As the marketplace lending arena continues to grow, one of the most common critiques is that many of the emerging players have no ‘skin’ in the game. In other words, most of the originators get paid to make loans but are not in the business of retaining any of the risk pertaining to those loans. Taken even further, the implication is that given an infinite amount of costless capital, these institutions would make loans at any price simply to maximize their underwriting and servicing fees.
Let’s break down this argument into a few key questions.
1) Do marketplace lenders have an adverse selection incentive?
We think the answer here is a pretty clear ‘no’, at least for now. While the space is hot and valuations on the equity side are high, any significant deterioration in default rates would destroy these businesses. The most obvious evidence of this to us is that the major platforms have resisted to urge to sharply lower borrowing rates, even though the demand for product at this point is extreme. Theoretically, the lenders could lower their loan rates and lower the borrower quality at the same time to increase origination volume. While this would increase their origination at first, the risk would be that investors pull their capital in response. Over time, there is risk of quality drift as borrowers become more difficult to source, but we do not see that problem in today’s market.
2) Are investors making different decisions knowing that underwriters have no skin-in the game?
We cannot speak for all investors on this point, but our answer is an emphatic ‘yes.’ We trust the underwriting ability of our partners – as I’ve written before, absent that fact we wouldn’t fund their loans no matter how strong their data mining capabilities were. That said, we are very much aware of where the data has the better track record – which in our view is the higher FICO borrower. Our fund has an average FICO of around 720 – which is higher than any other portfolio we’ve seen in the space. Why are we sacrificing income to achieve this higher quality? We think it is much harder to understand the future default rates in the higher risk buckets, and that there are specialty lenders with longer history in those buckets with more significant datasets. Sure, some of these specialty lenders retain risk, but it is really their handle on the data that makes them attractive to us. The overarching point here is that it is up to the investor to determine where to draw the line – risk retention may move the line one way or the other, but it isn’t the driving factor behind investment strategy or returns.
3) Does a lack of risk retention increase the likelihood of a financial accident in the marketplace lending arena?
As securitization heats up and we get closer and closer to rated transactions, we’ll go with “eventually, but not now,” as the answer. We are close enough to the financial crisis that originators, investors and rating agencies have a strong incentive to be conservative in this emerging space. We’d point out that some current and emerging marketplace-lenders do retain risk, and that investors could direct their capital to these platforms if they considered it to be critical. It is important to remember that this space is new and much remains to be finalized. Our guess would be that risk retention becomes more standard as platforms grow and mature through credit cycles. For now, investors have a pretty full look at the data underlying the origination, and we do not think any should claim to be surprised by the risk they are taking when the cycle turns.
This question should and will continue to be asked by all players involved in marketplace lending. It is a healthy conversation because it reminds us that no matter what vehicle we choose, achieving investment returns involves risk. We must ensure that our investors are being compensated for the risk that they are taking and believe that the majority of marketplace lending platforms are doing their jobs well. However, as the space becomes more competitive, so must our scrutiny.