Is The Tide Going Out On Marketplace Lending?

Warren Buffett is a lot more than just a mega-billionaire and one of the world’s most revered investors. He’s a philanthropist. He’s a wickedly competitive bridge player.

He’s also a quote machine about business and investing.

I mean, what’s not to love about this one:

“I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

Or this one (which also seems to have served his portfolio well over time):

“Be fearful when others are greedy and greedy only when others are fearful.”

But here’s one that might foreshadow what’s soon to come in the world of FinTech investing:

“You only find out who is swimming naked when the tide goes out.”

We’ve seen and read enough to know that the unicorns are starting to lose their mythical stature as the not so mythical market valuation chickens are starting to come home to roost. It turns out that you really do have to make money in order to sustain a business over the long term.

But there’s a FinTech segment, in particular, that may soon be dotting the landscape with a lot of naked investors as the tide goes out on what is touted as one of the greatest transformations ever to have hit financial services:

Marketplace lending.

ARE MARKETPLACE LENDERS SWIMMING NAKED?

Over the last 7 or so years, marketplace lending is to VC money what high-end retail is to me – simply irresistible. <wink>

Hundreds of millions of dollars have been poured into a variety of these tech-enabled, data-driven lending platforms. Some have even IPO’d. Funding Circle, Prosper and Lending Club, among the largest and most notable veterans in the marketplace lending space.

Marketplace lenders were, in many ways, in the right place at exactly the right time.

During the financial crisis, these new players innovated lending in a way that highly regulated, traditional financial services players simply couldn’t. Using data, technology and sophisticated credit scoring and risk management algorithms, these new technology platforms created a business that matched borrowers with a lack of capital with investors with money to lend.

Their business was extending  unsecured loans ranging in size from $1,000 to $35,000 to borrowers at attractive interest rates. And the appeal to investors was that their data-driven risk models were every bit as good or better as those of their traditional bank lender counterparts. Since marketplace lenders do all of their business online, they didn’t have to worry about absorbing the onerous operating costs of maintaining physical bank branches or the personnel to staff them. That, analysts and investors say, shaved roughly 400 basis points off the cost of operating these new lending platforms – making them a highly efficient and cost-effective, new lending model.

At least in theory.

But the really clever part of these lending platforms  is how they make money. The clever angle that marketplace lenders have parlayed into hundreds of millions of dollars in venture-backed investments is that they really aren’t on the hook for any of the credit risk associated with making their loans since, oh, they don’t actually make the loans.

Rather, marketplace lenders are a conduit to investors who actually put up the money that’s given to borrowers. Marketplace lenders are a platform in the truest sense of the word. They acquire customers online and assess their creditworthiness. They then match that borrower with an investor willing to buy the loan. They then service it, once the loan is made. Investors come in all shapes and sizes: hedge funds, pension funds, PE firms, private investors and banks. JPMorgan Chase just bought a portfolio of loans that were dragging down the performance of Santander’s consumer loan portfolio that included loans originating from Lending Club.

A bank in the background does the regulatory dirty work of actually making and booking the loan that a marketplace lender has matched up with an investor. That bank carries that loan on their books just long enough for it to be packaged as a securitized asset and sold to those investors. Often in a matter of days, a borrower has his money, and an investor has a securitized asset that is now part of their investment portfolio.

Investors make their money on the spread between the cost of capital and the rate of interest charged to the borrower. Thanks to the insanely low cost of capital over the last several years and the interest rates charged to the borrower, investors have made a pretty handsome return on their investment.

(But hold that thought.)

So, it’s the investor, not the marketplace lender, that assumes the credit risk for the loan and, therefore, must hope and pray that the risk models underpinning those loans are as bulletproof as advertised.

The marketplace lender, on the other hand, makes most of its money on the originating fees that borrowers pay them to get access to funds. That makes job No. 1 for a marketplace lender acquiring customers who want a loan and may otherwise have few options to get one. Naturally, marketplace lenders also need borrowers to be creditworthy enough to repay the loan, but their incentives are first and foremost aligned around getting as many customers as they can onto their platform so that they can book revenue from originating fees.

So, without the same capital requirements as banks, without the brick-and-mortar operations to support like banks, without the onerous regulatory and compliance boxes to check like banks and without the credit risk to get in the way of financial performance like the banks, it’s not surprising  that VCs were attracted like bees to honey to this innovative lending model.

But the same business model that gave marketplace lenders life, could ultimately deliver its death knell.

In the form of the platform death spiral driven, ironically, by the credit risk that these platforms thought would be someone else’s problem to deal with.

FOLLOW THE BOUNCING MARKETPLACE LENDING PLATFORM DEATH SPIRAL

The marketplace lending model is designed to offload the most pernicious risk in the lending business  – credit risk – to the investors who buy the loans from them. And, when all works well – e.g. the credit underwriting is spot on, borrowers repay their loans as promised and capital is plentiful – everyone makes money and the happy and virtuous circle of platforms works well.

Booya!

But, something funny can happen on the way to platform business success in this business. And it all comes down to the risk that marketplace lenders thought that they cleverly got rid of when they designed their businesses.

Not all borrowers pay their debts. And when times get tough and consumers feel pinched, more of them may decide not to or may not be able to. Topping the list of bills not to pay first – or at all – are unsecured loans – and for one simple reason: There aren’t dire consequences when consumers stiff those lenders. If it’s a choice between an apartment eviction, car repo, mortgage foreclosure, or cellphone or cable interruption, unsecured credit gets shoved to the bottom of the pile. And when borrowers stop paying, investors start losing money.

When that happens a lot, investors get sad. Some may even get mad — and mad enough to decide to take their money elsewhere.

For a marketplace lender, that’s bad news.

No investor money means no ability for marketplace lenders to acquire new customers since they have no other access to capital to extend credit to borrowers. Unlike banks, marketplace lenders don’t have deposits on hand that can be turned into loans. And since they don’t have the loans on their books and the repayments from those loans to turn into capital to lend either, without investor capital, there’s simply no capital.

So, no new customers for marketplace lenders means no origination fees to book as revenue, which, as I mentioned, is how marketplace lenders make the majority of their money.

And no revenue means no business.

And that could spell Platform. Death. Spiral.

All because of the credit risk that they never thought they’d have to worry much about.

THERE’S NO RISK LIKE CREDIT RISK (IF YOU’RE A LENDER)

Credit risk not only establishes the profile of the borrower and his creditworthiness, but ultimately, the rate of return on the investor’s portfolio – which is their incentive for playing along with marketplace lenders in the first place.

That’s where, at least according to some reports, the tide might be starting to go out and we might start to see some naked investors.

Moody’s said last week that it was reviewing for a “possible downgrade” of a particular class of assets originated by Prosper and issued by Citi Held for Issuance (CHAI). The review was triggered by what Moody’s describes as evidence of many more delinquencies and charge-offs than originally anticipated. The brief that accompanied this announcement pegged losses of up to 12 percent of that asset class, up from 8 percent when the transaction closed. That, they believe, will translate into losses that could go as high as 13.6 percent, reducing the overall return on the investment that, in this case, CHAI anticipated.

The same has been written about the experience of Lending Club’s investors. Lending Club’s CEO reported last week that it returned 7.8 percent to its investors in 2015 (he described it as “nearly 8 percent”).

But that’s a good 2 percentage points below what it was two years ago. Lending Memo did an analysis in March of Lending Club’s interest rates, which is a leading indicator of investor rate of return. What they disclosed is that in just about every asset class, interest rates have declined – which corresponds to a declining rate of return to investors.

Source: Lending Memo, March 2015

But perhaps the most cautionary dimension to this story is that these declines seem to be independent of the borrower’s FICO score. Remember how marketplace lenders make their money? Origination fees. In an effort to attract more borrowers – and more origination fees — Lending Club appears to have lowered interest rates, and the profile of their borrower at the same time. In other words, interest rates are lower at the same time the risk profile is higher In the best case scenario, which is that these borrowers repay the loan in accordance with the terms, investors will see a lower return on their investments. If these borrowers don’t repay, well, then a lower rate of return might become the least of anyone’s problems.

Lending Club is, of course, the poster child for the marketplace lending sector since as a publicly traded company it’s had the unfortunate consequence of having its every move scrutinized by the public markets. It’s also watched its market cap shrivel to $2 billion from its high point of $8 billion a little more than a year ago. Prosper, which was reported to have had its own plans for IPO in 2015, put them on hold, and is said to be eyeing a 2016 event.

But what’s clear is that once-bullish investors seem to have cooled on the space as these platforms work their way through the natural cycle of business and they wait to see how good the new science of credit risk and underwriting really are. It’s really too early to tell.

At the same time, regulators are circling the space, uncertain about how to classify — and therefore regulate — them. Marketplace lending proponents say that, unlike the financial crisis in 2008 that had the real possibility to bring down the financial system and do real harm to the economy, that the only people who could be hurt by a marketplace lending meltdown are the fat cat hedge funds and PE firms who have a lot of money to burn. Maybe. And maybe there won’t be any contagion like there was in 2001. But we’ve never been through a cycle like this with lending platforms like this, so we’ll all be watching this play out in real-time.

Warren Buffett also said “only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” Prosper and Lending Club were both established in 2006. It’s probably fair to say that most investors, making their decisions then to invest, and waking up 10 years later, would probably still be pretty happy.

It’s just the next 10 years that they — and marketplace lenders — need to worry about.