Objective Analysis - BNPL Bad debt explained

Let's take a closer look at the characteristics of the BNPL sector through the COVID-19 period. For the purpose of this analysis I'll make the assumption that most users of Afterpay would not use Afterpay knowing they cannot pay it back.

I would characterize the COVID-19 era as three distinct phases:

Phase 1 (orange) is before the social restrictions were implemented and essentially before the sh!t hit the fan.
Phase 2 (yellow) is the time when social implementation were implemented, people started having their hours cut and some losing their jobs and those that haven't lose them would start seeing uncertainties around their employment.
Phase 3 (green) the job losses start piling up and social restrictions are truly starting to choke the economy.


This simplified scenario shows different $300 purchases made throughout this time period. To explain, the first row has a $300 payment made in week 1 February and follows up 3 more $100 payment to complete transaction by Week 3 March.

Phase 1
Now, the reason why I initially had concerns about bad debts for APT was specifically in reference to people who bought in Phase 1. Some of these people would have debt and suddenly find themselves without a job. Notice that in the worst case scenario, if one made a purchase in Week 1 March, they would have it paid off by Week 3 April. Anyone who bought in phase 1 and who stops making payments would have been picked up as a bad loan in the APT business release dated 14 April. Even though the report stopped 31 March 2020, the COVID-19 questions that analysts asked in the results presentation were answered up to 14 April with management noting that no material deterioration was detected in their books up until that point.

Phase 2
So moving on to phase two. Here I would expect that many people who have incomes tied to industries heavily affected by COVID-19 would reduce their discretionary expenditures, and maybe opt not to buy that new bag through Afterpay. In fact, this period did show reduced transaction volume due to uncertainty from everyone. There may have been some people who did lose their jobs in that period and stupidly still bought stuff through BNPL but any default rate deterioration would have been picked up in the Afterpay business update, and if not then by the time Sezzle and Z1P did their updates.

Phase 3
Phase 3 would be characterised by purchases from people who are comfortable that either they won't lose their job or that any government support could finance their purchases. It's important to note that the phase 1 and phase 2 purchases would have been the most likely to result in a rise in default rates.

Business updates
Afterpay noted on 14 April that Gross losses are estimated at 1%, and verbally confirmed that they have not seen a material increase as of 14 April.
Sezzle noted in their business update dated 5 May that their leading loss indicators are "steady to improving" so again, no increase. In fact, repayments increased.
Z1P released an update on 8 May that monthly arrears remained flat at 1.57%.

This means that there have been NO signs of material increases in default rates through phase 1 and phase 2, the highest risk phases.

The posters who keep banging on about a jump in bad debt would have to explain where this jump would be coming from. Everyone shopping through the BNPL right now would be well aware of their employment situation at this stage, and that would include people who are still employed but who may have uncertainties around their employment.

For obvious reasons many of these customers would scale back their discretionary purchases. To assume that BNPL company's bad debt charges would increase materially from here would have to make the assumption that people purposely buy from these companies knowing they cannot pay back (fraudulent). I would argue this would be a very small amount of people and Afterpay has many levers they can pull to avoid this.

Risk Management
The main lever they have pulled has been the requirement for ALL customers (not just US and UK) to pay 1/4 upfront which means they instantly have 25% less risk on each transaction but this also works as a disincentive for fraudulent customers because they would have to cough up the initial 25%. In addition, the company has tightened credit in March and reduced limits to all customers, more so to ones that have had late payments in the past or that were picked up as lower quality through Afterpay's behavioural credit risk model. Their credit risk management is second to none.

I hope this hasn't confused anyone but it's important to keep in mind what BNPL is and what their exposure is at each stage of COVID-19. The loans aren't 30 year loans that have gone foul, that customers AND banks are stuck with. These loans are nimble, and paid off very quickly.

Some people have argued that Afterpay should be struggling because look at the banks stopping dividends, raising capital and putting provisions aside. There are large fundamental differences between bank's loans and Afterpay's loans (as a banker I would know) and I might do another objective analysis on this when I get time.

Please note that this is an extremely simplified example but the point is to demonstrate why, in my view, bad debt should not be an issue going forward. My concerns has always been a slowdown in transaction volume as people cut back on discretionary spending, however, the push to online shopping as well as government support appears to have accelerated BNPL transactions across all companies I listed.

Please provide objective analysis (positive/negative) to this and let's not turn this thread into another sh!tstorm. If someone has an objective analysis and I'm not responding, please let me know as I might have to un-ignore them to read it.

I'd particularly encourage conversation on the depicted repayment schedule through the three COVID-19 stages.