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On Deck Capital IPO, An Insider’s Perspective

August 16, 2014
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It was August 23, 2011, the day the Virginia Earthquake could be felt all the way up in New York City. The four of us were enjoying outdoor seating at a restaurant on the Upper East Side. The ground shook, my drink spilled and Ace looked at each one of us and said, “Okay so I’m putting you down for five deals this month.” OnDeck Capital’s relationship managers were aggressive. If you were a small Independent Sales Organization (ISO), they didn’t expect to get all of your dealflow so they roped you in little by little. It was hard to say no. If five deals was too much, Ace would say three and if three was too much, then he’d put you down for three anyway. Zero was not in the cards. OnDeck owned a specific niche and if you didn’t send your premium credit clients to them, then any ISOs you were competing against would. That was a death knell in those days. Just a few years earlier I would’ve shrugged them off, but public sentiment was changing. Merchants were embracing the fixed daily payment methodology and the merchant cash advance industry would never be the same.

OnDeck Capital is now going public. Will you buy stock?

ondeck capital ipoI’m in a unique position to discuss OnDeck. I started my career in this industry before they even existed. I’ve competed against them as an underwriter at a rival firm, worked with them as a referral partner when I was in sales, and covered them in my capacity as Chief Editor of an industry trade publication.

I left my post as Merchant Cash & Capital’s Director of Underwriting in late 2008. I was 25, about a year or two older than the average employee in the industry. Several of MCC’s rivals got demolished in the financial crisis but OnDeck wasn’t one of them. They also weren’t much of a competitor either. Struggling to define themselves as the anti-merchant cash advance, their product ran counter to the spirit of the industry’s rise. The single biggest allure of a merchant cash advance wasn’t that it was easy to obtain but that there was no fixed repayment term. The funds came with a pre-determined net cost but no specific date on when the delivery of future sales would be due.

Outsiders like the news media aren’t exactly sure what separates merchant cash advance from OnDeck except for maybe the cost of funds. Cash advance just sounds expensive, doesn’t it?

Outsiders identify the company by three characteristics.

1. They’re a non-bank business lender
2. They’re more expensive than a bank
3. They’re a tech company

These bullet points gloss over the fact that OnDeck’s loans require payments to be made every day. Can you imagine a credit card company forcing you to send a payment every day of the month? Or your landlord asking for rent on the 1st of the month, the 2nd, the 3rd, 4th, 5th, and so on every day until your lease is up?

This is not to say that this system is necessarily bad for borrowers, but that it is quite possibly the most unique and important part of what makes OnDeck different. It’s their secret sauce. It is why OnDeck gets lumped in with merchant cash advance companies in many conversations. OnDeck and the legion of copycats they have spawned are part of a broader industry that includes merchant cash advance companies. I call them daily funders. Daily funders provide financing on the condition that payments are made daily. I don’t call them daily lenders because traditional merchant cash advance products are not made by lenders, but by a unique group of investors that purchase future revenue streams.

Transition

Under company founder Mitch Jacobs, OnDeck had established themselves as the de facto loan option.

The merchant’s not biting on merchant cash advance? Send it to OnDeck. The merchant doesn’t accept credit cards? Send it to OnDeck.

They were every merchant cash advance ISO’s frenemy. They’d solicit you for your deals and then throw you under the bus to journalists as evil purveyors of expensive financing. They needed us to source dealflow and we needed them to maximize closing ratios but neither was quite satisfied with the arrangement.

When the company’s first employee took over as CEO in June 2012, the rhetoric changed. While still happy to be portrayed as the anti-merchant cash advance, OnDeck transformed their image from a niche Wall Street lender to a Silicon Valley-esque tech company. Noah Breslow was a curious choice. He has a BS from MIT and an MBA from Harvard Business School. He’s tall, charismatic, and he introduced vocabulary words such as algorithm to an industry that relied entirely on manual human underwriting.

At a recent lending conference, the younger crowd characterized Breslow as the Steve Jobs of business loans. He commands a cult-like following inside and outside the company, and in 2013 was embraced by New York City’s Mayor Bloomberg.

Breslow fast tracked OnDeck. With only $43 million raised in the first 5 years, the company went on to raise more than $300 million in the first 24 months under Breslow’s leadership.

This was their plan all along

In November 2012, OnDeck entertained a buyout offer from UK-based payday lender Wonga in which they reportedly received a $250 million valuation. The deal fell apart in the late stages but at the time I believed the negotiations were all a ploy for OnDeck to get a true market valuation. With a solid offer on the table, they knew both where they stood and where they needed to go. Last week the WSJ reported that preliminary IPO discussions valued them at $1.5 billion, six times higher than where they were two years ago.

With stock options being offered to new employees at least as far back as 2012, the plan to go public should come as no surprise. Later this year, those employees may actually get to do something very few startup workers ever get to do, convert those options into real shares.

So will OnDeck ride off into the sunset of billion dollar bliss? Not so fast say several industry insiders, some of whom are itching to short the stock on the first day they can.

smoke and mirrorsSmoke and mirrors?

As OnDeck took advantage of the swing in public consensus (that fixed terms were better and lower costs increased the attactiveness ), insiders began to ask an important question. Why weren’t merchant cash advance companies collectively countering with lower prices to remain competitive? Greed was fingered by journalists especially in the wake of the financial crisis. But greed is a weak prerogative if you consider that merchant cash advance companies were filing for bankruptcy left and right in 2009.

And oddly or perhaps even ominously, an entire segment of merchant cash advance companies began to raise their prices just as OnDeck was lowering theirs. When I wrote The Fork in the Merchant Cash Advance Road in April 2011, I said:

While the margins earned on high credit accounts shrank, funding providers were dealing with another challenge simultaneously, defaults. Whether the business owner intentionally interfered with their credit card processing or the store went out of business altogether, bad debt in the MCA world was mounting…FAST!

Risk was and still is the number one reason that merchant cash advances cost so much. While it’s true that OnDeck serviced higher credit businesses, insiders speculated that the spreads were too thin. For years, OnDeck’s merchant cash advance competitors have doubted the soundness of their model.

long vs. shortIt’s a debate that continues even to this day and yet OnDeck has secured hundreds of millions in investments from companies like Google Ventures, Goldman Sachs, Peter Thiel, and Fortress Investment Group. Their notes got an investment grade rating from DBRS. And as far as volume is concerned, they have likely eclipsed the industry’s all time reigning giant CAN Capital. If they had reached none of these milestones, OnDeck would have little credibility to convince critics of their sanity.

With a mountain of circumstantial evidence through big name backing in OnDeck’s favor, it seems to be indicative that the skeptics are wrong. But maybe they’re not. Could their model be both seriously flawed and superior at the same time?

It’s all about eyeballs

Going back to the 1990s, Internet companies have been judged, valued, and made famous by the price of eyeballs and the number of site visits. It’s a measure that’s never disappeared and according to USA Today is making a comeback. And while OnDeck Capital has always been based in New York City, true to their Silicon Valley form, their model has been to conquer market share first eyeballsand take on profitability second. In their case, it’s not eyeballs or site visits, it’s loan origination volume.

Five months ago Breslow was quoted in the WSJ as saying OnDeck is “imminently profitable“. With seven years in business, it’s proof that their critics have been right all along, that their model doesn’t make money.

What scares their competitors though, is that this strategy has been intentional. Very few if any players in the industry have had the luxury, guts, or the purse to lose money for seven years as part of a coup to conquer the market. Disbelievers in this long term wildly risky strategy are salivating at the opportunity to inspect the company’s financial statements in the IPO.

In When Will the Bubble Burst?, RapidAdvance CEO Jeremy Brown, whose company became part of the Quicken Loans family last winter, fired shots at OnDeck, “To accomplish high growth rates, which may be driven by a desire or need for an IPO or to raise investment or to sell to private equity, assets are being overpaid for through higher than economically justified commissions (I’ve heard 12-15 points upfront from the more aggressive companies) and stretch the repayment term of the MCA or loan even further (On Deck24, I am talking about you).”

Insiders testify that OnDeck’s strategy has not so much been about lower costs but about growth at all costs. Among the evidence is the sudden removal of an industry-wide practice of verifying the business owner is current on their rent. Repayment terms are getting stretched out, commissions have shot up, and for a while they ran a program that allowed applicants to get funding with the submission of just a single bank statement.

Merchant cash advance companies look at their own default figures and scoff at the notion that OnDeck’s aggressive practices could produce low single digit defaults as they’ve publicly claimed.

Imminent

imminentThrough it all, there remains the fact that OnDeck has never claimed their methodologies to be profitable, at least not yet. Red ink at IPO time might reward their detractors with a certain delicious satisfaction, but what will they say if and when they become profitable?

I’m reminded of The 20 Smartest Things Amazon Founder Jeff Bezos ever said. Below is a few of them.

  • “There are two kinds of companies: Those that work to try to charge more and those that work to charge less. We will be the second.”
  • “Your margin is my opportunity.”
  • “We’ve done price elasticity studies, and the answer is always that we should raise prices. We don’t do that, because we believe — and we have to take this as an article of faith — that by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term.”
  • “If you never want to be criticized, for goodness’ sake don’t do anything new.”
  • “Invention requires a long-term willingness to be misunderstood. You do something that you genuinely believe in, that you have conviction about, but for a long period of time, well-meaning people may criticize that effort. When you receive criticism from well-meaning people, it pays to ask, ‘Are they right?’ And if they are, you need to adapt what they’re doing. If they’re not right, if you really have conviction that they’re not right, you need to have that long-term willingness to be misunderstood. It’s a key part of invention.”

I wonder if the executive team at OnDeck would share these philosophies.

They’ve always claimed themselves to be a tech company, much to the bewilderment of their competitors. Will technology come through for them?

The data available on businesses has changed. Bank statements and a credit report might’ve been all there was to go on when the company first started, but in Automated Intelligence Breslow said, “the fact is most businesses operating today, in 2014, are already technology focused to one degree or another. They have computers, they have online banking, they use credit card processors, their customers are reviewing them online, there are public records, etc. All this electronic data helps paint a deeper and more accurate picture of the health of a business.”

OnDeck Capital featured on a PBS Special

With such easy access to important data, it might be possible that through the use of 2,000 data points, OnDeck doesn’t need to do all the manual investigations that their competitors still place high values on. The available data might be able to predict loan repayment success just as well as a human analyst.

And if that’s true, then they can reduce the cost of overhead as they scale. As their predictive algorithms get fed more data, they might be able to eliminate humans altogether. At the May 2014 LendIt conference, Breslow admitted that 30% of their loans were still manually underwritten but said that “if customers want full automation, we are prepared to deliver it.”

By that charge, a sustainable model should not be that far out of reach. Through advanced data analysis and decreasing fixed costs, profitability may indeed be imminent.

Winner

If the story of the merchant cash advance industry has been a race to the top, then OnDeck might be declared the winner in a successful IPO. It would be an ironic achievement for the company that positioned itself as the anti-merchant cash advance. In their wake today are hundreds of daily funders offering fixed payment products.

everybody wins?OnDeck’s critics are in a paradoxical position because a successful IPO is good for them too. They want to believe OnDeck’s model never worked, can’t work, and have it be proven a failure. But if it goes the other way, the legitimacy of the daily funder universe will be solidified in the mainstream. What’s good for the goose is good for the gander.

As AmeriMerchant CEO David Goldin said to Inc, “the OnDeck IPO shows that Wall Street is now taking this industry seriously.”

So does that mean he’d buy stock? Somewhere out there at a restaurant in New York City, an OnDeck relationship manager is probably putting Goldin down for five shares.

Cue the earthquake, the industry will never be the same.


Curious how it will change it exactly? Read my magazine published prediction, The Retail Investor.

Industry Survey Results

July 6, 2014
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Curious what the general consensus is on a variety of issues? DailyFunder® polled business lending industry insiders and analyzed the results. Click below to expand the graph, check out the image, or scan the text beneath it:

DailyFunder Survey Results


Text version


#1 What’s a Merchant Cash Advance?
61% consider it to be strictly a purchase of future revenue.

32% believe it’s an ambiguous term that could be used to describe a purchase transaction or a loan


How much are you earning?
62% reported making at least $100,000 per year

Almost half of the respondents in that group claimed to be making more than $200,000 per year


Stacking
62% said stacking is OK in the right circumstances

19% said stacking is not OK

16% said stacking is the bane of the industry


Who’s earning more?
57% of respondents that were in favor of stacking make at least $100,000 per year

73% of respondents that were against stacking make more than $100,000 per year.


Trade show anyone?
78% would attend an alternative business lending/merchant cash advance conference.

4% flat out said they wouldn’t.


Do you have skin in the game?
58% of respondents have invested funds in a merchant cash advance directly or through syndication


Top influencer?
A substantial portion of respondents wrote in OnDeck Capital CEO Noah Breslow as the most influential person in alternative business lending or merchant cash advance


Is government friend or foe?
49% fear future regulations could hurt their business

25% do not fear future regulations


What do insiders want to read more about?

  • Regulatory issues
  • Ethics, best practices
  • Lead sources, lead generation, marketing strategies, sales guides
  • The future, evolving products, trends

This graph appears in the July/August print issue of DailyFunder® magazine. Not subscribed? Get it free!

Access to Capital – A Dose of Reality

June 15, 2014
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So much for a lack of transparency… While sitting directly next to Maria Contreras-Sweet, the head of the Small Business Administration, OnDeck Capital’s CEO corrected U.S. Senator Cory Booker’s comments about the APR of their loans. High teens? Not so, said Noah Breslow who explained their average 6 month loan has an APR of 60% even while costing only 15 cents on the dollar.

Why is access to capital so expensive? Rob Frohwein, the CEO of Kabbage said that up until recently his company was borrowing funds at a net rate of more than 20% APR. In order to turn a profit, they had to lend at a rate much higher than that.


The Access to Capital small business panel included:
Maria Contreras-Sweet – Head of the U.S. Small Business Administration
Noah Breslow – CEO, OnDeck Capital
Rohit Arora – CEO, Biz2Credit
David Nayor – CEO, BoeFly
Rob Frohwein – CEO, Kabbage
Paul Quintero – CEO, Accion East
Rohan Matthew – CEO, Intersect Fund
Jonny Price – Senior Director, Kiva Zip
Jeff Bogan – SVP, LendingClub
Steve Allocca – Global Head of Credit, PayPal
Jay Savulich – Managing Director of Programs, Rising Tide Capital

Do Opportunities Abound?

June 8, 2014
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Are there opportunities left?Just recently I found myself in an office surrounded by some folks who had each worked in the merchant cash advance business for more than 10 years. The first generation of MCA pioneers are still out there of course but it’s rare to be in the presence of so many at one time. It was weird. Weirder still was the realization that no matter how much things have changed, some things continue to be exactly the same.

Me: You guys looking to recruit ISOs?
Them: Damn right

As far as the industry is concerned, these guys might as well have fought in ‘Nam. They’re from another generation where life was hard and men were still men. When businesses couldn’t get bank loans, these guys were splitting payments with their bare hands and reprogramming credit card machines with nothing more than a paper clip and a ball of twine. Funding a deal wasn’t a product of technology, it was one of sweat, tears, and blood. Have you ever bled for your deals?

This August I celebrate my 8th year in the industry. Next month marks the 4 year anniversary of this blog. I enjoy reading some of my posts from back then, particularly since most of them discuss the ordeals of credit card processing. A lot of what I’ve written no longer applies and some of what I’m writing these days will be outdated years from now. As I approach 600 articles and blog posts on this subject matter, I’ve had to stop and ask myself if everything has already been written. What more can possibly be said about this business? Perhaps the tale of the industry has already been told and I am on my way to retelling exaggerated stories to anyone who will listen. I don’t want to be that wrinkled up old man swaying back and forth in a rocking chair talking about how ISOs got it so easy these days.

olden daysSadly, even the name of the website is reflective of a previous era. This is the Merchant Processing Resource, not exactly what you’d expect a top destination to be called on the subject of alternative business lending.

But the story’s not finished. Every passing month is filled with events that inspire a dozen new chapters, which is more than one man can keep up with. Last month at the LendIt conference, I got a glimpse of just how many opportunities still lie ahead.

Some alternative business financing companies such as Funding Circle and DealStruck are diverging away from merchant cash advance and going back to the traditional roots of term lending. Funding Circle is doing it with a 21st century twist, by making their system peer-to-peer based.

Still other firms have sprung up around LendingClub’s and Prosper’s APIs and offer their users ways to make better loan investment decisions.

And even among the players we’re all familiar with, there is innovation, growth, and new ideas. Just recently CAN Capital launched CAN Connect, a software application that can be integrated with any other company’s software. According to CAN’s release,

Through CAN Connect™, merchants will be able to receive a CAN Instant Quote™ based solely on data provided by the partner. Once the merchant elects to proceed, they are taken through a simple online application process and can obtain access to working capital without ever leaving the partner’s platform.

Indeed technology has even allowed me to become a lender myself,

Net Annualized Return

My LendingClub portfolio, which is still very young and made up by hundreds of $25 consumer loan contributions has a current Net Annualized Return of more than 10%. Contrast that against the average U.S. savings account that pays out less than 1%.

While it’s certainly not the 54% yield that OnDeck Capital enjoys, there are levels of risk and markets set up for just about anyone interested in alternative lending.

And what might come next may not all be broker/funder related. As the industry flies in a thousand different directions, entire new industries and services are going to grow up around them. That brings me back full circle. Has everything already been written? 4 years of blogging here and this might as well be my first day.

Some things haven’t changed a bit, but the rest of it, well… we must soldier on in this strange new world.

Do you see opportunities ahead? Discuss with industry insiders on DailyFunder.

Throw Out the 5 Cs?

May 19, 2014
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the credit struggleThe 5 C’s of lending? “Throw that book out” says Darrell Esch, VP of SMB Lending for Paypal. At the Federal Reserve Bank’s New York Small Business Summit last week, critics hammered away at the high rates being charged by some alternative business lenders.

In the first video below, PayPal’s small business loan program (which is a textbook merchant cash advance) is characterized as too expensive and not transparent.

APRs? Business owners don’t think that way, says Esch:

The transparency debate is a hot topic in alternative business lending. Merchant cash advance industry hater Ami Kassar pressed me on the transparency issue just last week over twitter, to which I conceded transactions structured as loans should clearly state an APR, even if that metric is not the most relevant or helpful.

What confuses me is Kassar’s belief that an APR represents the “real cost.” It is nothing more than an annualized metric. Many people understand APRs, but many do not. My point is that an APR is a mathematical formula that may or may not be relevant and may or may not be understood.

In fact, Bankrate.com’s loan calculator helps borrowers ascertain the true cost of their loans by helping them calculate what they really need to know, the total dollar amount to be repaid. And with that reality, alternative business lenders and their merchant cash advance counterparts are speaking the language of their clientele by making the dollar for dollar cost as transparent as possible.

After all, business owners regularly borrow at rates that exceed 3,500% APR via overdrafts.

Kassar claims that more than 50% of borrowers substitute MCAs for something else once they’ve learned the “real cost” of such financing. This implies that all of his clients have better options, a circumstance which generally isn’t true of small businesses that use merchant cash advances or high cost business loans. Deficiencies in Credit Score, Capital, or Collateral tend to disqualify them in the real world.

This debate leads us down the same road every time. Should businesses rejected by low rate lenders be banned from accessing credit because the options available to them now are too expensive? “No,” a critic would say. “They should just be charged a lower rate.” But considering the risk, could a lender survive drastic price cuts? With all the competition in today’s market, alternative business lenders have been slashing rates to as low as they can possibly get them… for now.

But to critics like Kassar, things like profitability are an afterthought. What’s profitability got to do with the price of a loan?

I wonder if his clients who have exhausted all their options choose a low rate SBA loan that they can’t get once he has educated them about the high cost of a merchant cash advance. Oh wait…

Esch suggested throwing out the 5 Cs. I don’t think that’s a good idea. It’s leeway that’s needed, not discarding the book altogether. That leeway comes at a cost.

Questioning the costs that alternative business lenders charge is a beautiful example of the free market at work. They’re an easy target for criticism, yet a badly needed component of the American economy. No harm can come from keeping them honest. But as Esch commented on how he feels about what he does, “I feel blessed to be serving this higher need.”

A Look at Data Security

May 17, 2014
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Data SecurityIn the latest issue of DailyFunder, Cheryl Conner explored data security in the alternative business lending industry. Its basis was rooted in the ETA’s 2008 Merchant Cash Advance White Paper that stated Merchant Cash Advance companies must be PCI compliant.

That white paper was drafted in a different era, particularly when 99% of all transactions required a payment processing split rather than ACH debits. It’s true also that it specified companies “that handle sensitive payment related information”, namely cardholder data as part of its regular business operation.

Credit card processors that engage directly in issuing merchant cash advances are naturally already subject to PCI compliance, but for the funding companies that aren’t in the processing business, they’re basically off the hook. Indeed a spokesperson for the PCI Security Standards Organization informed Conner that “PCI standards apply to payment card data branded by one of the five founding brands, which means any entity that accepts, processes, transmits or stores account data from a PCI branded payment card should be applying PCI DSS for the protection of that data.” She went on to say that PCI DSS doesn’t apply to bank account data.

Data PrivacySo while PCI compliance does not have a place in alternative business lending, it raised the question as to whether or not there were other privacy regulations that do, particularly the Gramm-Leach-Bliley Act (“GLBA”) of 1999. According to the FTC, the GLBA “requires financial institutions – companies that offer consumers financial products or services like loans, financial or investment advice, or insurance – to explain their information-sharing practices to their customers and to safeguard sensitive data.” The law is broad enough to cover any financial institution that is engaging in activities that are financial in nature.

The GLBA imposes a host of requirements on these financial institutions, including the need to establish an information security program to protect customer information.

But as is the recurring theme in alternative business lending, such rules do not govern institutions that engage in business-to-business transactions. On the FTC’s website, it states:

Under the Rule, a “consumer” is someone who obtains or has obtained a financial product or service from a financial institution that is to be used primarily for personal, family, or household purposes, or that person’s legal representative. The term “consumer” does not apply to commercial clients, like sole proprietorships. Therefore, where your client is not an individual, or is an individual seeking your product or service for a business purpose, the Privacy Rule does not apply to you.

Similarly, I’ve been told that the Consumer Financial Protection Bureau does not have jurisdiction over business-to-business transactions, even if one party is a sole proprietor. In a business-to-consumer transaction, there’s an assumption that the consumer may not be as sophisticated as the business and thus deserving of protections. In the course of two businesses engaging in business, it would be extremely difficult to draft rules that only protected one side as both are free market equals.

While there may not necessarily be any laws that regulate security or privacy in commercial transactions, there are plenty of benefits to following GBLA-like guidelines. For one, it could be used to build goodwill with clients. Additionally, security and privacy are sure to be examined during the course of a due diligence audit by potential investors. In this day and age, a breach of privacy or security could permanently disrupt a business’s ability to maintain the good faith of the public.

Do you feel that alternative business lenders are doing a good job?
—-

Note: I am not a lawyer and this post should not be considered legal advice.

Would an APR Help?

May 14, 2014
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Merchant cash advance industry hater Ami Kassar added to his collection of rants today in the Wall Street Journal by writing about the True Costs of Cash-Advance Loans.

Bloomberg BusinessWeek writer Pat Clark, knowing full well that Kassar and I have sparred online, tweeted:

merchant cash advance APRMy response:

Do I think merchant cash advances when structured as loans should include a prominently displayed APR on the contract?: Yes, though I believe this is less helpful than the dollar for dollar cost explanations that are already presented. But in the name of maximum transparency, it would be a good thing to have on there.

Do I think less business owners would use such loans if the APR was prominently displayed?: No

If DealStruck can make their model work, then great. What I want to know is, what happens to the businesses they won’t approve?

Alternative Lending: Big Government and Big Data

May 7, 2014
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“Who wants to fill out financial paperwork? We’d rather go pick out a pair of sunglasses”
Professor Michael Barr at LendIt 2014

man and machineOne of the clear themes of the LendIt 2014 conference was that borrowers are willing to pay extra for speed and convenience. Regulators have taken note of this trend but they’re still supportive of the alternative lending phenomenon anyway. Truth be told, the government is acting like a weight has been lifted off its shoulders. Ever since the 2008 financial crisis, the feds have prodded banks to lend more, but they’ve barely budged, especially with small businesses. Non-bank lenders have relieved them of the stress and all they need do now is make sure everybody plays nice.

Professor Michael Barr, a former US Treasury official, key architect of the Dodd-Frank Act, and Rhodes Scholar, believes the best way forward is to empower consumers. That’s something lenders can accomplish through education and transparency. On transparency, he cited many of the commendable practices that credit card companies and mortgage companies have implemented, but did not fail to note that these were forcibly instituted through regulation (Hint hint…).

federal reserve credit card rules
Credit card transparency regulations that went into effect 4 years ago

When a LendIt attendee asked Barr to name someone in the alternative lending industry that is a great role model for transparency, Barr answered by saying, “I haven’t seen anyone in the industry doing things the way I would do them in regards to education and disclosure.” On the path towards transparency, “the potential is not yet realized,” he added.

While it sounded as if he favored eventual regulation of alternative lending, he offered all in attendance advice to prevent it. “Take the high road to prevent regulatory interest,” he said.

Barr’s sobering presentation also covered the Consumer Financial Protection Bureau (CFPB) and the role they might play in alternative lending, if any. Payday lenders and debt collectors were their primary supervisory targets he said, but added the “the CFPB has the flexibility in the marketplace to address problems before they occur.” That flexibility essentially gives them jurisdiction over whatever they decide they want to be in their jurisdiction.

Sophie Raseman, the Director of Smart Disclosure in the U.S. Treasury Department’s Office of Consumer Policy appealed to the industry in a different manner. “Small businesses are at the heart of the economy. We want to serve you [alternative lenders] better so that we can better serve them,” Raseman pleaded. As part of that, she came bearing gifts, a reminder that the federal government had loads of data available via APIs at http://finance.data.gov. The government wants to make sure we have access to as many tools as possible, most likely to help drive borrowing costs down. If you need to verify someone’s income, Raseman recommended the IRS’s Income Verification Express Service.

The Income Verification Express Service program is used by mortgage lenders and others within the financial community to confirm the income of a borrower during the processing of a loan application. The IRS provides return transcript, W-2 transcript and 1099 transcript information generally within 2 business days (business day equals 6 a.m. to 2 p.m. local IVES site time) to a third party with the consent of the taxpayer.

The irony with this service is the two business day timeline, though I haven’t confirmed if that’s still the case. Delays and archaic data aggregation methods are the exact things alternative lenders are trying to overcome. Kabbage comes to mind as the length of time it takes for them to go from application to funding can be as quick as 7 minutes, a time frame I found to be reality after watching the demonstration by Kabbage’s COO, Kathryn Petralia.

Kababge’s blazing speed is made possible by access to big data, which made Petralia an excellent choice to have on the Big Data Credit Decisioning Panel. She was joined by Noah Breslow of OnDeck Capital, Jeff Stewart of Lenddo, and Paul Gu of Upstart.

Stewart, whose company lends internationally presented the idea of mining not just data on social networks, but the photographs on them. One possibility was measuring whether or not borrowers appeared in photographs with other borrowers known to be bad, or whether or not they hung out with undesirables such as ex-convicts. He was a big believer in association risk, speculating that friends of bad borrowers also made them more likely to be bad borrowers themselves.

big dataBreslow of course said you have to be careful with the noise of social media as there can be a lot of false signals. Does that mean there are big data problems then? Upstart’s Paul Gu said, “we have small data problems” in reference to why there seems to be so much trouble evaluating applicants that have little to no credit history. Gu believes that basic information such as where a borrower went to college, their major, and their grades can be used as an accurate predictor of payment performance and his company has acquired the data to back that up.

Somewhere along in the discussion though the meaning of automation got twisted. OnDeck for instance has an automated process, yet humans play a role in 30% of the loan decision making. Does that mean they are not actually automated? Breslow clarified that aggregating data from many different sources using APIs and computers was automation and that there was still a role for humans. The goal is to make sure that humans aren’t doing the same things that the computers are doing.

algorithm“The world’s greatest chess human can beat the world’s greatest chess algorithm,” said Lenddo’s Stewart. “Humans should be pulling what the algorithms can’t think of,” added Breslow. He presented an example of an applicant satisfying all of an algorithm’s criteria but sending up a red flag at the human level. “Why would the owner of a New York restaurant live in California?” Breslow asked. That’s something an algorithm might get confused about. It might mean nothing or it might mean something.

“Algorithms are probabilistic,” Stewart reminded the audience. They spell out the likelihood of repayment, they don’t guarantee it.

For Kabbage, algorithms and automation have been instrumental in allowing them to scale. “I don’t need to hire a lot more people to serve a lot more customers,” Petralia explained.

“Let the data speak for itself,” Breslow proclaimed. And there is a lot of statistically interesting data. “People with middle names perform better than people without them,” added Breslow.

For Gu, borrowers with degrees in Science, Technology, Engineering, and Mathematics fare better than their academic peers, though he wouldn’t reveal which major is #1. That information, while probably available to OnDeck, likely plays little or no role. “There is a lot more data to analyze on the business side than the consumer side which is why [things like] the social graph is a little less relevant,” Breslow said.

In the end, lenders don’t need to go on a wild data goose chase to learn all about their prospective clients. Kabbage applicants for instance are asked to provide their online banking credentials in the very first step of the applications. “A lot of people would be surprised as to the amount of data borrowers are willing to share,” Petralia proclaimed. Indeed, many alternative business lenders and merchant cash advance companies are analyzing historical cash flow activity using third party aggregating services like Yodlee, something that requires the client’s credentials.

During Kabbage’s earlier demonstration, some members in the audience worried that factors such as deposit activity could be gamed. Petralia assured them that their algorithm was sophisticated enough to detect manipulation and at the same time explained that they analyzed far more than just deposit and balance history.

Perhaps all this technology though has gone overboard. Is it possible to predict performance just based on what the applicant says? Believe it or not, “the language someone uses is an indicator of default probability,” Stewart said. But even that kind of detection has become automated. “Lenddo uses semantic analysis. People tend to use different words when they’re desperate.”

Who knows, a year from now getting a loan might be as easy as picking up your phone and saying, “Siri, send money.” Just make sure to delete all the photos of you hanging out with criminals off your phone first. A lender might use them against you.

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