over the next two quarters. Any recovery in market revenue will be redeployed to retain other highly rated prime loans. It’s also why LC took a restructuring charge in the fourth quarter and reduced its cost base by 24%, all in an effort to preserve profitability.

When will headwinds turn into tailwinds?

A Fed pause is the key ingredient for the momentum to change. This allows LC to “catch up” with the gross return on assets and restore the economy required for investors.

A rate cut will clearly be beneficial and will immediately result in widening the NIM in the existing portfolio and making the economy much more attractive to investors. Of course, the flip side is that if the rate cut is due to a deep recession, loan losses are also likely to be higher.

Management provided an illustration of the profitability of its loans:

As can be seen above, the marginal ROE after taxes (and expenses) is 36%, even in this challenging environment. Even taking into account higher credit losses, it remains at around 30%. These are exceptionally strong returns for this asset class.

Final Thoughts

The current headwinds for the business model are very strong. Nonetheless, LC remains resilient and carefully manages credit risk by remixing the portfolio with higher quality assets. The path of interest rates is the biggest game-changer, if you think the Fed is getting close to a rate break, this will likely be the turning point where headwinds turn into headwinds.

The market is also worried about a possible recession and loan losses to come. LC’s management, cautiously enough, is conservatively funded at around 5% unemployment. My base case is that once the unemployment market cracks, the Fed will cut rates fairly quickly, so any additional loan losses (above provisions) will be somewhat offset by a rising NIM number.

The business model remains very attractive and I expect a boom in profitability once the environment normalizes. Under normal macroeconomic conditions, I would value the company at around 3 times its tangible book value. It is currently trading at only ~1x tangible book value. For me, it’s a classic case of being greedy where the street is fearful. I remain very bullish and will continue to monitor price action and developments very closely.