Can Marketplace Lenders Go the Distance?

marketplace-lenders.pngRenaud Laplanche started LendingClub Corp. in 2006, and built it into the largest player in the white-hot marketplace lending space. Along the way, he became the public face of an industry whose methods and processes are revolutionizing the way people and businesses borrow money.

So when Lending Club’s board handed Laplanche an abrupt resign-or-be-fired ultimatum in May, alarm bells went off. If the poster child goes down, can the rest of the industry be far behind?

The short answer is no, at least not yet. In fact, even Lending Club will likely be okay, thanks in part to some fast action from a board filled with financial-world heavyweights. But the reaction to the news-including an abrupt pullback by the investors whose funding makes the entire industry go-highlights the concerns that have dogged marketplace lenders as their profile in the financial space grows.

Marketplace lenders, or MPLs, use online applications and algorithms to match borrowers with investors willing to lend, taking a cut out of the transaction. Think of them as the eBays of lending. Critics admire their technology and processes, but argue that the MPL business model has a fatal flaw: funding. Instead of using deposits to bankroll loans, they rely on retail and institutional investors. When the going gets tough, the thinking goes, funding will dry up.

In Lending Club, Laplanche, a 45-year-old French-born former securities lawyer, built the closest thing the industry has gotten to proof-of-concept. The San Francisco-based company features a robust network of retail and institutional investors, and nearly doubled its origination volume in 2015, to $8.4 billion. It capped its first full year as a public company with a fourth-quarter profit, and looked poised for more of the same this year.

Laplanche resigned over $3 million in misdated loans and his failure to disclose an ownership stake in a Lending Club partner. The numbers were relatively small, but in a fledgling industry built on the confidence of investors, such transgressions can be devastating.

A board that includes former Morgan Stanley Chairman John Mack, former Treasury Secretary and Harvard President Lawrence Summers and former Visa International Services president and Citigroup executive John “Hans” Morris acted decisively to staunch the damage.

After an investigation confirmed allegations the board had received, directors voted unanimously to release Laplanche if he didn’t voluntarily resign. While it is not a bank, “as a public company that provides a financial service, Lending Club must meet the industry’s high standards of transparency and disclosure,” Morris, the company’s executive chairman, said in a statement.

Laplanche “was probably the most prominent person in the industry, but at the end of the day, responsibility lies with the board,” says Bob Ramsey, an analyst who follows Lending Club for FBR & Co. “The directors showed pretty clearly that there is zero tolerance for any sort of impropriety. That’s the right message to hear from the top in an industry so reliant on investor trust.”

Investors initially fled-not only Lending Club, but the entire space-but by June, many had either already returned or were planning on it. “A lot of investors responded (to the Lending Club news) by saying, ‘We need to slow down and take more time,’” says David Snitkof, co-founder and chief analytics officer at Orchard Platform, a New York company that operates the technology that facilitates most MPL transactions. “But it hasn’t diminished their long-term commitment to investing.”

So there you have it: Crisis averted … at least for now. But what about the next time something unsettling happens in the market? Or the time after that? What if the economy tanks? If the industry’s future involves dodging from one funding crisis to the next, is it really viable? Worse, does it pose a danger to the financial system?

For bankers who legitimately view MPLs as both rivals and partners, such questions are more than academic. While the new-style lenders might steal some business from banks, they also are a growing source of assets for deposit-rich institutions looking to add some diversity to their balance sheets.

Over the past 18 months, dozens of banks-ranging from JPMorgan Chase & Co. and Citigroup to small community banks-have invested in MPL loans or even entered into more formalized partnerships with them. In total, about one-third of Lending Club’s funding in the first quarter came from banks. Given the troubles banks are experiencing with loan growth, and the potential yields, more are sure to follow.

As ties between the two industries grow stronger, the health of MPLs’ business models will likely have more of an impact on banks, whether anyone wants it or not. Indeed, it’s entirely possible that banks may emerge as the primary solution for the industry’s funding problems, either directly through acquisitions or partnerships, or simply through increasing loan commitments.

Tellingly, part of Lending Club’s recovery pitch to reassure other investors was a public commitment from Citigroup to purchase more of its loans.

Marketplace lenders are modern-day versions of the old-line consumer finance companies, making unsecured consumer installment loans that no one else will make for relatively high rates, and getting their funding from the capital markets. Compared to traditional banking, it’s a relatively high-risk, high-reward game, fueled by dazzling technology.

A typical Lending Club loan, for example, is for $14,500, with a 12.81 percent interest rate and a three-year term, and is used to consolidate credit-card debt. Few banks want to make loans like that because they’re too costly to underwrite. MPLs, unencumbered by old technologies, old processes and regulation, can turn a profit on them.

With MPLs, borrowers fill out an application on a lender’s website, where high-tech lending algorithms quickly crunch more than 100 variables, including FICO scores, to assign credit ratings and set loan pricing. (Fully 90 percent of Lending Club’s applicants get rejected.) That information then gets posted, along with some location specifics on the borrower, and investors use different strategies to pick and choose the loans they’d like to fund.

Tom Grant, managing partner with Intelligent Lending Advisers, a Boston firm that assists MPL investors, says he focuses on B, C and D credits, with interest rates between 8 percent and 14 percent. He marvels at the transparency of the loan data. “We get a continuous feed of data showing the types of defaults, where they are happening, the types of borrowers that are defaulting,” Grant explains. “It’s a lot of interesting data.”

Efficiency is a calling card. Some MPLs require just four human interactions to complete a loan, compared with up to 14 for a traditional bank. Such streamlining, along with having no branches or deposit accounts to maintain and relatively few regulatory concerns, keeps costs lower than banks.

“Most banks don’t look at it from the top down and say, ‘How can I speed up what I’m doing by automating the credit decisioning?’” says Todd Baker, managing principal for Broadmoor Consulting LLC, which works with both banks and MPLs. “The beauty of these guys is that they found a way to automate the origination process in a way that is compliant and cuts a lot of time out of the process.”

The way things have worked thus far, everybody wins. Consumer and small-business borrowers get the money they need, while investors-including a growing number of banks-get exposure to an attractive asset class that is too costly for most banks to pursue profitably on their own.

Lending Club and other MPLs, such as Prosper Marketplace, Avant and On Deck Capital, make their money mostly off of upfront origination and servicing fees. The niche is small, but expanding rapidly.

In 2015, U.S. MPLs issued $36.17 billion in loans-an impressive 212 percent jump from 2014’s $11.68 billion, according to the U.K.-based Cambridge Centre for Alternative Finance. By 2020, Morgan Stanley estimates that MPLs will originate 8 percent of all unsecured consumer loans, and 16 percent of small-business loans.

“We’re transforming the banking system into a frictionless, transparent and highly efficient online marketplace, helping people achieve their financial goals,” intones LendingClub’s website.

That kind of we-can-do-it-better-than-you-can brashness is part of the industry’s persona. Many MPL leaders are former bankers who say they were frustrated by legacy technologies and processes.

Mike Cagney, a former Wells Fargo & Co. trader and now a founder and CEO of Social Finance, or SoFi, an MPL based in San Francisco, has ruffled feathers with talk of his firm eventually becoming a “bank killer” with a full array of bank-like accounts and services.

“People in the space think of themselves as doing something special,” says Snitkof, who worked at Citigroup and American Express before co-founding Orchard. “Banks are very good at compliance, managing large amounts of capital and mass distribution. But this is the future. MPLs offer better, more seamless customer experiences to borrowers, better investment options for investors and greater transparency. They’re increasing the utility of the financial system for everyone.”

That may in fact be true, but first the industry has some issues to work through. For starters, MPLs have yet to endure an economic downturn to prove the validity of their underwriting, and don’t possess the gravitas of more traditional lenders. No one knows for sure what might happen to MPL-underwritten loans in a recession.

“If you’re in some kind of financial distress, you’re probably going to pay your mortgage and auto loans, and maybe even your credit-card bill, before your Lending Club loan, because the relationship doesn’t mean that much to you,” Snitkof says.

In the worst case, high default volumes could pose a systemic risk. As intermediaries that make their money off of origination fees and have very little skin in the game, MPLs don’t face the same risks as banks and could be looser in their underwriting.

Small wonder that MPLs are starting to draw regulatory scrutiny. Last spring, the Office of the Comptroller of the Currency and Treasury Department each issued white papers on MPLs, hinting at a need for greater borrower protections and oversight. This fall, the Consumer Financial Protection Bureau is expected to unveil its own supervision plans for the industry. More direct regulation, viewed as inevitable by many, could negate one of the big cost advantages the space has over banks.

For all that, the elephant in the room is funding. While banks have deposits to fall back on, nothing commits MPL investors to continue funding loans if they see something they don’t like, be it an economic stumble, a rise in loan delinquencies, a jittery market-or a high-profile leader acting inappropriately.

MPLs “have largely taken the view that their use of technology somehow exempts them from the funding constraints nonbank lenders have always faced,” Baker says. “Nothing could be further from the truth.”

If investors were to stay away for a prolonged period, the loan machine would grind to a halt, and with it the transaction fees MPLs rely on for revenue. “An MPL has to keep issuing loans to survive,” Baker says, “and that requires funding.”

Laplanche’s resignation wasn’t even the first time this year investors pulled back. In February, falling oil prices and international market instability sparked questions about the economy’s recovery. Lending Club and Prosper both boosted borrower rates to reflect changed economic outlooks, and MPL investors got spooked. Many pulled back and some looked for a quick exit.

“A lot of people wanted their money back, and hedge funds realized they couldn’t sell $1 million a day of MPL loans, which is what they needed to do” to satisfy investor redemption demands, Grant says.

When some hedge funds told their investors to halt redemptions, some began to have second thoughts. “Immediately you saw concerns: Is something wrong here? We can’t get our money back,” Grant says. “Hedge funds like to move in and out quickly.”

Clearly, new and better funding options are needed. MPLs got their start in the United Kingdom as pure peer-to-peer lenders, and many remain that way today: It would be heresy to do otherwise, or so the thinking goes across the pond. In the States, the thinking has evolved by necessity: The industry grew so fast, it more or less outstripped the supply of retail capital willing to invest in loans.

The first steps beyond pure P2P funding were taken by hedge funds, which were attracted by the rapid growth and relatively high yields in the space. As recent experience suggests, however, hedge funds can’t be relied on in a pinch.

Loan securitizations are another option, but the problem remains mostly the same: Institutional investors are the most likely buyers and are easily spooked.

Last year, Citigroup securitized $377 million of Prosper loans. The reception was good, but in February ratings agencies downgraded some tranches based on performance. When Citi went to sell another offering in March, the spread demanded by investors was nearly double last year’s offering. Citi exited the relationship a short time later.

Complicating things, the industry is scrambling to avoid some states’ loan-rate limits. In March, a federal appeals court ruled that buyers of a loan from a national bank are not entitled to preemption of state usury laws, which cap interest rates and make the loans less attractive to investors.

Lending Club loans, for example, are technically issued by Web Bank, a Salt Lake City, Utah-based bank with a state industrial bank charter that permits higher rates to be charged on loans. In response to the court case, Madden v. Midland Funding, Lending Club changed its contracts so that Web Bank now owns a small piece of each loan, preserving the federal protection.

These are the expected growing pains of a new industry. The MPLs that survive long-term, Snitkof says, will be those that first diversify their funding sources. He points to Avant, a fast-growing Chicago-based MPL that caters more to the subprime space, as a potential model.

Avant has originated more than $3 billion in loans, and employs a variety of funding schemes, including maintaining its own balance sheet, securitizing loans and maintaining outside credit lines to give itself options. “If a platform has only one source of capital, it’s going to be at risk,” Snitkof says.

Critics say that investor diversification alone won’t solve the funding problem, because it all eventually comes back to institutional investors. What might work better is strengthening ties with-you guessed it-banks.

While many bankers bristle that MPLs are encroaching on bank space, a growing number have found that partnering with MPLs isn’t such a bad thing. Banks funded about one-third of Lending Club’s originations in the first quarter, and Ramsey expects the percentage to increase in the future. “There’s a natural partnership there,” he says. “They’re the yings to each other’s yangs.”

The list of banks that have invested in MPL loans includes large superregionals, such as Atlanta-based SunTrust Banks, Regions Financial Corp. of Birmingham, Alabama, and MUFG Union Bank in San Francisco. Community banks like WSFS Financial Corp. in Wilmington, Delaware and Sacramento, California-based Golden Pacific Bank, also are in on the act.

BankNewport, a $1.4 billion asset institution in Newport, Rhode Island, has put about $23 million in Lending Club loans on its books over the past 15 months. The appeal, says chief lending officer Leland Merrill Jr., is the ability to diversify the bank’s loan portfolio geographically while also putting on an attractive asset class-small-dollar consumer loans-that the bank can’t do profitably on its own.

“You’re talking about $10,000 or $15,000 loans, and we’re doing manual underwriting, collecting tax returns and financial statements from the borrower. It costs too much for us to do profitably,” Merrill says. “We could go out and buy a credit-scoring system, but that’s probably $50,000 or $100,000 just to set up. Are we ever going to get the volume to offset those costs? Probably not.”

BankNewport selects the loans it invests in through a partnership between Lending Club and BancAlliance, a group of 200 community banks. It put a temporary stop to purchases when Laplanche resigned, but plans to resume them this summer. In addition to Lending Club’s standard underwriting formula, BancAlliance set a floor on FICO scores of 680, so most of the loans are graded A, B or C on Lending Club’s A-G scale.

“We’re seeing an 8 percent yield on those loans. It’s been phenomenal,” says Merrill, who serves on BancAlliance’s board. He expects yields to eventually settle to around 5.5 percent or 6 percent once the loans, which have durations of between two and three years, season. “But hey, a 6 percent yield on a three-year asset is pretty good.”

As the relationships mature, banks are finding new and varied ways to utilize the MPLs’ expertise. Citigroup, for example, has been using a partnership with Lending Club to help achieve its Community Reinvestment Act mandates by investing in loans from specific census tracts. Other banks are considering similar programs.

BankNewport plans to open a new branch in an area that includes several low-income tracts. “We’re going to have trouble meeting our CRA requirements on our own,” he says. “You can go to Lending Club and say, ‘I only want to buy loans from this area.’ We’re looking at it as a solution.”

A commitment from banks to buy more loans would ease the funding concerns. Or banks could simply acquire the best companies for their technology. While the MPLs strongly object to the characterization, many say it’s more appropriate to view them as technology firms.

In one closely watched experiment, JPMorgan Chase has begun using On Deck’s platform to originate loans for its own small-business clients. Such “white label” arrangements, branded under the bank’s name, could give the MPLs another source of revenues. Or they could be setting the table for an acquisition.

Ramsey says that On Deck would have little incentive to sell itself, because it would preclude the firm from working with other banks. But every company has its price. If JPMorgan were to conclude the technology has enough value, On Deck’s founders could get a nice payout, and the firm’s funding problems would be solved.

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