After a career trading student loans at Deutsche Bank, I had arrived at a pivotal moment in my life. I was shopping for my own loan, which would be a ticket of sorts to pursue my MBA at Wharton in the Fall. I looked at all the typical originators: Sallie Mae, Discover, and the largest of all, the US Government. Despite the size and gilded reputations of these institutions, I chose a loan from a five-year-old start-up: SoFi.
I chose SoFi not just because it had the lowest rate (which it did), or the simplest process (which it also did), but because it made it seem that taking a loan was tantamount to admittance to an exclusive club rather than a sentence to years of debt. In short, SoFi had performed something of a miracle from the perspective of pre-crisis financial sensibilities.
SoFi is not alone. It is a member of an industry that in the US began in 2006 with the founding of Prosper and Lending Club, first known as peer-to-peer (P2P) lending, and later as marketplace lending (MPL). While business models vary, the underlying core principles of these lenders are simple: 1) to use technology to make the process of originating loans both more efficient and 2) to create a market where investors (individuals or institutions) can buy loans directly from the originator, without the need of a banking intermediary.
The industry has benefited highly from the post-crisis financial environment. Years of near-zero rates and ever-stricter banking regulation made it harder and less profitable for banks to give loans, and increasingly necessary for institutional investors to find an alternative to traditional fixed income investments. MPL’s stepped in to fill the gap.
Fast forward to 2017. Next month, LendIt will hold its annual conference on lending and fintech (on March 6–7 in the Jacob Javits Center in Manhattan), and I cannot think of a better time to reflect on the state of the industry today and give some thoughts on where we are going from here. To help me in this endeavor, I had the opportunity to chat with Jason Jones, industry veteran and Co-Founder of the LendIt conference, and Karan Mehta, the Head of Capital Markets at Marlette Funding, one of the most innovative lenders in the space.
MPL is now host to a variety of models. While there are many permutations, we can organize MPL into two main dimensions: size and source of capital. In terms of the former, Jones refers to the most established of these as “banks built on tech,” examples of which are SoFi and Lending Club. These businesses have since grown by building out the verticals in which they participate (e.g. mortgages and investment advice). Today, SoFi doesn’t just do student loans — it gives personal loans and mortgages, helps you find a job if you become unemployed, and even holds dating events for its “members.” In short, these larger lenders aim to own the relationship with the consumer across all financial services. One of their core strengths lies in their scale and, as Jones opined, “you need to scale to make it work” within MPL.
This is not the only perspective, however. On the other end of the size spectrum there are companies such as Mehta’s Marlette Funding. In contrast with the ~$22.6bln of origination by Lending Club (as of Q4 2016), Marlette has originated over $2.5bln through its Best Egg platform. While such businesses do not have the customer base of their larger cousins, the small size can be an asset rather than a liability. Smaller scale allows a more targeted approach by borrower demographic and the ability to maintain high quality origination pipelines in niche markets. Further, a smaller pipeline can be less demanding should capital become scarce; it is much easier to raise $500mm through whole loan sales or securitization than $5bln. As far expanding to other verticals, there is as reason that “auto lenders don’t give mortgages,” Mehta says. “You don’t need to be full service.”
We see similar divergence in the models for capital structure. On one end of the spectrum lies companies such as OnDeck (which specializes in small business lending), that apply their own balance sheets to originate loans, focusing on risk-adjusted yield to drive revenue. The ultimate source of this capital can range from venture capital, in the case of early stage operations, to bank warehouse lines to achieve incremental leverage, to securitization.
On the other end of the spectrum lie the true P2P and MPL models, such as Lending Club and Prosper. These companies do not retain any risk, selling loan production directly to investors, who may further lever them through warehouse lines or securitization. These companies rely on origination and servicing fees for their revenues. The trouble with such models is the reliance on fickle institutional investors, who in turn have a healthy distrust for loan originators with “no skin in the game.” Such an issue came to the fore in the May 2016 Lending Club scandal, which resulted in the departure of founder and CEO Renaud Laplanche.
The goldilocks between these two is the so-called “hybrid model.” In this model, originators both sell loans to investors and retain some risk on balance sheet. Such a model “provides ballast,” according to Mehta, to lending businesses for two reasons. First, it aligns the originators’ incentives with the investors’, giving the latter more confidence in the product. Second, it provides a mechanism through which lenders can survive periods of capital scarcity and invest in loans when they believe they are undervalued by the market. Mehta’s Marlette funding uses a hybrid model, and last year SoFi introduced a fund through which they can invest up to $4bln of its own capital. Each of these models has its own benefits. A whole loan model has allowed businesses such as Lending Club to achieve huge scale quickly, both in terms of customer acquisition and loan origination, but the balance sheet and hybrid models provide protection in a number of downside scenarios.
However, several risks pose a major threat to the continued success of of MPL. First, MPL grew up in an age of historically low interest rates, and as yet has been untested by a higher rate environment and the increased competition from traditional banks that may accompany it. Diversification through the integration of verticals and a focus on the consumer experience (i.e. better customer acquisition and retention) may mitigate this, but not entirely. Second, while the overall lending universe is titanic, there is a finite number of high-quality borrowers that most institutional investors are interested in.
If this supply becomes exhausted, originators may begin tapping into more levered borrowers who may be more susceptible to economic shocks, resulting in deteriorating credit performance. The industry is particularly susceptible to this risk as it remains untested by recession, which may expose holes in underwriting. Third, the future of the regulatory landscape is uncertain, particularly in the new Trump era. Deregulation of banks (e.g. roll-back of Dodd-Frank) or new regulation pertaining to the originators themselves may jeopardize the business.
These risks aside, there is reason to be optimistic about the future of MPL. While the focus of this piece has been on the US, the vast majority of the world remains underbanked, and MPL is already making forays into markets in India and Africa. Even within the US, MPL businesses can grow the pie of unsecured consumer lending (still small compared to traditional consumer debt) and continue expanding into other verticals. Improving customer experience and becoming an increasingly integral part of consumers’ financial lifecycle is also likely to remain a key focus for the foreseeable future. Ultimately, as Jones put it, “being a better bank” is here to stay.