Growing pains of marketplace lenders
The fintech darlings of online lending are becoming victims of their own success. Questions over loan performance and industry structure have put the young sector firmly in the regulators’ sights. What started out as a market known for its transparency is becoming increasingly complex, not least through the growing use of securitization and involvement of the biggest banks and asset managers. Marketplace lending needs to grow up fast.
Just before Christmas last year Moody’s issued a rating on the securitization of a pool of marketplace lending (MPL) loans from a Citi-run shelf known, in the clunky parlance of the industry, as Citi Held for Asset Issuance (Chai). The $265 million deal was the third from the platform and was backed by consumer loans originated by online lender Prosper Marketplace. All the notes were privately placed.
As the industry returned from the Christmas break in January, however, the analysts at the rating agency were clearly having second thoughts. On February 11, a mere 36 working days after issuing the rating, Moody’s declared that it was placing the $43 million Class C notes of this deal, which it had rated Ba3, on watch for downgrade along with the Class C notes from the two prior Chai securitizations, both of which had taken place since August 2015. The Class C notes in the December deal had 15% credit enhancement and had been offered at 6% over swaps.
That is a remarkably short period of time for the dynamics of the pool to have changed so dramatically. By the end of the first quarter of this year there had only been 29 securitizations of consumer MPL loans, totalling $3.9 billion, so for three of them to be put on rating watch is a big deal.
It isn’t just Chai. In June 2015 Florida-based marketplace lender CircleBack Lending securitized $126 million of loans through Jefferies, with which it has a $500 million forward-purchase agreement. By March this year, however, cumulative losses on the deal had already caused it to breach its triggers, according to Morgan Stanley.
Anyone who lived through the financial crisis – or even saw the film ‘The big short’ – should have a nasty sense of déjà vu about the evolution of the MPL ABS market. This is a market that was launched on the back of a simple idea: two peers lending to and borrowing from each other.
It has, however, developed into a complicated network of risk transfer, with the original loan application often travelling from online platform to agent bank where the loan is made but then transferred back again to the online platform in as little as 24 hours. It is then matched with an investor and is often sold again – this time to a securitization platform. It will then be packaged up and sold on to ABS investors – a process that by any measure has become horribly complicated. Complexity is not what this industry, which is supposed to live and breathe on transparency, needs.
Are concerns about this complexity an over reaction? The marketplace lending sector remains tiny in global financial market terms. These are private placements sold to institutional investors and hedge funds, so the systemic implications are minimal.
There is, however, much to feel uncomfortable about if marketplace lending grows to become as big as many expect. That is because securitization will fuel much of that growth. “No regulator is looking to make the banks bigger,” muses Gyan Sinha, founding partner at Godolphin Capital Management, a New Jersey-based investor specializing in MPL asset-backed securities. “Credit has to come from the non-banks.”
Sinha has first-hand experience of ABS deals going wrong: immediately before the 2008 crisis he was the lead analyst covering the sector at Bear Stearns where he attracted criticism for his bullish calls on sub-prime residential mortgage-backed securities right up until mid 2007.
After Bear, Sinha joined KLS Diversified, where he worked with Samir Desai, who went on to found UK marketplace lender Funding Circle. “Securitization will be absolutely essential to the growth of the MPL market,” he says. “It will require a huge investment of time and effort on the part of securitizers and issuers.”
If non-bank lending is the future, then the securitization industry had better figure out how pools of these loans perform over time – and fast. Because, despite its fintech swagger, marketplace lending is not new.
“This is not a new asset class, it is a new business model,” explains Ram Ahluwalia, chief executive officer at research firm PeerIQ in New York. “Consumer-lending ABS has been going on since the 1990s.” So investors, issuers and rating agencies need to take a hard look at exactly what is different about MPL platforms to unpick exactly how risky this brave new world of consumer finance really is.
Marketplace lending accounts for only 0.08% of the $96 trillion global corporate and household debt outstanding. However, the sector is accelerating fast, growing an average 123% a year since 2010. Some $24 billion of marketplace loans were originated globally in 2014; Morgan Stanley forecasts that this will reach $290 billion by 2020. It’s also attracting big names in finance, most recently ex-Deutsche Bank CEO Anshu Jain, who joined the board of marketplace lender SoFi this year.
The global marketplace lending figures are, however, distorted by the dominance of China: Creditease, China’s largest marketplace lender, has originated $25 billion in loans to 2 million borrowers, while the largest US player, Lending Club, has lent $13.4 billion to 756,878 borrowers. China accounted for 85% of the global online direct lending market in 2015, according to specialist strategic adviser Liberum Alternative Finance.
Research firm LendAcademy has described Creditease as “like Lending Club, Avant, LendUp, SoFi, LendingHome, and Charles Schwab wrapped into one company”. It spun out its online lending platform, Yirendai, via an IPO in December last year. Confidence in the Chinese market was, however, hit by the collapse of Ezubao, one of its largest marketplace lending platforms, in February this year. Around 95% of the loans on the platform were found to be false; investor losses are believed to have reached $7.6 billion.
The US market is dominated by Lending Club and Prosper Marketplace. Lending Club originated $8.4 billion in loans last year, increasing its loan book by 50%. It projects a 70% increase to $14 billion in 2016. Prosper originated $3.7 billion of loans in 2015 and saw revenues grow to $200 million from $81 million the prior year.
The number of players in the industry is set to grow exponentially: US online lending start-ups raised $2.4 billion in the first three quarters of 2015, and there are already more than 100 platforms in operation.
“The barriers to entry for marketplace lenders appear to be very low and the presumption is that marketplace lenders don’t need a balance sheet,” says Richard Kelly, managing director at advisory firm NewOak Capital in New York. “New entrants can just buy a white label website for $15,000. However, many will find it that they need to raise significant capital to be able to invest in the loans that they source until they establish clear performance and show they are viable and have the right operational and capital regimen.”
These lenders left their peer-to-peer roots behind long ago, as the number of individuals investing in the sites failed to keep pace with loan growth. The model very quickly became peer-to-hedge fund, and attracted intense interest from the banks, who calculated that if they can’t beat them, they might as well join them.
In June 2014 one hedge fund, San Francisco-based Colchis Capital Management, had already invested $663 million in marketplace loans – 10% of the entire sector. The big institutional investors were already very active too: by mid 2014 BlackRock was buying 25% of all loans originated by Prosper. Faced with this kind of firepower, individual peers have been increasingly squeezed out.
Bank involvement has taken many forms: some have invested in platforms directly – for example BBVA, Credit Suisse and JPMorgan have all invested in Prosper; Silicon Valley Bank and Wells Fargo (via Norwest Venture Partners) have invested in Lending Club; and SoFi raised $1 billion from Softbank Capital last year.
Others have partnered with the lending platforms either by originating through them or buying pools of loans from them. Santander was an early adopter when it cut a deal to buy 25% of Lending Club’s loans in March 2013. It also struck a referral agreement with Funding Circle in the UK. In February this year JPMorgan bought nearly $1 billion worth of Lending Club loans from Santander Consumer Bank USA. It has also invested in Avant and partnered with OnDeck.
Flow purchase agreements such as that between Jefferies and CircleBack are also popular; Citi had such a deal with Prosper allowing it to purchase a proportion of all loans originated on the platform (which were subsequently securitized through Chai). The future of this arrangement is, however, now uncertain. In the UK, Metro Bank set up an alliance with Zopa in March 2015 – the first UK bank to lend through a MPL platform and Santander UK has teamed up with Kabbage to provide SME loans.
Several marketplace lenders have also partnered with US community banks: Lending Club with BancAlliance, a national consortium of around 200 community banks and Prosper with Western Independent Banks, which represents more than 160 independent and community banks. The most direct approach is to set up their own online lender: Sun Trust Bank set up online lender LightStream in 2013, but that is a path few others have chosen.
This could change following the news that Goldman Sachs is building a team to launch its own online platform, to be called Mosaic. It will be funded via Goldman Sachs Bank USA, but is unlikely to be operating in the same space as many other platforms.
“This is part of Goldman’s fintech strategy, they won’t be lending to consumers,” one online lender reckons. “They won’t be offering $25,000 loans to purchase a car.”
Goldman is, however, now offering an online instant access savings account and has hired Harit Talwar from Discover to run its online lending business.
Cormac Leech, founder of Liberum, sees the connections between banks and marketplace lenders getting only stronger. “There is nothing magic about digital lending – it is just an efficient way of extending credit. Banks have a very cheap cost of funding, so they are natural partners for this. Over time the banks will become more efficient. Marketplace lending and the banks will become more integrated into each other. Digital lending is the endgame for smaller loans – it will dominate.”
As this process accelerates, regulators are becoming more twitchy. The US Department of the Treasury launched a request for information on the online lending industry in July last year to determine if these lenders should be subject to similar risk-retention requirements as banks. In November last year the FDIC issued a letter reminding FDIC-supervised institutions of the importance of underwriting and administering purchased credits as if they had originated the loans themselves.
This looming regulatory oversight had already created nervousness around the industry when it was hit by further bad press at the end of last year. Syed Rizwan Farook, who together with his wife shot and killed 14 people in San Bernardino, California on December 2, had been the recipient of a $28,500 loan from Prosper Marketplace (that was subsequently purchased by Citi). The California Department of Business Oversight launched an inquiry into the lending practices, investors and business models of 14 marketplace lenders just a fortnight later.
The big worry for these lenders is that they will be hit with the same kind of risk-retention requirements that have been ushered in for bank issuers under the Dodd-Frank Act.
“Fidelity and T Rowe Price are not required to retain a percent of every investment they make or recommend to their clients because there is an inherent alignment of interest,” grumbled founder and CEO of Lending Club Renaud Laplanche in response to the Treasury’s RFI. “If their clients earn disappointing results, they will pull their assets out, much as a disappointed Lending Club investor would.”
The structural difference between balance sheet lenders and marketplaces is fundamental to this argument. The latter are platforms with lenders and borrowers on either side. “The primary function of a marketplace lender is that of a risk-matching platform,” says Ahluwalia at PeerIQ.
“These are technology companies that do not have the loss-absorption capacity or risk-management capabilities of their institutional investors. If risk retention was attached to the marketplace lenders, the business model would shift abruptly and prematurely select winners and losers not by the underwriting competencies but by their ability to attract low-cost sticky capital.” For this reason, he argues, risk retention must be attached to the securitizer not the platform.
Sachin Patel, global co-head of capital markets at Funding Circle in the UK, is also critical of any move towards risk retention requirements. “The whole skin-in-the-game argument makes no sense,” he tells Euromoney. “Mortgage originators all went bankrupt even though they had sold whole loans. The problem was not market structure per se. We publish details of every loan on our website. There is real reporting. You can very quickly see what is going on. Our skin in the game is that we are totally transparent.”
Funding Circle, which concentrates solely on SME lending, was due to become the first European marketplace lender to securitize a pool of loans through a £130 million transaction as Euromoney went to press.
Perhaps sensing that the regulatory winds are not blowing their way, Prosper, Lending Club and Funding Circle launched the industry’s first trade organization, dubbed the Marketplace Lending Association, in April. The MLA will swiftly draw up a code of business conduct to address transparency for investors, responsible lending, governance and controls, and risk management. Many marketplace lenders are also assembling an impressive array of regulatory expertise with which to fight their corner: Chicago-based Avant has former FDIC head Sheila Bair on its board, while former Treasury secretary Larry Summers is on the board of Lending Club.
Negative press, heightened regulatory scrutiny and the threat of rating downgrades have all conspired to turn the perception of marketplace lending from the fintech industry darling of mid 2015 into a wild west of risky credit today. It has no track record to fall back on, so each bad headline spurs a fresh round of nerves and share-price deterioration (Lending Club, which has been one of the most shorted stocks in the market, has seen its share price fall from a high of $24 after its December 2014 IPO to $7 on March 2). These firms urgently need to demonstrate that they have the systems and processes in place to provide comfort to investors that loans will perform as they are expected to.
“There is high degree of sensitivity around lending today, which is fair and reasonable following the financial crisis,” observes Philip Bartow, portfolio manager at RiverNorth Capital Management, a Chicago-based asset manager with $3.3 billion of assets under management. RiverNorth has applied for SEC approval to launch the first closed-end fund focused on marketplace lenders.
“When investors make broad assumptions and predictions about asset classes it’s hard for them to be right all the time,” he says. “We think it is important to do the actual work on the asset: underwriting losses and the timing of those losses, and then compare that profile to other credit products. I certainly don’t think marketplace lending is going to perform without losses across cycles. There is a risk there, and investors need to underwrite accordingly.”
The raison d'etre of marketplace lenders is that they have developed underwriting engines that are more efficient and superior to the banks’. As these algorithms are closely guarded black boxes, potential investors must take them at their word.
Prosper uses the ‘Prosper score’ to determine a Prosper rating, while Lending Club uses a ‘model rank’ to create a loan grade.
“Platforms are pulling in a lot of raw data which is used to calibrate a statistical model of the likelihood of default,” says Sinha. “We back-test the scores and have enough of an insight into the factory to be comfortable.”
Perhaps those algorithms will become less of a black box as online lending inexorably comes to dominate the consumer space. “Banks are good at large lending but not so good at small lending,” says Leech at Liberum. “They could reach these borrowers, but it costs them too much to do so.
“Bank credit officers have often been doing the same job for 20 years, whereas the underwriters at many marketplace lenders have been to MIT or Harvard and are highly incentivized,” he continues. “They are on Facebook and LinkedIn and using three or four different rating agencies to make their decisions. They are often lending to people that the banks would reject.”
A quick scroll through borrower comments about WebBank on free online credit and financial management platform Credit Karma certainly confirms this. “I am exited [sic] over Web Bank. They financed me when no one else would,” declared one borrower in December 2012, with another in December 2013 revealing “I got approved for $400 from Fingerhut (WebBank’s catalogue credit account) after a month of discharge with bankruptcy. Love WebBank.”
In January 2016 another borrower revealed: “Even though I had two credit cards in collection, WebBank lent to me through Fingerhut. I paid off my first and only use of that Fingerhut credit and after that I got approved for a personal loan through Avant. I was surprised to know that Avant is owned by WebBank [borrowers frequently reveal a lack understanding about exactly who owns their loan]. It’s true that they will lend to you when others don’t. I’m happy that there are banks like WebBank.”
Unsecured consumer credit has always been a risky business, so let’s hope that institutional investors remain happy that there are banks like WebBank too. The loans in the Chai pools were originated through WebBank for Prosper Marketplace, and Moody’s misjudgment of their cumulative net-loss trajectory has left many scratching their heads.
The rating agency used its standard methodology for consumer loan-backed ABS to assess the pool and determined that expected losses were 8%. This was based on the early performance of loans originated on the Prosper platform from 2013. The pool of loans is very similar to the pool backing a $325 million securitization of Prosper loans issued by BlackRock in January last year (CCOLT 2015-1), which has the same 8% expected loss. Moody’s declined to speak to Euromoney for this article.
By February, however, the expected cumulative lifetime net loss for each of the pools backing the three Chai transactions had increased to 12%. Why would the performance of an asset class as tried and tested as consumer credit be so wide of the mark? Is there something about online lending that makes performance much harder to predict?
Citi, which declined to speak to Euromoney for this article, has also securitized loans from Marlette Funding through Chai.
“The downgrade rating watch on the Chai deals sounds like a breakdown in processes,” reckons Sinha. “There is obvious confusion about what the underwriting looks like. No one has acquitted themselves well over this and it has created a false narrative of credit deterioration.”
But that is a narrative that is proving hard for the industry to shake off. In January 2016, LC Advisors, an investment adviser owned by Lending Club, revealed that some of its loans are not performing as expected. Charge-off rates for some five-year loans are around 7% to 8%, against a forecast of 4% to 6%.
Ahluwalia at PeerIQ believes that it will take time for investors to get completely comfortable with this young asset class. The first securitization of marketplace loans was brought by New York-based hedge fund Eaglewood Capital (run at the time by ex-Lehman trader John Barlow), a $53 million deal bought by one large reinsurer. The first small and medium-sized enterprise marketplace securitization was transacted by OnDeck in April 2014 and BlackRock launched the first rated deal through its CCOLT (Consumer Credit Origination Trust) programme in January 2015.
“This is a new credit product for institutional investors,” Ahluwalia says. “These are unsecured instalment loans with a three to five-year maturity. There is no prepayment penalty which makes it very difficult when you try to project cash flows. There are no smooth monthly cash flows. Investors must model prepay and default behaviour.”
These loans take time to go bad, but stronger borrowers prepay early, so for marketplace lenders most of their profit comes in the early years of the loan: portfolios will tilt towards weaker credits as time passes.
“Investors are grappling with an unfamiliar but promising asset class and headlines have created investor apprehension,” Ahluwalia continues. “Merely putting a spreadsheet online is not enough to unlock institutional capital. There needs to be transparency not just at originator level but at ABS level as well.”
He says that while there is a year-on-year uptick in delinquencies of 30 basis points to 50bp, “these are still multi decade lows as compared to credit card charge-offs.”
There is no getting away from the fact that marketplace consumer lending can involve weaker borrowers. According to Morgan Stanley, by mid 2015 80% of MPL consumer loans were being used to consolidate debt. By year end, 68.5% of the origination volume on Lending Club was for refinancing or paying off existing credit-card debt. In the US, borrower quality is traditionally determined using a FICO score that is based on a set of borrower criteria. The generic FICO score is between 300 and 850; the median score was 713 in 2014, down from 723 in 2006. When Lending Club first launched, it required a FICO score of 660 or above in 2013 but lowered this to 640. Prosper has had a floor of 640 from the outset.
The unique selling point of marketplace lending is that all those Harvard-educated underwriters using their proprietary algorithms can judge the credit risk better than the traditional banks could.
“Is the pool of borrowers an adversely selected subset of bank customers?” asks Sinha. “Two thirds of credit card users are convenience users which pay off their balance at the end of every month. If you compare the performance of the other one third of credit card users that do not, the MPL loans performance is about the same.”
Investors should hardly be surprised, therefore, if marketplace lending securitizations of consumer loans turn out to be riskier than traditional credit card securitizations. According to Liberum, US credit cards achieve an average net yield of 8.2%, with stable losses and consistently positive returns. The equivalent figure for the UK is 6.4%.
“There is a risk that some marketplace lenders gravitate to making hard money loans at soft money rates which is not a recipe for long-term survival,” points out Kelly. “The rates credit card companies charge are reflective of the credit they are dealing with and they are profitable but not wildly. They lend to consumers at 19% and marketplace lenders reckon to do the same at 15%. However, this could be explained by marketplace lenders having no formal capital requirement as well as more efficient operation acquiring clients.”
According to Liberum, average yields of marketplace lending platforms range from 5.5% to 8.8% when converted to US dollars, with the highest being UK-based Bondora at 16% and the lowest SoFi at just over 2%. Lending Club and Prosper yield around 7%.
Kelly reckons that loss severity could actually be worse than it was in some RMBS asset classes. “The principal distinction between this kind of lending and mortgage securitization is that MBS is backed by real property. It was an extraordinary anomaly that the value of property fell as precipitously as it did in the financial crisis. Over a long period of time there is a floor on losses with mortgage lending. Loss severity is much less than that for unsecured individual lending, where loss severity may become high under stress. For example, unsecured creditors may be entirely wiped out in bankruptcy. Typically, the defaulted instalment loans will end up being sold at 10c on the dollar or discharged,” he warns. “Servicers of these loans are not going to sue someone over a $5,000 business or personal loan; even if you get a judgment, enforcement is expensive and uncertain.”
As in traditional banking,marketplace lenders are trying to differentiate themselves. Those that focus purely on SME lending, such as OnDeck in the US and Funding Circle in the UK, are keen to distance themselves from the consumer market, and they emphasise the higher quality of lending in this segment.
Nevertheless, as long as investors understand the risks and are being compensated properly for them, then both consumer and SME marketplace lending and the securitization underpinning them should continue to grow. In the US, total MPL ABS issuance now stands at $8.6 billion from 47 deals (29 of consumer loans, 11 of student loans and 7 of small business loans), according to PeerIQ. The pace of issuance slowed in the first quarter of this year, however, and the headlines around Chai have seen spreads in that programme widen by 100bp from its first issuance in 2015.
The relationship between each marketplace lender and its investors is the key to how these platforms will fare as the industry enters choppier waters. “Contrary to what most traditional bankers believe, not all lending capital thinks alike,” observes Frank Rotman, founding partner of QED investors, a venture capital firm that has invested in, among others, Credit Karma, Prosper, Avant Credit and SoFi.
“The key to managing a non-bank lending originator is to find the right partners who like the economics of the business,” he says. “Some investors are looking for low risk, low volatility and collateral-backed loans. Others are looking for high-yield assets from which they can quickly exit if warning signs arise. Retail investors don’t look anything like giant international insurance companies, nor do the insurance companies look like hedge fund traders.”
If marketplace lending is hit by more negative headlines, investors could disappear, taking with them the funding on which the platforms are reliant for growth. Indeed, SoFi’s recent decision to set up a fund, the SoFi Credit Opportunities Fund, to purchase its own loans is a rather surreal illustration of the extent to which these platforms are dependent on borrowing and lending expanding at the same pace.
“In normal environments, we wouldn’t have brought a deal into the market,” SoFi chief executive Mike Cagney said in March when he launched the fund. “But we have to lend. This is the problem with our space.”
Sinha at Godolphin tells Euromoney that the answer is for MPL platforms to be more programmatic in their approach to clarify the risks to their investors.
“The industry has done itself a disservice by treating loan sales as fungible,” he claims. “The whole loan sale investor market has become very fragmented and balkanised, with a small number of players dominating. We need a set of uniform standards. If these were balance-sheet lenders, they would set up their ABS platform and put a stamp on it. MPLs need to curate their programmes – they can’t just keep randomly pumping out loans.”
The honeymoon period for marketplace lending is over, and there is a sense that the industry is desperately trying to smarten itself up, put on a suit and persuade the regulators that it can be trusted. But in trying to move away from its roots, it may also go back to them if the institutional capital it has courted becomes too wary of the predictability of loan performance.
In response to an analyst’s question at the end of Lending Club’s fourth quarter earnings call Renaud Laplanche pointed out that 62% of [Lending Club’s] funding already comes from individual investors, and it wants to preserve and then potentially grow that share of retail investors. “We really think that retail is a core competency and a core competitive advantage of Lending Club and pretty much no other platform has any scale in retail distribution. So we think that’s going to be a nice differentiator, particularly if and when the economy starts slowing down, because we believe retail is more sticky than any other source of capital.”