Marketplace Lending

GAME OVER: Is The Marketplace Lending Model Dead?

Lending Club received a Department of Justice grand jury subpoena on May 9th, according to the company’s quarterly earnings report, the same day that the resignation of their iconic CEO was announced. Grand juries are selected to decide if a criminal indictment should be brought against a party. The timing of the subpoena is suspicious because it leads one to suppose that a federal prosecutor had listened in on the May 9th earnings call, read news reports, decided there might be criminal activity, summoned jurors and issued a subpoena all within hours of the original announcement.

The WSJ, which did a great job reporting the details of the events leading up to Laplanche’s ouster, was not able to pin down the smoking gun that “convinced directors that more drastic action was needed,” just that the board had been “presented with evidence” that Laplanche knew many details of the $22 million loan sale.

A highly likely possibility (and this is just my theory) is that someone at Jefferies, the investment bank that Lending Club fudged the numbers on and ultimately bought $22 million worth of loans back from, tipped off federal authorities as to what took place with the loan sale.

Contrary to what people think about Wall Street, many bankers are scared to death about having knowledge of something that could lead to investors being harmed. Someone at Jefferies (and again just my theory) very well could have been so bothered by what Lending Club did, that they made sure the authorities knew what transpired. In doing so, they would probably have been viewed positively for blowing the whistle on bad behavior.

Cue a prosecutor’s interest, a grand jury, and likely a subpoena to individuals who would’ve had direct knowledge of the transaction. In my opinion, nothing would convince a board of directors more to give their famous CEO 24 hours to resign or be fired than having acquired knowledge of a grand jury investigation.

According to the WSJ, by Thursday, May 5th, Laplanche was removed as board chairman. On May 6th, he resigned. Over the weekend, he emailed friends from a new personal address, and on May 9th it was announced that he had resigned. That same day, Lending Club (the company), received a grand jury subpoena, of what I theorize was probably part of an investigation that was already in progress.

We may never know the full truth, but a seemingly innocent chain of events has clearly spiraled out of control to the point where over the course of a single week, Lending Club’s business model is seemingly coming undone. If nobody wants to buy loans or notes from their marketplace, then they are essentially out of business.

The dearth of interest in buying the loans they originate given the recent news has forced the company to disclose that it might actually have to use its own money to fund loans. No buyers, no business. So what else can they do? For one, they admit that they may need to reduce the volume of loans they originate, and that in doing so, it would likely have material adverse impact on their business.

These consequences have been predicted for years. What happens when investors just don’t want to buy the loans? How could a company where 90% of the income comes from loan origination fees provide continuous value to shareholders in an environment where there are no longer buyers?

Notably, veteran banker Todd Baker has been one of the most vocal on this issue. Six months ago, he publicly challenged SoFi CEO Mike Cagney about the viability of the marketplace model. Cagney had previously addressed Baker in an American Banker article by writing, “It is true that an MPL [Marketplace Lender] needs a buyer to originate loans — without one, the marketplace needs to raise rates until a buyer emerges. If there is no buyer, MPLs simply stop lending — they won’t start originating underwater loans.”

Stop lending?

Seemingly willing to undermine his own assertions, Cagney told the WSJ less than a year later a different story. “In normal environments, we wouldn’t have brought a deal into the market, but we have to lend. This is the problem with our space.” The environment of which he spoke then of course, was one where loan buyer interest was simply not as high as they would’ve liked, and thus it was becoming a “problem.”

Cagney’s reversal played right into Baker’s point, that a marketplace lender has to keep issuing loans to survive. When those loans don’t have organic buyers, at least in SoFi’s case, the weird idea of launching a hedge fund to potentially artificially keep up loan originations was proposed.

For Lending Club, their Plan B to keep things going is to simply buy their own loans if no buyers are available. Lending Club has a strong balance sheet and could potentially have success with this, for a time of course. The problem is that it would be taking on the credit risk of those loans as a result and put its retail note buyers at risk in the process.

Here’s why: When investors use the Lending Club platform, they are lending money to Lending Club and Lending Club is using that money to lend to borrowers. Investor yield might be tied to the performance of the notes they acquire but the credit risk is ultimately Lending Club itself. If Lending Club goes kaput, note holders would have a major problem, one that hasn’t really been a possibility until now because Lending Club hasn’t kept much risk on its balance sheet. That might soon change, according to their recent quarterly earnings report, where they say they might have to balance sheet some loans. Investors then wouldn’t really be participating in some disruptive peer-to-peer sharing economy revolution, but rather become very much like bondholders in an unregulated non-depository financial institution. And that smells horrifyingly risky. Throw in the fact that Lending Club is facing class action lawsuits, one of which alleges them to be a Racketeer Influenced Corrupt Organization. Does this sound like the kind of bond you want to invest in if you’re an unaccredited retail investor?

What Laplanche actually did or what a grand jury finds are unimportant in the grand scheme of what’s already been revealed. The only thing that matters is that when buyers dry up (whether for rational or irrational reasons), the entire system’s foundation shakes. The marketplace as it was supposed to be anyway, certainly can’t forever operate as a marketplace when it has shareholders who expect ever-increasing revenues and profits. According to Cagney’s original libertarian fantasy, nothing should theoretically be going on balance sheet. Lending Club should just be lending less, and if there are ultimately no buyers, the company should shut down until such a day that buyers return. One could only imagine that conversation with shareholders.

At the LendIt Conference last month, Renaud Laplanche joked with the crowd about cutting off the sleeves of his Lending Club jacket to make the Lending Club vest he sported on stage during his keynote speech. But was it just the sleeves that were missing? Speaking so confidently, Laplanche projected the authority of an emperor, perhaps one we’ve all been introduced to before.

“Was it really just the sleeves that have been cut away?” You may have thought to yourself for a split second. Or is it possible that the emperor of the marketplace, unbeknownst to the crowd, was simply wearing no clothes at all?

Loan Originations Slow Industrywide

It’s not just one marketplace lender experiencing a slowdown in originations. Some of the largest players across the spectrum cooled their jets in Q1 of this year compared to Q4 of last year.

While Lending Club weathered the storm relatively well, the resignation of their CEO amid a loan manipulation scandal does not bode well for its immediate future prospects.

Avant CEO Al Goldstein, whose company’s loan volume among the bunch dropped off the most, told Crain’s Chicago last month, “If we can’t find capital, we’re not going to grow fast. If we can, we will.”

In a later comment to the WSJ, an Avant spokesperson explained that Q4 loan volumes are typically elevated because of the holidays and Q1’s volume down because many borrowers are receiving their tax refunds.

Square Capital Has No Borrower Acquisition Costs, Hints at Making Loans to Non-Square Users

As the marketplace lending industry frets over acquisition costs, one lender is sitting pretty, Square. That’s because they source their borrowers from their existing payment processing ecosystem. Square CFO Sarah Friar said on their earnings call last week that it was one of the big advantages they had with investors looking to buy loans. “We’re not having to go out and it’s not costing us more to do customer acquisition because it doesn’t cost us anything. We’ve already acquired them,” she said. Compare that to OnDeck who spent $16.5 million in Q1 to acquire borrowers through sales and marketing.

Also on the call, Friar did reveal one benefit of having switched from a merchant cash advance product to a loan product that didn’t have anything to do with investors, and that’s being able to handle clients who want to satisfy the balance in full or obtain additional funds. Since no interest accrues with traditional merchant cash advances, there are no presumed discounts if you want to repurchase your sold receivables. Early repayments were apparently the number one request they received from their clients.

It’s not clear exactly what Square did previously when merchants wanted to “repay early,” but there are other merchant cash advance companies that will allow clients to repurchase back their sold receivables at a slightly discounted price if it’s relatively soon after the original transaction occurred. Either way, Friar said that the shift from MCA to loan hadn’t changed the level of demand.

Notably, while not even directly asked, Friar also said that they are also continuing to look into making loans to non-Square users, perhaps through other card processors.

Jim Cramer Unimpressed With Square Capital’s 4% Bad Debt

Jim Cramer told TheStreet that he wasn’t impressed by Square Capital’s 4% bad debt because as he put it, the average default rate on credit cards is about 2.67% right now. That comparison belies the fact that Square’s customers make payments daily, the cost of capital is more expensive than a credit card, and that Square did little or no underwriting to achieve these results.

In fact, a study conducted jointly by deBanked and Bryant Park Capital last year determined the average industry (SMB Lending & MCA) default rate to be 6.4%. Square if anything, is outperforming some of their successful peers and given some recent structural changes, they probably stand to improve even further.

OnDeck’s default rate is reportedly about 7% and that’s with an underwriting model often touted as revolutionary.

The comparison between credit cards and Square Capital’s daily payment product is interesting but misleading. Nonetheless, Cramer appears to be unimpressed with alternative lending in general. “Is Square going to be like an On Deck and Lending Club? We don’t want that,” he said, referring to their recently depressed stock prices.

Three days ago, Cramer made his views known through a tweet.

You can watch his comments about Square Capital, OnDeck and Lending Club below:

So far his analysis is quite the opposite of what it was imagined to be 18 months ago.