What We Learned About Alternative Finance In 2016

As often happens, the world we leave behind going out of 2016 is very different than the world we imagined 2016 would be going in.

There are, of course, a variety of ways to document that. A year ago today, you had never heard the word “Brexit,” never seriously said the words “President Trump” and never once considered that you would have to make sense of a world where Brad and Angelina had fallen out of love. Wells Fargo was just a bank that was really good at getting its customers to sign up for credit cards, and Lending Club and its P2P counterparts were coming to eat mainstream banking’s lunch.

As is the general rule with years full of surprises, there are all kinds of objective lessons one can learn from 2016. The chief among them being: Take all predictions people make about the forthcoming year in December/January with an appropriate grain of salt. If the last 12 months on this planet taught us anything, it is that, for every “sure thing” out there, there is also quite possibly a black swan lurking in the wings (pun fully intended) waiting to defeat that certain knowledge.

So, when it comes to looking back at the wide world of alternative financial services — and looking ahead to the year to come in 2017 — we’re not making any predictions. Our crystal ball is broken. Instead, we’re telling you what to watch for once we ring in the new year and what stories we think will get bigger before they get smaller. We can’t say we know what’s next for P2P lending, the CFPB or subprime borrowers — nor do we think anyone else can either — but we can tell you that how those stories unfold will make a very big difference to the shape of financial services yet to come and who will (and won’t) be included as part of the mainstream financial system.

The CFPB

Saying the CFPB had a busy year is true, if a bit misleading. The CFPB has had a busy year every year since it was created in 2011. Still, the breadth of topics the Dodd-Frank consumer protection watchdog took on in 2016 was fairly impressive — even by the CFPB’s aggressive internal standards.

Last year saw the agency offer up major revisions to regulation governing payday (and short-term) lending, arbitration in consumer contracts, car loans, marketplace lenders and prepaid cards. The agency also handed down the largest fine to a bank in its history — $100 million to Wells Fargo for creating an incentive system that pushed its employees to set up a series of consumer accounts without actually getting consumer permission. Wells was additionally hit with $85 million in fines from the Office of the Comptroller of Currency and the L.A. DA’s office.

Wells was easily the agency’s big win of the year. In a rare moment of bipartisan agreement, Republicans and Democrats on Capitol Hill came together to publicly bash the bank for abusing their consumers’ trust and offered at least tacit praise to the CFPB for bringing the big deception to light. There was also a pretty active chorus encouraging then-CEO John Stumpf to resign — a wish that Wells Fargo’s board of directors granted first by limiting Stumpf’s compensation sharply and then by “coming to an agreement about his resignation.”

Translation: They canned him.

But the CFPB’s actions didn’t all receive quite so much universal praise and, on the whole, were more divisive. The various regulatory upgrades the CFPB put out this year — particularly those to connected to payday lending, arbitration and prepaid cards — all generated significant controversy. Proponents argued that consumers need deep, rule-enshrined protections from the deprivations of the financial sector. Opponents argued that the CFPB was most effectively protecting consumers from ever having access to credit products and that regulating the system as though all banks were secretly depraved is probably not a great idea.

“Financial service providers should be vilified for doing wrong. And they are. A public beating on Capitol Hill is a common part of running the gauntlet. They should, however, be commended for lending money. Too often, though, they are vilified for that, too,” Dr. David Evans recently noted.

The problem is that the economy needs consumers to have reasonable access to credit to sustain growth, and consumers need reasonable access to credit to maintain happy, healthy lives. And that growing voice of discontent could be problematic for the CFPB, especially as it is moving forward with a new administration.

What To Watch:

The CFPB suffered a pretty big legal defeat earlier this year when a three-judge panel of the DC Circuit Court ruled its independent single-director structure is unconstitutional. The organization can either remain under said director, who will then serve at the will of the president instead of as the head of a wholly independent agency, or it can switch its leadership structure to that of a bipartisan board, the way other independent government agencies, like the FTC, have.

Given that the CFPB will now serve under an administration that has vowed to roll back the legislation that enables it — and that the courts will also certainly be taking a closer look at its structure through the inevitable series of appeals — it seems that what we want to watch next year is the structure of the CFPB and whether it will be a very different-looking agency when we write this recap next year.

P2P (Marketplace) Lending

For the last half decade or so, P2P lending — now better known as marketplace lending — had been building a reputation for being the great and signature innovation of the digital age when it came to underwriting. The marketplace lenders, after all, had a very compelling story for both borrowers and potential marketplace investors.

Consumer and SMB borrowers were offered an opportunity to escape underwriting processes at banks that even the most patient people tended to find onerously slow and paperwork-heavy. Alt-marketplace lenders had their own credit ranking algorithms and could make underwriting decisions in minutes that banks, in some cases, needed weeks or even months to make. Plus, Lending Club et al. were generally speaking of services for prime — or nearly prime — borrowers who found themselves caught up unfortunately in the post-recession credit freeze.

Marketplace investors — big and small — on the other hand, had a crack at an investment with a reasonably good chance of producing some yield, which was important given that interest rates were literally held at zero for nearly a decade.

Marketplace lenders got to connect these two groups to each other, charge fees for packaging up and selling all of those consumer loans to investors and then sit back and enjoy the network effects in action without assuming any of that nasty risk that goes with lending money.

Everyone was winning, and some were predicting that bank-based underwriting was about to go the way of the typewriter.

But the flipside of network effects is that they can run in reverse, which is what seems to have happened this year.

Part of that was spurred by the great Lending Club debacle in May. An internal investigation turned up some loans that were sold to customers whose standards they didn’t meet (in a way that made it clear that Lending Club employees were intentionally, not accidentally, misleading investors as to the quality of the loans) and that there were some anomalies in how much the firm’s risk committee knew before making certain investments in third-party companies. By June, founding CEO Renaud Laplanche was out. By fall of 2016, Lending Club — but also Prosper, OnDeck and a host of other marketplace lenders — were all reporting similar issues.

Consumer interest had remained the same, but investor confidence had plummeted, leaving many of these firms to fund their own loans instead of selling them off to investors. That has led to multiple rounds of layoffs across the P2P ecosystem and questions starting to emerge about whether or not P2P lenders are really quite as strong competitors for banks as was once thought.

And while it might be convenient to blame Lending Club for all of it, the reality is that cracks were starting to show in the P2P ecosystem before things exploded at Lending Club. Default rates were already on the rise, leading to questions about how good all those new, fancy credit ranking algorithms really were, and interest rates were showing signs of increasing, meaning those marketplace investors had more competition in the field for their love and dollars.

What To Watch:

Two things to watch this year. One, where do those default rates go, because a lending platform that can’t get people to pay back their loans isn’t a lending platform at all — it’s a charity. Two, which players survive and how they do it. Will they partner with the banks they were once primed to destroy, or will they find a way to keep on going it alone (mostly)? And those default rates, we should note, won’t just be important to watch in P2P lending.

The Rise of The Subprime Defaults

And finally, the Federal Reserve Bank of New York is ending the year by not quite sounding the alarm bell, but they are certainly trying to draw some attention to the fact that subprime loans — particularly for cars — are spiking.

As of Q3 2016, 2 percent of auto loan balances were at least 90 days delinquent, a 0.4 percent increase from 1.6 percent in 2014.

Rates peaked at around 2.4 percent at the low water mark of the Great Recession.

“The increased level of distress associated with subprime loan delinquencies is of significant concern,” researchers for the New York Fed wrote in a blog post.

That uptick, however, is made a bit more alarming by the fact that unemployment is low at present, meaning borrowers should, in theory, be able to make those payments. One explanation is that auto lenders have gotten a bit too lax in their standards and have helped buyers get in over their head with credit lines.

Subprime auto lending has been a growth industry over the last few years. There are presently about $1.1 trillion in outstanding auto loans.

The good news is that, unlike the mortgage crisis before it, auto lending is a much, much smaller part of the economy than mortgage underwriting is. Moreover, bank-based auto loan defaults remain low, and financing companies are the more likely group to be hit by the wave of delinquencies than more traditional lenders are.

Subprime auto lending has attracted a series of financial players on the margins — those attracted to the much higher interest rates that can be charged, up to as much as 30 percent. Those loans can then be securitized and sold to investors.

But higher interest rates are justified by a higher risk of default, and now, those defaults are coming to bear.

The good news — sort of — is that analysts at Fitch Ratings said that, although losses on subprime loans were rising, they were within the firm’s expectations.

But even that comes with an “if.”

“Subprime auto performance could decline further if there are any stresses to the underlying economy,” said Kevin Duignan, Fitch’s global head of structured finance, in an interview.

What To Watch:

The strength of the underlying economy. Duignan went on to note that the recession and its aftermath have changed how both consumers and lenders look at large, securitized loans (i.e., mortgages or car loans, as opposed to unsecured credit card debt). While it was once taken for granted that consumers rarely walked out on car loans and home loans (since they need both transportation and homes), the trends of the last eight years say otherwise.

Also worth watching is the rise of firms that are looking to refinance car loans and perhaps take some of the sting out of the extremely high interest rates some companies charge. With wide enough adoption, they could push more consumers to stay in restructured car loans, rather than let high interest loans get away from them. Of course, Lending Club, Blinker and any other firm offering car loan refinancing have to find a way to profit off of a loan on an asset that loses value every day that passes and every time it is used.

So, what did we learn this year — other than the fact that making predictions is a quick way to be proven wrong publicly?

Though much changes in the credit marketplace, one thing remains the same: Consumers have to pay their loans, and those that lend to consumers have to either be pretty sure the repayment is coming or price the loan to account for the risk. Whether regulation and the loan products next year reflect that unchanging reality remains to be seen.