On Deck Capital: Loan-Shark Rates, Bad Loans, Bad Business Plan

by Sonya Colberg, Senior Investigative Reporter - 2/11/2015 10:28:12 AM

On Deck Capital (ONDK) seems to be swimming within those murky waters populated by loan sharks. Indeed, the online company makes loans to desperate small businesses with bad credit and charges them astronomic interest rates.

On Deck doesn’t tout the actual annual percentage rate charged. Yet fishing deep into federal filings yields actual APRs far above the company’s advertised rate of 18 percent to 36 percent.

In fact, filings show the company charges these desperate borrowers an annual rate as high as 99 percent.

On Deck gets away with this because interest rate laws affecting commercial loans vary from state to state. California, for example, sets the rates at 10 percent or 5 percent above the Federal Reserve Bank rate. The permissible limit is 9 percent in Illinois. In fact, a new report out today says payday lenders definitely face stricter regulations, so On Deck and peers may no longer get to fly under the radar.

Successfully positioning itself as a technology play for its initial public offering on Dec. 17, On Deck’s stock spiked to nearly $29.

So the market has slapped over $1 billion in value on a company with $354,000 net income in its pocket.

All that for a business model eerily similar to those that handed us the subprime lending crisis.

We agree with this article on On Deck, but investors should also consider other viewpoints, here.

*Background

New York City-based On Deck uses a computerized process to evaluate loan requests quickly – without looking a single business owner in the eye – and handing them the cash typically within a day or so.

On Deck primarily loans cash through credit lines provided by banks and by selling off pieces of loans. Also, On Deck allows institutional investors to buy loans. 

On Deck uses independent brokers to help attract customers. In fact, over nine months ended September, brokers penned an amazing $349 million or 44.3 percent of all loan originations.

Some of those brokers had been convicted of stock scams, insider trading, embezzling, gambling and dealing ecstasy, according to Bloomberg Businessweek. On Deck’s CEO responded that brokers are audited through customer feedback and that the company terminates brokers all the time.

On Deck is swimming in a tidal wave of additional issues that we believe make investing in On Deck as risky as the loans themselves.

*Reminiscent of subprime days: Strapped borrowers, easy loans, 50% interest rates

Loaning money to people who can’t pay it back is part of a poor business plan.

“They can’t sustain a business model if they’re doing these loans and not qualifying people very thoroughly,” said Jane Haskin, First Bethany Bank and Trust president and chief executive.

“Then they won’t be in business long, even if they’re doubling their money on the money they loan out, if they’re not being careful,” said Haskin.

Haskin, a certified public accountant, said reputable online lenders certainly do exist but added that the On Deck terms described by TheStreetSweeper sound “onerous.”

On Deck offers these onerous terms to the riskiest borrowers – folks in the subprime category who often can’t repay their credit. On Deck customers need only self-report $100,000 in annual sales, a year’s business experience and a credit score of at least 500. Take a look at the Equifax and Experian charts below to truly grasp this risk level.



 

These customers often find it’s impossible to make their payments, with interest charges two or three times higher than even a credit card company would charge.

 

Let’s look at a hypothetical borrower, “Big Hair,” hair salon, seeking a nine month loan from On Deck.

Loan

$100,000

Advertised interest rate

18-36%

Real annualized % rate

  50.0%

Repayment, monthly

$13,000

        

But since On Deck customers get daily payments automatically withdrawn from their bank accounts (On Deck monitors customers’ bank accounts), Big Hair would have to pony up $430 each weekday.

On Deck writes that customers think of their interest rate as a daily rate. That rate seems more manageable than the actual APR:

“We believe that a customer would likely evaluate this term loan primarily on a “Cents on Dollar” Payback Rate basis, meaning that the customer would view the loan as an obligation to repay $1.17 for every $1.00 it receives from us (or, in aggregate, a repayment of $58,500 for the $50,000 loaned to the customer).”

Yet On Deck states in an SEC filing on page 97:

“The APRs of our term loans range from 19.9% to 99%.”

“Sometimes small business owners don’t think about how much they’re paying for a loan if they’re paying it daily,” said Haskin.

That’s risky. Not just for borrowers. But ultimately also for On Deck  investors.

*Analyst Downgrade, Fierce Competition, Cautionary Tales

Though the business owner is personally on the hook to pay back the loan, On Deck virtually brags that it avoids some regulations because it loans to commercial businesses rather than consumers.

But like Sterne Agee – which recently axed On Deck’s rating to “underperform” and its price target to $15.75 - we believe On Deck and its peers in the alternative funding sector will face stiffer regulations.

In fact, a new report out today says new regulations are imminent for the $46 billion payday lending industry. On Deck and competitors need to steel themselves because, once all the details are worked out, they may find themselves operating under stricter regulations.

The list of alternative funding competitors is long and strong –including big boy Lending Club (LC), along with Kabbage, CAN Capital, Wonga.com, and even Amazon (AMZN).

“I would caution any small business owner,” Haskin said. “If you go to any lender and they are hesitant to tell you the true annual percentage rate that you’re paying on that loan, that would be a huge red flag.”

Some small business owners seem to like On Deck, others don’t. A former customer considered On Deck unpleasant and considered it a significant negative that computer software takes the place of a loan officer, adding:

“The people I spoke with there were very nice, but extremely misleading either intentionally or out of ignorance to lending and their own On Deck Capital platform.”

His online comment continued:

On Deck is very high interest and even higher ‘Loan guarantee fees’ to the point that their lending may violate the state and federal ‘Usary Laws’. When I simply asked 3 different On Deck Capital representitives for an amortization schedule on the loan for tax and accounting purposes not one had any idea what I was asking for and finally I received the answer, “We can’t do that”.

The Small Business Administration told TheStreetSweeper that the government agency simply considers alternative lenders another option in the marketplace.

“As with any line of business, some are reputable and ethical … and some may not,” emailed an SBA representative. “Therefore, small businesses seeking financing from those or any sources, are encouraged to do due diligence, research and investigate well with other customers, regulatory agencies, etc., before making any commitment.”

Contributors to DailyFunder, people experienced in the loan biz, expressed concerns about On Deck’s lax loan approvals. Bizloanbroker wrote:

“Everyone out there is trying to figure out why Ondeck is suddenly cancelling iso agreements on some of their larger isos, cutting commissions etc.

“The answer is real simple,” Bizloanbroker continues. “Their portfolio is a giant train wreck with a 20% plus default rate and climbing.

“They don't check landlords, financials, pretty much anything. For them it’s all about funding more deals and grabbing market share,” Bizloanbroker adds.

Funding pro states: “When you go from funding x in one month to 1.5x, 2x, 3x, 6x, etc. it will make the bad debt look manageable. The problem is once you hit the top of that bell curve and cannot push the multiple any higher, bad debt will start climbing rapidly.”

MCNetwork adds: “Can someone say...House of Cards?”

Bad Loans: “About” 6% Losses? How about 25%?

So how much money is the company losing through defaults of On Deck loans? According to a video interview of Mr. Breslow, tens of millions of dollars.

“What is the rate of default?” TheStreet’s reporter Dan Freed asked Mr. Breslow.

“So our rates of default are also publicly available on our S-1. We expect to lose about 6 cents for every dollar that we lend,” CEO Noah Breslow said in the video interview.

The company’s S-1 says that expected rate is 7 cents for every dollar loaned. According to LendingMemo, this compares with rival Lending Club’s actual default rate of about 5 percent.

But we want a clearer picture of the actual default rate for On Deck.

So let’s take the actual dollars lost or $26.7 million lost in loans charged-off in the last nine months. And look at that as a percentage of the last nine months’ gross revenue of $107.6 million.

That works out to a whopping loan loss of 24.8 percent.

And filings suggest On Deck is getting ready for even higher losses from defaults.

Indeed, lending companies set aside money they expect to lose from bad loans. So On Deck’s “provisions for expected losses” or the reserve through September 2014 rocketed to $47 million. That’s nearly triple the previous year.

“It makes sense to me that as the economy improves they should have smaller amounts being added to the reserve,” said Haskin. 

So, another furiously flapping red flag for On Deck.

Executives’ Compensation Dwarfs On Deck’s Net Income

Executives are hauling in nice salaries, despite On Deck’s long money-losing history, only recently posting that puny $354,000 net income.

Filings highlight the lowest pay level of chief executive Breslow, chief operating officer James Hobson and chief financial officer Howard Katzenberg, of course. But notes disclose that they’ve all gotten big raises: ultimately $50,000 for Mr. Breslow, nearly $27,000 for Mr. Hobson and nearly $42,000 for Mr. Katzenberg.

Check out the total salary, stock options and incentive pay for them:

 

CEO Breslow

 ~$866,000

COO Hobson

 ~$540,000

CFO Katzenberg

 ~$607,000

Total

~$2,013,000

 

So executives are making almost six times as much money as On Deck reported clearing last quarter!

Conclusion:

Share prices screamed as IPO-eager investors jumped on On Deck, largely believed to be a technology play rather than a payday loan company for small businesses.

Now On Deck faces use of shady brokers, growing competition, out-of-line executive compensation, massive debt, anticipated new strict regulations, and bad loan losses chewing up revenue.

Additionally, 56 million shares will become unlocked and may be sold on June 3. With 66.2 million shares outstanding, possibly dumping almost that many On Deck shares again on the market creates another negative catalyst.

At the foundation is On Deck’s unsustainable business model. Making easy-qualifying, quick loans to desperate small businesses and charging them 50 percent-plus interest rates reminds us of the sub-prime loan debacle.  

On Deck is a disaster just waiting to happen.

* Important Disclosure: The owners of TheStreetSweeper hold a short position in ONDK and stand to profit on any future declines in the stock price. 

Editor's Note: As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in the companies that they cover. To contact Sonya Colberg, the author of this story, please send an email to  [email protected].

  

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