In 2016, online lending marketplaces (OLM) took a hit. Lending Club disclosed falsification of loan data and CEO’s misbehavior. Graduate Leverage’s principal was sentenced to nine years for stealing $16mn of investors’ money. Prosper.com cut one fourth of its staff. On Deck Capital reduced its growth projections.
Poor performance by the leaders is not an exception. Lending marketplaces in their current form share several common problems.
Marketplaces’ misbehavior and increasing volumes of credit attract more scrutiny from federal and state regulators:
- Interstate operations may require honoring local state anti-usury laws that restrict the interest rates from above. Ongoing court litigations will determine whether loan resellers, such as Lending Club (LC), should be excluded from the federal anti-usury law exemptions.
- US Treasury, FDIC, and CFPB start requesting more information from lending marketplaces and their partners.
- The Equal Credit Opportunity Act protects borrowers from discrimination. Banks may avoid discrimination lawsuits by pooling discriminated groups together with other borrowers at higher interest rates. Some online marketplaces simply post loan applications, so disadvantaged borrowers are not rejected directly but simply may be unable to find buyers. Over the recent years, OLMs moved toward more centralized models where loans are packaged and sold by the platform. This can make the platform responsible for unbalanced portfolios of loans. It also applies to selective marketing practices. SoFi, for example, accepts borrowers only from top-tier universities.
- The risk of being classified as an investment company or a broker-dealer, with more compliance requirements and disclosures.
These regulations increase operating costs and the net interest spread. Which brings us to the other drivers of costs.
Some OLMs present themselves as low-cost, efficient lenders (see Figure 1 and 2 in the appendix). This is doubtful:
- Being lenders themselves, Santander and JP Morgan bought more than $2bn of Lending Club loans. It means that operating expense of 2-3% goes on top of “traditional lender” operating expense of 5-7% (Figure 1). Institutional investors generate two thirds of LC’s sales.
- Instead of removing intermediates, as claimed, OLMs add themselves and issuing banks to the chain between borrowers and lenders. See Figure 3: “Investors” buying private instruments (certificates and loans) on the right are professional investors: banks, investment funds, and funds of funds. Each taking commission and creating costs for their clients, so you can extend this scheme to more intermediates before the payments reach the end saver. Public notes sold directly to retail investors generate only one third of sales.
- No more NOLs. Many OLMs operate with losses that allow them to accumulate tax deductions for the future. Although a general feature of all startups, carryforwards in lending contribute more to profitability because of thin margins and slow growth.
- Institutional investors are vital to marketplaces. OLMs depend on them for credit lines, sales, funding. Institutional investors enter slowly and quit fast, as it was with LC in May. Such exits create holes in income statements because marketplaces can’t cut fixed costs proportionately to the decline of originated loans.
- Banks and investment funds may also quit in response to regulatory pressure on marketplaces. Marketplaces enjoy loose regulations, but recent trends are killing this advantage.
- The buy side uses leverage — another contradiction to the initial idea of the non-levered, non-fractional marketplace.
- Retail investors don’t do due diligence. OLMs offer retail investors diversified portfolios of personal loans. One investor lends to dozens of borrowers. If he invests $10,000 in 100 prime loans, he earns $500 a year, or $5 per borrower. Due diligence becomes non-economical with these numbers. So retail investors can’t add a personal expertise to the screening process. The platform sets rates itself and sells loans in bulk.
- The interest rate advantage is overstated. See footnotes of Figure 2: The borrowing rate of 20.7% comes from the LC’s customer survey. That is a credit card sort of rates. Its interpretation is impossible without LC telling the public how they conducted the survey. Secondly, the ROI of 0.06% is a straw man. LC is not a FDIC-insured depository institution. LC sells illiquid unsecured loans. The appropriate asset for comparison would be corporate bonds, which yield 5% for comparable risk. Corporate bonds have a performance history and can be sold without paying a 1% penalty set by LC’s secondary market.
- The Fed rate hike. OLMs emerged in the late 2000s when the interest rate had been cut to zero and many borrowers could refinance their loans on better terms. As the Fed raises the rate, refinancing and borrowing in general lose their charm.
- Fewer prime borrowers. Online marketplaces enjoyed an early influx of tech-savvy, doing-well borrowers. Now the borrower base deteriorates and the default rate increases.
- New data won’t help finding better borrowers. Marketplace underwriters use credit score by TransUnion, Experian, and Equifax. That’s what banks use. Some OLMs also employ unconventional data: borrower’s university, degree, social media activity. That’s barely an advantage. (1) Alternative data is often correlated with credit scores, which makes it redundant for screening; (2) Banks have access to the same new sources of data, and big banks have much more than that; (3) Some indicators imply discrimination: if you lend to the students of WASPy universities only, expect lawsuits; (4) Frauds based on falsification of alternative data — this may be the most innocent problem. In general, the alternative data has a neutral impact on the competitive advantage in finance: everyone can have it.
No international growth
American startups get high valuation because only they expand internationally. Lending is a highly regulated industry with each country having peculiar rules up to bans on foreign-owned banks. Online lenders currently struggle with state-specific regulations, and serving clients outside the United States is even more problematic.
Lending marketplaces comprise 8 out of 21 financial companies in the WSJ Billion Dollar Club of young private companies. Lending Club and On Deck are public and marked to market. These companies represent two general models of online lending: the marketplace and the single-lender credit line. They also target different borrowers (consumer vs small business). Consumer lending marketplaces are hit hardest by all the above problems. But small business lenders also promise to help underbanked business owners like banks never tried to finance SME before. Anyway, the private equivalents of Lending Club and On Deck will see down rounds after this year’s events.
OLMs did not create a new sector with high margins. They’re ending up paying regulatory and marketing costs in a commodity market. Still, online lenders have (had?) hi-tech-ish multipliers. Perhaps the better comparables would be credit unions and regional banks.
Banks ended up being big after years of M&As. They actually addressed the mentioned problems with growth (and being lucky to survive). Online lending marketplaces don’t have a particular edge against traditional banks. So their organic growth follows the industry’s average. Exit through acquisition? Goldman Sachs recently opened its own personal lending platform, instead of buying an existing player. It seems independent marketplaces need banks more than banks need them. Which makes acquisitions also unlikely.
Disclaimer: Not an investment advice. For information purposes only. No affiliation with or material interest in the companies mentioned. The future tense is not a promise.