Business Breakdowns
· Fraser
[00:00:00] S1: Definitely. Max is reading scientific papers late at night on AI. We caught up with Max a few weeks ago, and he said one recent weekend he used AI to build an app to control all of the TVs and stereos in his house because he was sick of hunting around couches for remotes. He's an engineer. They are extremely technical. 70 or 80% of code is already being deployed by AI. You compare that culture and that leadership team, how AI-pilled they are, with every other credit card business on earth — it's just not a fair fight or a fair comparison. The reason we back founder-led businesses is this alignment piece, because the founders are economically tied to their businesses and care deeply about pursuing growth opportunities and taking advantage of big transformational innovations like AI. Just for context, Max's salary is less than $40,000 a year. He earns no cash bonus, but he owns a couple of billion dollars' worth of stock and does earn an LTI of stock that's tied to the financial performance of the firm. And interestingly, the two presidents of the business — to your point on longevity of the team — those two presidents have been with the business eight to ten years, and they each own $100 million of stock plus, which is more than most CEOs of US public businesses. So the alignment is there through the organization and starts with Max. They've even recently made some org design tweaks so that Max is now spending more of his time in what he's calling his innovation lab in Affirm. And so the two presidents effectively run the day-to-day of the core business, and then Max has a small team of engineers and product people to build the next suite of growth levers to layer on top of what already exists in the business.
· S0
[00:00:00] S0: This is like the zero-to-one idea that's inside the business, and Affirm Card is kind of spun out of it.
· Fraser
[00:00:00] S1: Exactly. So Affirm Card — we've mentioned 20% of GMV, growing 100% year on year — that is a product that spun out of this innovation lab. A lot of what we're talking about on the merchant-funded 0% loans network — where either brands, so you can imagine Adidas can fund a 0% loan when someone buys an Adidas T-shirt on Amazon, or Amazon could fund the 0% loan — that behind-the-scenes network has been built out of this innovation lab. Max is very focused on making sure the whole organization is obviously implementing AI — and we've already talked about it being in their underwriting models — but also that the innovation coming out of Affirm continues long into the future. We haven't talked about it, but Edge is another example, where banks are going to start white-labeling Affirm's offering. So imagine you're a regional bank. Your customers have a debit card, but you historically haven't played in credit cards because it's just too competitive a space. You can now turn on functionality in that debit card, like the Affirm card, where your customers can move between debit and credit offers. And Affirm powers all that — does the underwriting, does the servicing, builds the functionality into the regional bank's app to manage the repayments. So it's another way that Affirm thinks of itself as a payments network. And in the same way you can have a — and I'm going to get this analogy wrong because I'm not American — but a Delta American Express card or an American Airlines American Express card, today you can have the Shop Pay Installments powered by Affirm, or the regional bank hybrid card powered by Affirm. And so Affirm wants to be everywhere, and it wants to be the payment network. It's not trying to be the primary bank account like a lot of other fintechs are racing to be. So in the same way that the JPMorgans and the Bank of Americas and the Citis exist to be a full-service traditional bank, American Express exists as a payment network. They still accept deposits and those sorts of things from a funding perspective, but at its core, it's a payments network, and Affirm is very closely aligned to American Express in that sense.
· S0
[00:00:00] S0: We've talked a little bit about interest rates, and now it's particularly important as rates are going up quite fast. And one could say that Affirm's moat is really its incredible credit underwriting, which we've talked a lot about, and it's only getting better now as they moved into some different architecture with the transformer-based architecture, and its access to capital markets. So I want to spend a good amount of time talking about what's maybe least understood and most important, particularly for this environment — where the money actually is coming from to service some of the loan portfolio. What happens when interest rates move, particularly upwards? You could intuitively say — and maybe this is reductive — that they're borrowing money to lend money, and if interest rates are going up, that's presumably quite bad. But maybe level-set us there on the capital markets side of things and interest rates.
· Fraser
[00:00:00] S1: The key principle to think about on the funding side of the business is Affirm is trying to build out a diversified range of funding sources with lots of redundancy. So they have different investor types, banks, insurers, and other institutions funding these loans — securitized, non-securitized, on-balance sheet, off-balance sheet, static, revolving, fixed and floating rates. The list goes on. Affirm is in the process of getting a banking license. They will also have consumer deposits as a piece of the funding mix. And the idea is that if you have the broad group of funding sources, you're never reliant on any individual piece. If for whatever reason the private credit market has issues, or the banking ecosystem has issues, or insurance companies are having issues — unless the whole system dries up, Affirm has built a very sophisticated capital markets engine to ensure it's got this diversified funding base with plenty of redundancy. So the outcome of this diversified funding strategy is about 50% of loans are off balance sheet in forward flow facilities and static ABS facilities. And then the other 50% is on balance sheet in warehouses and revolving ABS facilities. And you can imagine the warehouse is typically where a lot of the redundancy is, because you fund the loans via the warehouse and then think about where you want to move them subsequently. But it's not a case of you all of a sudden building up lots of loans on balance sheet and then three quarters later selling a big chunk. The split between on balance sheet and off balance sheet, and the splits between the different funding sources, is very consistent and constantly managed. The key risk you have on the funding side of the business is more in the short term, and this goes to the 2022–2023 scenario. When Affirm writes the loan to the consumer and the consumer accepts the loan, the interest rate is fixed. So if the average loan term is 11 or 12 months, the interest rate is fixed over that period of time. A small portion of the funding base is floating. And so if the Fed lifts rates very quickly in serious magnitude, you have this short-term gap where you're not earning any more interest on that pool of loans that's amortizing, and you've got to wait for the new loans at the higher interest rate that you're charging to flow through the book.
· Fraser
Because the book turns so quickly — I think I mentioned — within a quarter, 50% of the loan book would be on the higher interest rate, and within two quarters, 75% would be on the higher interest rate. So it's a one- to two-quarter air pocket. That's really what we saw in 2022, 2023. Because that book turns quite quickly, rates have to move very quickly and very sharply to have a material impact. So for example, in the most recent reporting, I think the business said if rates rose by 100 basis points, it would have, call it, a $90 million impact to the P&L. And this is a business doing $2.5 billion of gross profit this financial year. I think the bigger issue is if rates go from 0 to 5% and you have a 500-basis-point increase — then that causes a big issue. 50 to 100 basis points over the course of many months or quarters doesn't have as much of an impact. What's also interesting is the mechanism is slightly different to a credit card. Let's say Affirm was offering 12-month loans on a $500 couch at a 15% interest rate, and then the Fed lifts rates and now all of a sudden Affirm has to charge a 25% interest rate for the new loans it's writing — that actually chops out a bunch of the loans they were otherwise writing at that lower interest rate. There are a certain pool of consumers that turn up, and Affirm says that's good credit and good underwriting to offer someone a $500 loan at a 15% interest rate, but it's not good credit, and we don't think it's worth the risk, to offer that same person a $500 loan at a 25% interest rate. The bigger issue in these air pockets is actually growth slows materially, because Affirm just stops writing loans to a portion of their user base that they were previously. And because the interest rate being charged to the consumer on the loans outstanding doesn't change, you don't necessarily see a huge blowout in credit losses. Credit losses did rise in 2022, but typically it's because there's a whole bunch of other debt that consumers have that's variable rate, and so they get squeezed elsewhere in the credit ecosystem. It's a combination of growth and margins, and it's one or two quarters of impact, and that's only in those moments where — 2022 was the largest and fastest rise in interest rates in 40 years or something. The average gyrations of interest rates shouldn't have a material impact on the business.