PayPal seeks graceful retreat in the subprime credit business
At the height of the panic in late 2008, PayPal Holdings made a counterintuitive move: It entered the subprime lending business. And disproving the naysayers, the payments giant built loans of last resort to online shoppers into a lucrative business.
Since 2013, the San Jose, Calif.-based PayPal has generated an estimated $575 million in earnings from its consumer lending business, PayPal Credit. Shoppers who max out their credit cards frequently use the product to finance big-ticket online purchases.
But now PayPal, which was spun off from eBay in 2015, is looking to reduce its footprint in consumer lending.
While the firm will continue offering PayPal Credit to consumers, it has hinted that is exploring options to reduce its exposure to souring loans. Close observers of the company have floated different possibilities, including a sale of all or part of the PayPal Credit portfolio, as well as a deal in which a partner agrees to fund all future loan originations.
The shift, which comes at a time when fewer PayPal Credit borrowers are paying on time, may be motivated in part by the prospect of rising losses. It could be a harbinger of tougher times for the subprime credit-card industry, which has boomed in recent years. Earlier this month, a credit-card unit of the British bank Barclays PLC reportedly agreed to sell off $1.6 billion in subprime card balances.
PayPal relies much more heavily on borrowers with damaged credit histories than large card issuers such as JPMorgan Chase and Bank of America, and even Synchrony Financial, which has a substantial subprime business, analysts at Instinet noted in a recent report. At the end of last year, borrowers with credit scores below 680 owed 49% of PayPal Credit’s loan receivables.
The Instinet report urged PayPal to shed or significantly reduce its credit risk, in order to avoid big losses in a scenario where unemployment rises and credit conditions deteriorate. “The valuation of any business with credit exposure gets crushed in that kind of environment,” the report warned.
Back in October 2008, PayPal agreed to pay roughly $945 million in cash and stock options for a firm called Bill Me Later, Inc., which offered financing for e-commerce purchases, and had deals with Amazon, Overstock and Zappos, among many other online retailers. In 2014, the Bill Me Later service was rebranded as PayPal Credit.
PayPal offers the product with specific retailers as part of the online check-out process. Once borrowers get approved, they have access to a revolving credit line of at least $250.
The product, which is available both in the U.S. and internationally, can benefit savvy shoppers. But it can also turn into an expensive form of credit.
PayPal offers interest-free financing on certain purchases when borrowers repay the full amount within six months. But when consumers fail to pay off the loan in time, PayPal charges an annual percentage rate of 19.99% that gets applied retroactively, back to shortly after the purchase was made, a practice that has come under fire from consumer advocates.
In recent years, PayPal Credit has helped to power the company’s strong earnings growth. Today, roughly 6% to 7% of the firm’s revenue comes from PayPal Credit, and it accounts for a similar percentage of total profits, said Lisa Ellis, an analyst at Bernstein Research.
PayPal Credit’s value to the company’s shareholders goes beyond the income it generates, since the product generates more spending on the PayPal network. Many shoppers who use PayPal Credit do not have other payment options. PayPal has stated that merchants who adopt the product see a 20% to 30% lift in total payment volume.
“The lending business is a strategic business for PayPal,” said Gil Luria, an analyst at D.A. Davidson & Co.
At the same time, credit quality is a growing concern. PayPal’s consumer lending business reported a net charge-off rate of 6.4% at the end of 2016, up from 5.9% one year earlier. Loans and interest receivable that was more than 90 days past due rose from 3.9% to 4.1%.
When it comes to borrowers' likelihood to repay, PayPal faces a structural disadvantage versus issuers of cards with Visa and Mastercard logos. Since such general-purpose credit cards can be used for far more purchases, borrowers have an incentive to pay those bills first.
“Cash-strapped consumers facing difficulty meeting their financial obligations would likely view the limited utility of PayPal Credit as an excuse for placing it at the bottom of their repayment priority list,” Instinet wrote.
PayPal executives have indicated that they are exploring ways to reduce the company’s credit exposure.
“We are in the early process of looking through this right now,” CEO Dan Schulman said during a Jan. 27 conference call. “It is a very competitive process out there as people look to potentially partner with us. We will look to make a decision as we digest and sort through all the different proposals that we are seeing.”
PayPal is expected to announce its plans this year, analysts at Deutsche Bank said in a March 10 research note.
Worries about credit quality are not the only reason that PayPal might want to scale back its presence in the consumer lending business.
The product has generated regulatory problems for PayPal. In 2015, the company agreed to pay a $10 million fine and $15 million to consumers after being accused of enrolling customers in PayPal Credit without their consent and deceptively advertising promotional benefits.
There is also the fact that investors typically assign lower valuations to lending businesses than they do to payment networks or tech companies.
Nonetheless, this year is looking like an auspicious time to scale back in the subprime consumer credit business, said Nick Clements, a former credit-card industry executive and the co-founder of MagnifyMoney.com.
He noted that subprime credit providers made big profits in the wake of the financial crisis, when mainstream card issuers were seeking shelter from the storm. But since then, competition has picked up substantially. Last year, subprime accounts made up 21% of the U.S. credit-card industry, up from 18% in 2014, according to the rating agency DBRS.