p2p lending

Did Peer-to-Peer Lending Sell its Soul to Wall Street?

“We have so many fans but we also have some people here that are looking to take advantage of us, that are here for a short term trade and they won’t be part of this industry.” – Ron Suber, President of Prosper Marketplace

Ron Suber may have been talking about specific players in the capital markets when he said those words at LendIt just a few weeks ago but that characterization could just as easily apply to all of Wall Street in general. During his presentation, he offered two real world examples about how their message got hijacked by the same facilitators they originally believed were there to help them. The first was a case of bad buyers.

“When a marketplace lender sells a bunch of loans and the buyer isn’t aligned with the marketplace, if the buyer of those loans is going to buy those loans and leverage them, rate them, and securitize them every single quarter without alignment with the industry and just sell those bonds into the marketplace, […] that won’t be good for you, for the industry,” he said. “And we learned that lesson. When we don’t have alignment with our investors, when groups sell our loans into the market no matter what if the market’s not ready, it’s not good and we learned that at Prosper this year.”

Keynote Presentation by Ron Suber of Prosper at the LendIt USA 2016 conference in San Francisco, California, USA on April 11, 2016. (photo by Gabe Palacio)

What he was saying is that the buyer matters because if they’re repackaging up the product for mass consumption, it is ultimately the original seller (i.e. companies like Prosper) that is being judged for the success or failures of the product’s reception down the line.

A second example stemmed from mismatched projections. You might think it’d be a good thing if a rating agency’s own analysis of your loan portfolio projected even lower loss rates than you projected on your own. Not so, and this actually happened; Moody’s projected loss rates for the loans packaged inside of Citigroup-issued Prosper bonds were lower than what Prosper projected itself for the same vintage. So when default rates were on pace to exceed Moody’s aggressive projections (and fall in line with Prosper’s), news of an impending bond downgrade due to allegedly poor performance roiled the market. The media interpreted Moody’s adjustment to mean that something was wrong with Prosper, not that something was wrong with Moody’s initial assessment.

Suber summed these experiences up by telling the audience, “we must control our story.” That’s a challenge because Wall Street loves to commoditize things, especially loans. The value goes up, the value goes down, and Wall Street will sell it if there is a buyer for it without any regard for the story. What to do then?

CommonBond CEO David Klein said on a panel in late March that marketplace lenders will look to tap back into individual investors, that there will be a return to the industry’s peer-to-peer roots.

Fundera CEO Jared Hecht, a co-panelist, said that “retail investors are more loyal to a specific platform” and that this can create a “network effect.”

The problem of course with retail investors, aside from the steep regulatory hurdles to sell to them, is the comparably slow speed at which they allow a platform to scale. The downside for any company that takes this organic approach is that they could grow so slowly that they get eclipsed by everyone else.

But perhaps the underlying issue is that some companies that originally set out to be peer-to-peer lenders have succumbed to this identity of being “online lenders.” That’s a problem because traditional financial institutions can use technology to lend online too and the Internet will eventually become the standard medium for all lending. That means that soon being an online lender will just mean being a lender period. And if you are just a lender, well then Wall Street will indeed take advantage, control the story and charge their standard fare just for playing the game.

The price? One soul.

And once you sell yours, it’s hard to get it back.

Will Marketplace Lending Revert Back to Peer-to-Peer Lending?

Institutional investors wanted higher yields on Prosper’s latest bond offering, an entire five percentage points higher, according to the WSJ. This wasn’t necessarily brought on by performance either. Instead the once voracious appetite for all things online lending is being tempered by uncertainty.

Bain Capital Ventures partner Matt Harris told the WSJ that online lenders will need to replace the easy hedge fund money by “longer-term capital.” Normally, that would include traditional bank lines and credit facilities, but moving that direction could irreversibly sever the ties with their peer-to-peer roots and image.

Peer-to-peer (p2p) lenders embraced Wall Street’s easy money to scale, rationalizing to the peers on which they were founded that this was all necessary to change the status quo. The road to the sharing economy utopia required hobnobbing with the very institutions they were set on disrupting, they said. The P2p term wasn’t compatible with this narrative so it was replaced with “marketplace lending,” which helped it retain its Silicon Valley feel and gave it the range to argue that hedge funds and peers were virtually the same thing since they were both buyers in a new-age marketplace.

But early this year, something started to happen. Loan originators like SoFi (which was never peer-to-peer) could not sell loans fast enough. One solution they came up with was to launch their own hedge fund to buy their own loans. SoFi CEO Mike Cagney said, “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.”

But blaming financial institutions for pulling back credit is a scenario that has played out thousands of times in history. One only need watch The Big Short to connect why it’s dangerous for a lender to depend on the institutional credit markets. That’s where the peer-to-peer model was supposed to come in, a new way for a new day without Wall Street to prevent these problems.

But it’s not too late to go back. Lending Club for example, has capped their wholesale channel (the institutional portion) at 50%. They’ve kept more than 100,000 retail investors and intend to grow that even larger. “We’ve always been more exposed to retail, and I think we want to keep it that way,” said Lending Club CEO Renaud Laplanche to the Financial Times. “We’ll probably see that as a competitive advantage, as a source of stability and predictability, particularly in an economic downturn,” he added.

Prosper meanwhile has depended almost entirely on the institutional channel, an astounding 92% of their loans were sold to that category of investors. It’s a far cry from the slogan that appeared on their website back in 2007. “People-to-people lending. It’s an old idea that’s new again,” it said. Today it says, “We connect people looking to borrow money with investors.” Those investors are predominantly Wall Street.

But what to do when Wall Street will one day no longer be interested? It’s not too late to go back in time.

“Borrow money from people just like you,” said Prosper’s website nine years ago. People just like you might not suddenly decide they want five percentage points more. Peer-to-Peer implied a human aspect to the marketplace, that empathy played a role in a world where Wall Street had always been stone cold.

Will the industry revert back to the people? Or will ideas such as starting your own hedge fund to buy your own loans rule the day?

Lending Club Loan Size Cap Raised to $40,000 (Should Investors Be Worried?)

Consumers can now borrow up to $40,000, an increase from the previous cap of $35,000.

The new maximum should raise eyebrows. That’s because while one of Lending Club’s biggest allures is the ability to refinance credit cards into a lower rate over a fixed term, there are zero safeguards in place to ensure that the borrower actually uses the proceeds to do just that. Instead, the applicant simply checks a box and if approved, gets the loan minus the origination fee wired to their bank account. That means today’s consumer can obtain 40 grand in one lump sum online. Unsecured. In their bank account. For whatever purpose. From a lending marketplace that puts none of their own money in the loans.

No Recessionary Data for Loans Over $25,000

The numbers look okay, for now. Using NSR’s backtesting tool revealed that loans of exactly $35,000 have generated higher returns for investors than loans of smaller sizes, but have a higher loss rate. This is because the interest rate increases with loan size. The all time loss rate on $35,000 loans is 6.60%, according to the tool, but Lending Club didn’t start making loans this big until February 2011, after the recession had already ended.

That in itself should be alarming because when we examine the time period of June 2007 through June 2010, when the Great Recession occurred, loss rates hit the largest loans the hardest. At that time, the maximum loan size was $25,000 and the loss rate on those was 11.54%.

With the maximum size having increased to $35,000 and now to $40,000, there is no recessionary data to indicate how these large loans will perform.

The Temptations of a Cash Windfall?

Credit cards can moderate spending habits because there is a limit on the type of goods and services one can acquire with them. With cash, consumers may be tempted to indulge themselves in other things. One has to wonder if the average consumer really needs 40 grand wired to their account on an unsecured basis with no strings attached on what to do with it.

Lending Club might have considered this already though. In December, they announced Direct Pay, a pilot program in which Lending Club actually requires borrowers to use up to 80% of the proceeds to pay off their outstanding debt. There’s one caveat, it’s only open to a category of the most risky borrowers, those with Debt-to-Income (DTI) ratios of up to 50%. Lending Club’s traditional DTI cap is 30%.

That means that investors have to rely on the ability of borrowers to do the right thing with 40 grand in unsecured cash. Should they trust them?