For online lending to regain its footing, it must address the risks inherent in the emerging asset class and clean up the ecosystem.
Online lending had enjoyed significant wind in its sails over the past five years. Aided by the post-Great Recession healing of the credit cycle, lenders were able to originate increasing but limited volumes of loans that provided much needed yield to investors. Along the way, a myth developed that online lending could grow infinitely, stealing business away from big banks while providing investors with the Holy Grail of investing – high returns and minimal risk.
With traditional fixed income yields reaching unpalatable levels across the globe, investors piled in, giving online lenders the capacity to grow at breakneck speed. This growth came to a screeching halt earlier this year, as a combination of deteriorating performance and corporate governance issues came to light. While Lending Club’s management issues grabbed the headlines, the real devil is in the performance details. It turns out that as online lending volumes increased, so did the problems.
Competition for borrowers pushed lenders to lower rates and increase capacity more quickly than their models could handle. Defaults rose and returns fell accordingly – and that was during a relatively strong point in the credit cycle. It is safe to say the online lending myth has been debunked, or at least been brought back to reality.
While there are plenty of opinions about how to save this nascent industry, few of them focus on the most important issue – developing a deeper understanding of the risks inherent in online lending. To evolve as an asset class, lenders and investors need to take a close look at the lessons learned and turn them into the building blocks for the future.
The beginning of this evolution is straightforward. Online lending should be treated like any other investment, with the acknowledgement that with return comes risk. The return profile is attractive, with loans carrying high coupons and low levels of exposure to interest rates – but it is not riskless. The risks are difficult to predict, which suggests that there are going to be highly variable outcomes. For example, a 1% rise or fall in the unemployment rate will have a meaningful impact on defaults. Accordingly, there are levels of economic distress for which lending portfolios will have a negative return. Instead of approaching the concept of loss as anathema, a deeper understanding of the environment in which negative returns occur will enhance investor confidence in the space.
New analytical tools will need to be created to compare different loans across originators, allowing investors to do independent assessment of the risks involved. It is not enough to trust the estimate of the originator, who clearly has a bias to overestimate return and downplay risk to attract capital. This is especially true for loans that are extended to traditionally underbanked borrowers where losses are more difficult to model.
Beyond risk assessment, investors must demand clarity between the role played by the lender as loan originator, and the investor as fiduciary. Many online lenders do not keep the risk of their loans on balance sheet – they get paid an origination fee and sell the loans to others. This style of loan origination creates value for shareholders by maximizing the volume of loans originated, not from the ultimate performance of the loans.
Some of these lenders have raised private funds which exclusively buy loans from their own platform. The inherent conflict is that the lender cannot fulfill its fiduciary duty of maximizing loan volume while also being a fiduciary to a loan buyer demanding maximization of return. It is difficult to imagine the investment arm of a lender refusing to buy its own loans because of deteriorating underwriting standards. Trust issues caused by these fiduciary conflicts will slow the growth of the industry.
Online lending has accomplished some noteworthy things in its brief history. Increased competition has led to lower rates and faster approval times for borrowers. Advancements in quantitative underwriting techniques have allowed lenders to reach borrowers across the quality spectrum in a variety of products.
If the online lending ecosystem can evolve, it has the potential to grow into a meaningful asset class. In the age of the hyper-regulated mega bank, there is a real need to open up credit markets to small-balance borrowers. Combine this with investor need for yield, and all the building blocks are in place. Online lenders have not “solved” the lending problem – lending is a challenging business and losses will still happen. Facilitating an open and honest discussion around risk and drawing clear lines between lender and fiduciary will bring back investor confidence and help online lending develop into its next phase.