On Tuesday, Wall Street celebrated the creation of the nation’s largest subprime lender.
Keep in mind, Springleaf was the former subprime unit of American International Group (AIG). And both Citigroup and AIG cost America $100 billion in bailouts during the crash.
In other words, the ruins of the 2007 market crash just created a new entity.
Oddly enough, Wall Street didn’t seem to mind. LEAF gapped up by more than 32% on the news and finished $12.19 higher than Monday’s close. So what happens next?
A Big Deal for Springleaf…
The deal will give the Indiana-based lender 1,967 branch locations across 43 states once the merger is complete.
And in a nod to investors, the deal should prove immediately accretive to the company’s bottom line. Estimates show that Springleaf’s profits will more than double – going from $2.43 to north of $5 per share.
Furthermore, with post-recession wage growth showing miniscule improvement, the demand for loans among income-strapped borrowers with thin or impaired credit remains high.
In fact, The Wall Street Journal reported in February that loans to subprime borrowers in the first 11 months of 2014 reached their highest level since the start of the financial crisis in 2007. There are more than 50 million consumer loans totaling some $189 billion.
Now, while the Fed estimates the entire subprime segment at more than $1.29 trillion in size, the borrowing today has very little in common with the kind of reckless loan originations that helped precipitate the financial meltdown in 2007.
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In 2007, loans were reaching levels above $200,000, with loan terms reaching 30 years. But the average personal loan at Springleaf is just $4,000 to $5,000 in size, with a loan term of about 40 months. That’s pretty modest.
Even better, most loans are used to pay for home and auto repairs, as well as debt consolidation.
Of course, the distinguishing feature of the subprime loan industry is the high interest rates that come with these types of loans.
Springleaf offers loans with interest rates as high as 27% to 30%, due to the increased risk associated with high-risk borrowers. But with bad loans trending below 5%, Springleaf is left with an effective yield of 22% to 25%. This isn’t bad for an industry that nearly brought a nation to its knees just seven years ago!
Caution: Speed Bump Ahead!
Springleaf’s deal for OneMain isn’t without problems, though.
Standard & Poor’s Ratings Services placed Springleaf’s B credit rating on CreditWatch with negative implications. It did the same to OneMain’s B+ credit rating, as well.
The reason for the potential downgrades is the substantially higher leverage that the deal requires of Springleaf.
And because of the size of the increased leverage, the rating service said that Springleaf could expect a one- or two-notch reduction in its rating, while also bringing the credit ratings of both entities into parity.
Now, this could be problematic for the company because Springleaf is already carrying a debt-equity ratio above three to one. Plus, with a lower combined credit grade, the company would have to pay substantially higher interest rates on its debt.
And the irony of higher interest rates on a subprime lender with impaired credit shouldn’t be lost on investors.
The higher rates will most assuredly mean the company will need to raise additional capital through an equity offering, which will result in a substantial dilution for current shareholders.
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