Whether we like it or not, independent oversight and regulations exist in financial services for a reason: to protect borrowers, lenders and society's greater economic health. In other words, they help make industries viable. Therefore, as the marketplace lending industry continues to mature, it needs the oversight equivalent of Standard & Poor's, Moody's Investors Service and Fitch Ratings.
I've long argued that one of the fundamental problems in the marketplace lending business model is the fact that they serve as an originator, broker and credit rating agency, all in one. Marketplace lenders' businesses depend on top-line growth from selling all their originated loans. This model leads to an inevitable conflict of interest, and in many cases, less than complete transparency with investors.
Independent credit rating agencies — which helped play a role in creating the Great Recession — are still working hard to repair their damaged reputations. However, the mistakes made by the major credit rating agencies in 2008 should not make us doubt the value that ratings agencies can bring to marketplace lenders. In fact, the earlier mistakes can provide valuable guidelines for structuring the right type of ratings apparatus that will help lead the marketplace — and everyone working with them — to a brighter future.
The agencies conducting ratings of marketplace lenders should consider these four lessons:
Marketplace lenders shouldn't pay the credit rating agencies.
In 2008, the credit ratings agencies had clear profit incentives. The agencies were paid by the companies issuing debt — a revenue model that often resulted in ratings agencies bending standards in order to gain business. As we contemplate rating agencies for marketplace lenders, we must avoid repeating this past mistake. Marketplace lenders should not pay the agencies in any way.
Credit rating agencies should focus on real-time information.
In 2008, the credit rating agencies' analyses focused too much on the past. As the precipitous drop in real estate values demonstrated, history — no matter how recent — is not a reliable indicator of the future performance of investments. It is much more important to have real-time data.
Rating agencies for marketplace lender-originated loans need IT solutions that calculate and recalculate, automatically and continuously, consumer and small-business loan ratings. At any moment in time, these ratings should take into account all available information on particular loans and bundles of loans in order to deliver the most accurate risk assessments based on real-time market conditions.
Credit rating agencies need to set clear rules.
In the years leading up to 2008, banks were bundling loans at such a furious pace that loans weren't always uniform (all mortgages, all SMB loans, etc.), which often made it difficult to issue an accurate credit rating for a securitized product. To enable more accurate risk assessments, ratings agencies for marketplace lenders should set rules regarding loan bundling, so that “like” loans are bundled together.
In 2008, credit rating agencies also did not foresee that the government would let Lehman Brothers collapse while saving Bear Stearns. In addition to loan quality, ratings agencies for marketplace lenders should factor in individual marketplace lender's overall performance and their prospects for survivability, or even government intervention, in the event of a major economic calamity.
Don't overestimate rating agencies' usefulness.
While ratings agencies are very valuable, investors should not over-rely on them, as they often did in 2008. Ratings agencies for marketplace lenders should encourage those relying on their insights to supplement these with their own due diligence and research, and perhaps also provide tools for doing so.
Oleg Seydak is CEO of Blackmoon Financial Group.