Republic Bank of Kentucky, the Louisville bank well-known for its previous role in the refund anticipation loan market, is the bank with a new high-cost credit product. Republic is originating Elevate's Elastic Line of Credit.
Elastic is a line of credit whose interest rates range between 80 and 200 percent, depending on the loan size and term. This is the repayment schedule for a loan of $800:
The cash flows in this table describe the value to the lender. The initial advance is only $760 because the borrower pays an upfront cash advance fee. The principal balance is paid back in equal installments. The finance charge, opaquely referred to as a minimum charge fee, changes in a step-wise fashion as the outstanding balance drops. This schedule assumes that the borrower can repay every two weeks. Elastic also has a monthly loan product which is repaid in ten installments. The internal rate of return on this loan is 171.6 percent. The APR, as calculated with the OCC's APR tool, is 118.6 percent.
According to Elevate's IPO, Republic is considered the loan originator. Soon after it is made, ninety percent of the debt is sold to Elastic SPV. Elastic SPV is not owned by either Republic or Elevate. Rather, it is a subsidiary of the private equity fund that finances Elevate. As of the end of its last quarter, Elevate had approximately $276 million in outstanding debt to Victory Park Capital. The cost of that debt is extremely high. According to its S-1, the company is paying Victory Park a rate based upon the sum of the 3-month LIBOR plus between 13 and 18 percent. Elevate profits from licensure of its technology and underwriting to Republic Bank. Through credit default swap agreements with Elastic SPV, Elevate takes on risk for loan losses.
As to Republic's ability to make this kind of loan, I think the jury is out. But the story is far from over. A key question, in my opinion, is how regulators will view the use of out-of-the-box data in the underwriting process. A traditional FICO score is not being used to vet these loans. Elevate will not say what inputs they are using, but they do say that their algorithm is constantly being updated in order to account for changes in the economy. We do know that regulators are approaching data derived from social media with lots of skepticism.
Alternative credit scoring is at the heart of what a company like Elevate does:
In making a decision whether to extend credit to prospective customers, and the terms on which we or the originating lenders are willing to provide credit, including the price, we and the originating lenders rely heavily on our proprietary credit and fraud scoring models, which comprise an empirically derived suite of statistical models built using third party data, data from customers and our credit experience gained through monitoring the performance of customers over time. Our proprietary credit and fraud scoring models are based on previous historical experience...Our proprietary credit and fraud scoring models are also highly reliant on access to third party data sources. If these data sources are not available at time of credit decisioning or if the companies that have aggregated this data are no longer able or willing to provide this data to us, our products will experience higher defaults or higher customer acquisition costs...If our proprietary credit and fraud scoring models were unable to effectively price credit to the risk of the customer, lower margins would result. Either our losses would be higher than anticipated due to “underpricing” products or customers may refuse to accept the loan if products are perceived as “overpriced.
While Elevate does want to improve its underwriting, I am intrigued with how comfortable with a model that can accommodate such high default rates. Consider this paragraph from the same S-1:
Historically, we have generally incurred net charge-offs as a percentage of revenues of between 43% and 51%. Net charge-offs as a percentage of revenues can vary based on several factors, such as whether or not we experience significant growth or lower the APR of our products. Additionally, although a more seasoned portfolio will typically result in lower net charge-offs as a percentage of revenues, we do not intend to drive down this ratio significantly below our historical ratios and would instead seek to offer our existing products to a broader new customer base to drive additional revenues.
In any given vintage, Elevate expects that slightly less than one in every five loans will go unpaid.
Republic is leaving the underwriting to Elevate, which makes sense given their respective histories, but is that working agreement enough of a firewall to protect the bank from laws like the Fair Credit Reporting Act and the Equal Credit Opportunity Act?