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Marketplace Lenders Are a Systemic Risk

Once again the markets have fallen in love with a group of young, aggressive and not very regulated lenders.

Online "peer to peer" marketplace lenders like Lending Club, Prosper and Funding Circle are originating loans at a torrid pace and sporting eye-popping public and private market valuations. The growth predictions for this new class of technology-enabled lender are impressive — Morgan Stanley estimates that U.S. MPL originations will increase to more than 8% of total consumer unsecured lending and 16% of small business lending by 2020, with much of the loan volume taken from traditional retail banks.

MPLs combine an easy-to-use online loan application with a virtual marketplace to package and sell loans to investors. MPLs generally don't keep any of the credit risk on the loans they sell and don't issue the loans themselves either — they rely on a couple of specialty banks for that chore to avoid regulatory costs. And they don't have a lot of assets or capital.

Unlike lenders that hold loans on their balance sheet and use cash from principal and interest payments to reimburse their funders and make a profit, an MPL has no loans of its own. Virtually all of its revenue comes from transaction fees paid to it when a new loan is issued and sold to an investor. As a result, it can operate at levels of financial leverage unheard of in the banking industry.

It's an attractive story that plays well in the press, on Wall Street and with the general public — Silicon Valley techies in T-shirts and sneakers creating a financial Uber to "disrupt" traditional banking while putting up tech company-worthy growth numbers. No wonder scores of new venture-backed "me too" MPLs are rushing to cash in on the expected bonanza.

Not so fast.

The hard truth is this: while MPLs have introduced valuable innovation into financial services, they carry a fundamental flaw that threatens to undermine their business, destabilize financial markets and cause real economic hardship. The bigger the MPLs get before the inevitable squeeze, the worse the consequences will be for all of us.

But history offers us a solution — by bringing the MPLs into the regulated banking system now we can ensure that the flow of credit isn't disrupted when rates rise and the credit cycle turns.

If you peel back the skin of an MPL, what you find underneath is a finance company — which is simply a nonbank lender that gets all of its funding from the capital markets. Leading finance company names from the past like Household, GE Capital, CIT, MBNA, Countrywide, Money Store and GMAC all relied on the same liquidity model: borrow in the capital markets and lend that money to customers. In good times, this model works well. But when funding in the capital markets is unavailable or prohibitively expensive, a finance company quickly hits the wall.

The lifeblood of a lender is access to funding — a lesson society relearns every time a lender without adequate liquidity needs a government bailout or goes bankrupt. That's why the finance companies of the past all ultimately were forced or went voluntarily into the banking system to get access to the stable deposit funding they needed to survive and prosper — either by becoming banks themselves or being acquired by banks — or they failed. If there is any clear lesson from U.S. financial history, it's that the only truly reliable source of liquidity for lenders is insured bank deposits. A lender with deposit funding has cash to lend out in every environment, not just when the capital markets are feeling flush.

While MPLs share all the liquidity risks of traditional finance companies, they have an added characteristic that magnifies the instability of their business model. If an MPL can't issue new loans — which will happen any time investors refuse to buy loans in the MPL marketplace — the transaction fees that are the MPLs' main source of revenue and cash will instantly disappear, while expenses continue to mount. An MPL has to keep issuing loans to survive. It can't slow down lending and slash operating costs to stay afloat while collecting cash from existing loans, like a traditional finance company, because it doesn't own any loans. Unless the MPL can raise enough emergency capital to either hold loans itself or put enough "skin in the game" to satisfy funders, the MPL will go out of business in short order, with loan investors left to rely on whatever legal protections their contracts provide. It's an amplified version of the "hamster wheel" problem that has made the mortgage banking business so hard to manage over the years. The resulting mess will bring an avalanche of enforcement actions and lawsuits.  Financial crises have been started by less spectacular problems.

It's worth noting that some of lenders that call themselves MPLs — On Deck and SoFi for example — are hybrids which hold more capital and have business models that fall somewhere between that of a true marketplace lender and a traditional finance company. Their capital and balance sheet will provide them with a bit more flexibility in an MPL liquidity squeeze but they still won't have enough stable funding to avoid infection.

So how do things look for MPL liquidity? So far, MPLs have been good to their liquidity providers — initially wealthy individuals and now mostly hedge funds, pension funds, family offices, banks and other institutional investors. Lending Club, for example, has delivered an adjusted annualized return of almost 8.7% on its first $8 billion in issued loans. But any neutral observer would conclude that the easy access to capital markets funding enjoyed by MPLs is a temporary product of unusually good credit performance in the post-recession economy and repeated Federal Reserve interventions to keep interest rates low.

Investors are happy to fund MPL loans today because there are few, if any, alternative investments that provide such high yields. Self-interest matters too — hedge funds buy loans from MPLs rather than buying asset-backed securities in the market (managed by a tested issuer like Capital One) because they can justify their management fees by re-underwriting the loans they buy.

But all it will take is a credit issue or a serious legal or regulatory problem to shift investor sentiment away from MPL investments and toward other high-yield investments, and there is plenty of reason to think credit and regulatory issues are lurking in the background.

When sentiment changes, the MPL investors' rush to the exits will be no less swift than it was for traditional finance companies in 2007-8 or in the Russian and Asian debt crises of the late 1990s. There will be no rescue from the MPLs' original funders — the celebrated "peer-to-peer" individual investors — who will abandon ship the minute credit losses and passed-through collection costs begin to bite (although they will make sympathetic plaintiffs in the lawsuits that follow). When this will all happen is a matter for conjecture, but history shows that it will happen if present trends continue.

The most likely trigger for a liquidity squeeze will be rising loan losses and declining loan spreads. There's a strong whiff of adverse credit selection in MPLs — any time borrowers scramble to take out loans carrying lower interest rates and better terms than they can get elsewhere, especially when most of the lending is for consolidation of existing debt, we should expect credit problems.

In fact, MPL lending spreads are already coming under pressure from new market entrants, and MPLs are responding by increasing issuance of higher rate but lower-quality loans to keep their spread-dependent investors happy; Lending Club has already issued over $1 billion in personal loans carrying interest rates above 20%.

And one should always be skeptical of credit analytics that haven't been battle tested. It's important to recall how unanticipated changes in customer behavior and insufficient stress-testing of newly created financial products made the "highly sophisticated" models used in the pre-2007 mortgage business useless as loss predictors.

The impact of an MPL disruption on the real economy is likely to be much more severe than is commonly recognized. Imagine the consequences a decade from now if 8% of consumers and 16% of small business borrowers can't find replacement loans quickly from traditional lenders in an MPL liquidity squeeze, especially borrowers who may not meet traditional bank credit standards. As MPLs enter more sectors of the U.S. lending market, such as commercial real estate, healthcare, student and single family lending, the impact will be even greater. The rapid withdrawal of credit to so many Main Street consumers and businesses could be devastating to the U.S. economy.

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Comments (8)
Marketplace lending does not pose a systemic risk. In fact, marketplace lending addresses one of the root causes of the financial crisis, i.e., the systemic risk inherent with “fractional-reserve banking”.

Let's review the basic factors that give rise to systemic risk in our fractional-reserve banking system: A bank takes deposits from people and lends that money out to borrowers, retaining just a fraction of the money in reserve at any given time in order to accommodate potential withdrawals from depositors. In the olden days, a bank would get into trouble when too many depositors withdrew too much money from the bank all at once. Fortunately, the FDIC and deposit insurance have mitigated this type of risk. But deposit insurance does nothing to address the risk of a bank becoming insolvent, which can occur if a bank is forced to write down the value of its assets (such as the loans or other investments it has made, e.g., sub-prime MBS), wiping out the bank’s equity capital and making it virtually impossible for the bank to issue new equity in order to re-capitalize itself (who wants to buy stock in an insolvent bank???). If the insolvent bank fails (goes bankrupt), the problem can quickly spread to other banks, which may have lent money to the bank that failed or may be exposed to it in some other way. Even if other banks are not actually exposed to the failed bank, public perceptions of the other banks' potential exposure to the failed bank can get the other banks into trouble -- a problem that's often referred to as "financial contagion". Financial contagion is partly the result of information asymmetry, in other words, nobody really knows what "cards" (toxic assets vs. good assets) the other poker players (other banks) are holding. Note that the issue of financial contagion is unique to the banking system given its interconnectedness. For example, if a large manufacturing company went bankrupt, it probably would not pose any systemic risks. As And as Charles Smith mentioned in his previous comment, "Marketplace lenders do not hold loans, and, as a result, cannot default on their obligations. Consequently, they present no risk to the market, systematic or otherwise."

Fractional reserve banking was one of the root causes of the financial crisis. Ironically, deposit insurance and other government safety nets (e.g., bank bailouts) probably contribute to a bank’s tendency to make bad loans/investments because these safety nets insulate the bank’s managers and shareholders from the consequence of taking excessive risks with other people’s money — a problem referred to as “moral hazard”.

Policymakers are interested in marketplace lending because it addresses the root cause of the financial crisis by allowing loans to be funded with “private” non-bank balance sheets, addressing the systemic risk inherent with fractional reserve banking. And unlike fractional reserve banking, marketplace lending “privatizes” investment risks, attaching them to the same investor who stands to benefit from the potential investment returns, thereby addressing the issue of moral hazard.

In one of the previous comments, the author attempts to defend the assertion that "marketplace lenders are a systemic risk" by mentioning the possibility that "many""" (how many???) of the investors funding marketplace lending are leveraged themselves. This is not the case. In fact, only a few investors are using leverage; MPL platforms such as Lending Club no longer allow investors to utilize leverage to purchase loans on their platforms.
Posted by DanV | Wednesday, September 02 2015 at 10:08AM ET
I reject the author's premise and also his prescription.

1. Before all the regulation of the past century, JP Morgan and other highly professional and prudent bankers did a fine job of underwriting their loans. The quality of the system is not determined by regulation, but by the quality of the underwriting process including lending criteria and analysis of their borrowers.

2. Look at all the regulated institutions that cratered in the mortgage crises of 1982 and 2008. Regulation did nothing to prevent those events.

3. Banks in the regulated system did a fine job of withdrawing credit and liquidity from their borrowers in each of the recessions and credit crises of the past hundred years. There is nothing about the regulated banking system that either enables or encourages banks to support their good customers in bad times.

4. Like mortgages, MPL loans are fully funded at creation and do not involve revolving or unfunded commitments. So the author's implication that existing borrowers will somehow be left without funding is factually incorrect. If the market dries up and the MPL intermediaries shut down, there are portfolio management services built into the deals (as in all such securitizations) that will administer the loans during their lifetimes. No maturities will be accelerated, no terms will change. Investors understand this process before buying the securities. No government intervention is needed.

The author needs to prove his thesis, that banks are somehow more stable and responsible lenders than MPLs. Nothing in the above article even attempts to do so.
Posted by Bob Newton | Wednesday, August 19 2015 at 7:17PM ET
Thought provoking article.
Posted by rdrewsjr | Wednesday, August 19 2015 at 11:48AM ET
Lenders getting "squeezed" and decreasing their lending is a sign of a functioning market. When regulators intervene to prop up these lenders, that is when the market gets distorted. Let them fail.
Posted by BankerJoe | Wednesday, August 19 2015 at 8:01AM ET
The availability of liquidity during a financial crisis is the issue at hand, as I believe you agree. Absent a committed liquidity facility from an indisputedly financially strong lender, and assuming no outs by the lender for adverse market conditions, force majeure, etc, the only liquidity that can be guaranteed during a crisis is the excess cash a borrower has in the bank. That is a lesson I learned from my depression era father who saw the local bank fail. Real life has affirmed his wisdom.
Posted by Charles Smith | Monday, August 17 2015 at 7:18PM ET
oh snap
Posted by mbs | Monday, August 17 2015 at 6:04PM ET
Thanks for your comment. I don't plan to respond to all of them, but yours is a useful place to clarify a couple of points.

I find the distinction you draw to be a valuable one, but not likely to matter much in the real world when funding for marketplace lenders disappears. The MPL liquidity and business model risks I described in the article are primarily economic risks, from the sudden withdrawal of a large percentage of lending capacity and financial risks, from the disruptive effect of an uncontrolled implosion of these companies in a liquidity squeeze. You are correct that marketplace lending lacks the direct interconnectedness risk that characterized the most recent bout of systemic problems. I think we may find, however, that many of the investors funding marketplace lending are leveraged themselves, so there are likely to be indirect problems in an MPL liquidity squeeze affecting both those participants who are over-exposed to the space and their creditors, particularly if current projections of MPL growth come to pass.

Will the issue be systemic in the narrow way you are defining it? Perhaps not. But will anyone care when a squeeze happens?

By the way, I didn't write the headline and you'll note that the body of the story doesn't refer to systemic issues as you define them.
Posted by Todd Baker | Monday, August 17 2015 at 12:53PM ET
The author's argument has a fundamental, fatal flaw. Market place lenders do not hold loans, and, as a result, cannot default on their obligations. Consequently, they present no risk to the market, systematic or otherwise.

The author is confusing the disappearance of liquidity during a financial crisis with systematic risk. The former cannot be avoided. Investors and lenders inevitably pull back during uncertainty. The real lenders in the MPL structure are, of course, the public. That's just life in a free market economy, and why it always pays for a borrower, corporate or individual, to have a liquidity reserve.

The author may find it useful to ask a knowledgeable fed official about this subject. He will learn that he is way off base.

Charles Smith
Managing Partner
Pegasus Intellectual Capital Solutions
http://www.pegasusics.com
Posted by Charles Smith | Monday, August 17 2015 at 12:29PM ET
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