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Hey guys, Matt Harris here.

I'm the founder and executive chairman of Bloom Credit. Why am I here? I believe the Square acquisition of Afterpay is going to be a moment we remember in the credit markets, and Julie convinced me to write about it. This deal has the potential to have a huge impact on fairness and equality when it comes to credit in the U.S. Hopefully this inspires more inclusive action in the credit system and you enjoy reading it =) Ping me on Twitter with your thoughts!

Laying it all out

Last week, Squar announced it had acquired Buy Now Pay Later company (BNPL) Afterpay for a disclosed $29B. The move was seen as a huge moment in the fintech ecosystem, and a general affirmation that the BNPL market and ecosystem is thriving and here to stay.

While some might find it interesting to unpack why or if this is going to make a big difference for their merchant businesses and how they work together, I’m going to hold off on that. There are still dozens of questions around why Square didn’t want to launch a BNPL themselves, whether or not Afterpay was the right partner to acquire, if this will help Square’s standing in the debt capital markets and their ability to raise lending financing, and if the two organization are even going to be capable of working together. And frankly, it will be a year or two before we really know much of anything at all.

What I am interested in unpacking right away is what Square’s Jack Dorsey stated in the announcement of the acquisition: “Square and Afterpay have a shared purpose. We built our business to make the financial system more fair, accessible, and inclusive, and Afterpay has built a trusted brand aligned with those principles.”

“Fair, accessible and inclusive.” Dozens of fintech companies use the same language to show they too want to help consumers who have traditionally been locked out of mainstream financial services gain access to what are typically categorized as “prime financial services products.” Yet, helping consumers reliably improve their credit scores to gain access to fair and inclusive financing remains largely unsolved--despite billions of VC funding being dumped on dozens of fintech companies.

Why has fintech been unable to provide this population with a solution?

Square started out in 2013 as a B2B company, and has seen its consumer growth explode in the last five years. It didn’t even begin focusing on CashApp until 2016, but it has since been downloaded more than 100M times.

Did you also know that the majority of CashApp customers have credit scores below 600, and were spending an average of $856 per month as of June 2020? There are a plethora of reasons someone can have a FICO score below 600. One of those is that below 600 consumers have likely gone delinquent on an installment loan for 30 days or more.

Once someone begins to miss payments like this, their ability to access credit products that would allow them to make more on-time payments, increase their credit limit, and improve their scores vastly diminishes, leaving them stuck and frustrated.

These consumers need to be able to make a year or more of on-time payments to see their scores rebound and get back into good standing with lenders. And then, they might only be offered options like a secured credit card with a $250-$1000 dollar credit limit. The result being, if they were to put some of their available cash towards a secured credit card, they might see their score go down because their revolving utilization could be hurt by their spend.

While this general synopsis is a bit over simplified and it doesn’t encompass the entire path for every consumer to improve their credit, I simply call out rehabilitating credit under existing options in the system is HARD. And few fintech companies have actually offered real products to help people find their way back.

Who does CashApp (and fintech more broadly) serve?

Major banks look at subprime customers as unprofitable and tend to shy away from lending to them, leaving these consumers to non-bank lenders with high APRs and fees. There have been several fintech companies and neobanks along with CashApp, such as Chime, Current, and Dave, which have seen great success in acquiring consumers banks have traditionally ignored.

Most lending is dictated by what’s known as cost of capital. For a major bank like Wells Fargo or Bank of America, this cost is small and driven by an FDIC-insured deposit base. Many neobanks are not actually banks. They “rent” a bank charter from one of the many sponsor banks (Bancorp, Cross River Bank, and Green Dot are some examples). Generally, this does not allow neobanks to access their deposits at the same “cost” as the banks from which they rent their charters. So, when a Chime or a Current wants to lend to their consumers, they need to raise debt to finance the loans.

Debt funds such as Macquaire or Jefferies will look at the customer base of a neobank and essentially say “we see these (subprime) consumers as risky, therefore we are only able to offer our capital to you at very high rates.” This often forces neobanks to either lend at extremely high APRs to make money on traditional credit products and thus further exacerbate the plight of their consumers, or simply accept they will not be able to lend profitably to these consumers.

Without first improving their consumers’ credit scores, these companies likely will be capped at offering debit interchange type products and may never be able to reach the profitability rates of their big bank counterparts. This will hurt their comps on the public markets, and could result in their inability to stay independent. Many of the companies focused on these consumers look to launch innovative credit building products and features which should ultimately allow them to raise money at a lower cost of capital, thus providing an opportunity to lend in a profitable manner.

The point here being is this, fintech and neobanks alike realize that their long-term path to becoming sustainable businesses is a rising tide lifts all boats model. Neobanks will only be successful insofar as they can enable their customers. CashApp and Afterpay are no exception.

The solution should be a BNPL loan. My suspicion is Square is betting on offering BNPL loans to their CashApp customers, providing them a sustainable and profitable ladder to improving credit scores without leaving CashApp in the red.

Now you’re probably thinking “wait a minute, you just told me that offering lending to a subprime consumer is really difficult? Why is BNPL going to be any different?”

Great question, FTT reader. There are a few things about BNPL that make it unique.

First, BNPL loans are actually very simple to underwrite and take on much less risk than the average unsecured credit product. Second, operating a BNPL program requires less capital, meaning it likely can be acquired in cheaper ways. Let’s break these down.

Why is BNPL less risky?

Let’s start with risk. A big part of the reason lenders are so risk averse is they are usually accounting for up to 36 months in advance. Plotting for that amount of time is a really difficult challenge. When lenders make unsecured personal loans to consumers for large amounts (say $10K) over long periods of time (3-5 years), they are often taking macro economic factors into account in addition to factors about the consumer.

In comparison, BNPLs generally revolve for under a year. A consumer buys something today, with 1/4h of the total amount paid, and then pays the rest over installments every two to four weeks after this.

When the loan is three months long, the future financial picture of this consumer is much clearer. Even if this consumer loses their job and experiences hardship, a lender likely can still ascertain enough about them to determine whether they can repay in the next three months. In order to do this, they generally look at existing bank account data (if they have it), and revolving utilization. If between the remaining unused credit limit, and the amount of $$ in the bank account, the consumer likely has a source of cash with which to make the payment, the lender then feels comfortable approving the loans.

If the borrower defaults, the lender cuts their losses on a percentage of those loans and moves on. Total risk exposure is lower as a function of time.

Another reason BNPL is less risky to underwrite is the loan is effectively partially paid by the merchant enabling the transaction. Merchants see BNPLs as a major value add because by breaking up what would otherwise be a very large purchase (say, a Peloton bike) into much smaller and more manageable ones, the consumer feels more comfortable making the purchase and thus converts at a higher rate.

In fact, these merchants often will give a BNPL provider a discount against all the inventory it sells. For example, imagine Casper wants to sell more mattresses. Affirm will approach them and say “hey, we’ll ensure you get paid up front on a larger percentage of purchases. But in order to do that, we need you to give us access to your inventory at 90 cents on the dollar.”

This creates the spread for the BNPL. They are able to acquire inventory cheaper and effectively charge more for it. Thus derisking the loan further in their favor (and helping them more effectively abide by usury laws).

Why does BNPL require less capital?

As mentioned above, BNPL loans tend to revolve much faster than your typical unsecured personal loan. In addition, the average BNPL loan was about $480 in 2020, compared to the average size of a personal loan, which is $6,092. In other words, a lender would need ~13x the capital amount to be able to run an unsecured personal loan program as a BNPL.

Lenders who want to take a shot at BNPL are often able to do so by raising much lower amounts of debt or equity capital to test whether their program is efficient without dipping into the unprofitable dynamics that likely await them with more unsecured loan programs usually reserved for prime users.

Why is BNPL not making a dent in financial inclusion today?

A large part of the BNPL model is creating higher margins for the lender by working with merchants to discount against inventory. This dynamic generally insulates the lenders from being too APR dependent.

BNPL lenders would struggle if they had to make money the way most lenders do. While we often use APR interchangeably with interest rate, these numbers are not necessarily the same. When calculating APR, it is assumed the interest rate would be applied annually. This is why someone can make a $100 purchase with a $3 payment, and the APR comes out to 16-18%.

While BNPL programs can be profitable from merchant discounts, the actual lending business itself generally isn’t high margin so BNPL lenders often choose not to service their loans as the servicing function (i.e maintenance and collection of loans) would be too costly.

When you do not see the point in servicing a loan, putting in place the guard rails such as reporting a consumer as delinquent in order to incentivize them to repay is no longer necessary, as you will not generally chase them down for repayment if they do not.
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As a result, the vast majority of BNPLs do not report a consumer’s payments to the credit bureaus. Of those that do, they generally don’t report to all three. So consumers who currently work with BNPL lenders do not see improvements in their score. Traditionally, the BNPL lenders didn’t report these payments because they saw the bureaus as resistant to small dollar loans. Now that consumers are racking up thousands of dollars of BNPL outstanding balances, bureaus are becoming more receptive to these payments.

Though, what keeps them from ultimately integrating some of these services that help consumers is that integrations are costly and can take up to 1 year + when integrated directly with the bureaus. They also can come with some liability when reported incorrectly. This liability can result in compliance violations in the form of fines to the lender which could cut into the BNPL lender’s margins. This is why we launched Furnish by Bloom Credit, to help lenders quickly and effectively report payments without all the integration hassle and with less errors.

Because BNPL lenders choose not to report these payments, they ultimately miss out on the ability to see their consumer’s scores improve. This caps their ability to move up the chain to more prime-like products with many of their consumers, which is especially important to lenders like Afterpay.

So what should CashApp do?

Ultimately, what is important about BNPL is the degree to which CashApp in conjunction with Afterpay can on-ramp millions of CashApp consumers who are locked out of traditional prime-like services.

CashApp can start by offering small-dollar, small-risk BNPL loans to CashApp users. These loans effectively function in the same capacity as a credit builder loan, where CashApp is capable of seeing which consumers are capable of unsecured credit. When consumers make on-time payments, they will be rewarded with on-time payments reported to the bureaus.

Unlike actual credit builder loans, there is real (though manageable) risk at hand for the lender here. This means the bureaus will accept these payments, as they see each payment as being valuable to the network at large vs credit builder loans that may be rejected for potentially “gaming the system.”

This will also allow CashApp to look at payments and be able to determine when consumers are eligible for larger and larger purchase amounts. For those not capable of making on-time payments, CashApp will not have taken on thousands of dollars in risk. It is likely hundreds or less, and they do not need to make loans to these consumers again.

This cycling enables two things for CashApp. First, a higher score cohort will allow them to raise funds at a lower cost of capital to launch higher margin, prime loans. Second, they now have a built-in cohort of loyal consumers who positively selected themselves as being financially stable. These consumers will ultimately be the bedrock through which CashApp will actually be able to

cross-sell financial products, taking consumers who were seen as untouchable by other lending institutions and making them profitable through careful calibration and letting these consumers prove themselves one loan at a time.

OK good for Square and Afterpay, but how will an adoption of this type of program begin to change the roadmap for fintech?

For fintech as an industry to truly make an impact on a consumer’s ability to change their financial situation, we need to focus on credit scores.

A lot of fintech companies try to use alternative data like reporting rent and utilities, but these can only be so effective. The most impactful way consumers can actually afford a car or a home is to report their on-time payments to all three bureaus and see their credit scores improve. Plain and simple.

Otherwise, not only will many of these consumers never reach their potential, but many fintech companies will struggle to break out of the debit interchange business.

BNPL is one powerful path to seeing score improvement. There may be other variations without vast merchant relationships.

If implemented correctly, the combined efforts of Square and Afterpay should have all the necessary ingredients to provide a roadmap that all fintech companies can follow in helping consumers move up the financial ladder.

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