How Securitizing MCA Loans Enables Lax Underwriting Practices
Securitizing merchant cash advance (MCA) loans has become an increasingly popular way for alternative lenders to raise money. By bundling MCA loans into securities and selling them to investors, lenders can tap into capital markets for funding. However, this practice also enables lax underwriting standards that can harm small businesses.
What is Loan Securitization?
Loan securitization is the process of pooling loans together and selling them as securities to investors. The loans act as collateral for the securities. Investors receive regular principal and interest payments as borrowers repay the underlying loans.Securitization provides several benefits:
- Lenders can raise large amounts of capital upfront instead of waiting for loans to mature
- Risk is spread across many loans and investors instead of concentrated on the lender’s books
- Loans can be resold in secondary markets, providing liquidity
Securitizing MCA Loans
Merchant cash advance (MCA) loans are a form of alternative small business financing. The lender provides a lump sum of capital to a business in exchange for a percentage of future credit card or debit card sales. There‘s no fixed repayment schedule – the lender takes a cut daily until the advance is repaid.MCA loans are risky as their repayment depends on the business’s underlying card sales. If sales fall, so do repayments.However, by bundling MCA loans from many merchants, lenders can pool this risk for investors. Even if some loans underperform, others make up for it.As a result, securitizing MCA loans has exploded in popularity over the last decade. Issuances went from $100 million in 2010 to over $8 billion by 2018.
How Securitization Enables Looser Underwriting
To understand how securitizing MCA loans leads to looser underwriting, we need to understand incentives.Lenders have an incentive to maximize loan volume to generate fees. The more loans they write, the more money they make. Securitization fuels this by providing lenders with more upfront capital to lend against.However, this also incentivizes lenders to loosen underwriting standards. Instead of carefully evaluating borrowers’ ability to repay, it becomes more profitable to write as many loans as possible without regard to quality.Investors in the securities are naturally concerned with loan performance. But lenders often retain “skin in the game” by keeping a portion of the securities issued. This signals quality to investors and aligns incentives.But the retained portion is still small relative to the benefit lenders gain from increased loan volume. The short-term gains outweigh the long-term hit of underperforming loans.
Lax Underwriting Standards in MCA Lending
So how does lax underwriting actually manifest itself in the MCA lending process? Here are some common ways:
Relying Too Heavily on Point-of-Sale Data
Lenders often use a business‘s card receipts to estimate repayment ability. But this data has limitations:
- Sales can be highly variable month-to-month
- Future sales are unknown and projections uncertain
- External factors like seasonality or competition can impact sales
Blindly extrapolating past sales into the future without deeper diligence is naive and reckless.
Ignoring Other Debt Obligations
A business may show solid card sales coverage of the MCA loan repayment. But if they have other significant debt obligations, repayment ability can be overstated.Responsible lenders carefully factor in all fixed and variable business expenses. But loose underwriting ignores these other commitments.
Not Scrutinizing Business Viability
Some lenders don’t pay enough attention to the underlying business model. They see sufficient card sales to cover repayments in the near-term without considering long-term sustainability.Of course, every business carries risks. But prudent lenders seek to understand key drivers of revenues and costs to assess risks to repayment.
Rushing the Funding Process
Eager to finalize deals, some lenders shortcut due diligence steps. This can mean:
- Not thoroughly checking bank statements
- Using limited merchant data
- Failing to investigate explanations for unusual sales patterns
- Neglecting site visits or customer interviews when warranted
While slowing down the process has opportunity costs, it pays dividends when properly identifying risks.
Outcomes of Loose Underwriting
What happens when securitization enables lenders to pump out loans without proper due diligence? Consider the experience of the restaurant industry.Attracted by point-of-sale lending models, alternative lenders flooded the restaurant industry with cash advances. But they often failed to account for the sector‘s slim margins and frequent failures.When the pandemic hit, thousands of restaurants defaulted on these outstanding loans. Lenders then resorted to aggressive collection tactics like freezing bank accounts.This highlights the economic damage loose underwriting enables. Small companies are saddled with debt they can‘t afford. Financial distress leads to lost jobs and economic activity. Lenders themselves suffer losses.
Calls for Stricter Industry Regulation
In light of these concerns, there have been increasing calls to regulate the alternative lending industry. Groups like the Responsible Business Lending Coalition advocate for rules requiring lenders to consider borrowers’ ability to repay.They recommend policies like:
- Mandating the documentation and verification of income and expenses
- Basing loans on provable data and reasonable projections
- Accounting for total debt obligations and living expenses
The intent is to enforce responsible lending by aligning stakeholder interests. This would discourage overlending and help ensure merchants can actually afford loans.
Conclusion
By tapping into capital markets for funding, securitizing MCA loans allows alternative lenders to scale quickly. But this also enables looser underwriting as generating fees from loan volume is prioritized over credit quality.The result is small businesses saddled with debt they cannot afford. This causes financial distress and dampens economic growth. Stricter ability-to-repay policies would help enforce responsible lending standards.Balancing business funding access with appropriate guardrails remains an evolving challenge. But securitization will continue enabling looser practices without better protections against overlending. The health of small companies and lenders alike requires a more sustainable approach.
Key Takeaways
- Securitizing – Securitizing MCA loans provides capital for lending but incentives maximizing volume over loan quality
- Overreliance – This manifests through overreliance on limited data, ignoring total debt obligations, and rushing due diligence
- The result is small businesses taking on too much debt, leading to financial distress
- Calls are growing for stricter ability-to-repay regulations to enforce responsible lending
