Learning From Online Lending’s Stumble
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.
Marketplace Lending’s “Hobson’s Choice” Problem and the Need for Fiduciaries
The marketplace lending landscape has been changing rapidly over the past few months and I’ve been quite vocal that this is a great opportunity to allocate capital into loan investments. The more I think about the landscape, the more excited I get. Based on Prosper’s most recent estimates, the loans that they originate after April of 2016 will have over one-percent higher returns than their 2015 vintage. My guess is that the performance differential will be even greater, as the pressure on the marketplace lenders to perform is only increasing. While the opportunity set has become more attractive, it does not mean that gathering loans blindly is a good strategy. Lenders, no matter how careful, are going to make loans that default. Part of this is simple – no lending model is perfect. Beyond that, there are forces well beyond a lender’s purview, such as broad economic forces that change the landscape faster than their models can adjust. There is a wide gap between being a lender and being a fiduciary to those buying loans. The lender guarantees that the loans that they issue fit a certain set of criteria — a FICO band, for example. From there, they distribute … Continue reading
Podcast: Lend Academy
Podcast 65: Brian Weinstein of Blue Elephant The Chief Investment Officer of Blue Elephant Capital shares his thoughts on the industry in the context of recent events. Full transcript Below: Podcast Transcription Session 65 : BRIAN WEINSTEIN Welcome to the Lend Academy Podcast, Episode No. 65. This is your host, Peter Renton, Founder of Lend Academy. (music) Peter Renton: Today on the show, I am delighted to welcome Brian Weinstein. He is the CIO, the Chief Investment Officer, at Blue Elephant Capital as well as a Co-Founder. Blue Elephant has been around for a little while, they have been investing in this space, they are an investment management firm totally focused on the lending space. Brian has a fascinating background coming out of BlackRock for many years and I wanted to get him on the show to talk about what he is hearing from investors and also his perspective on the news and how he feels this is going to impact his business and the industry going forward. It was a fascinating interview. I hope you enjoy the show! Welcome to the podcast, Brian. Brian Weinstein: Thanks, Peter, thanks for having me. Peter: Okay, let’s just start by giving the … Continue reading
My Take on the Lending Club News
I’m sure everyone has seen the Lending Club news and read the articles about how badly the equity has done. I thought it was important to send out a note highlighting that there has been a major change in the investing environment in favor of loan investors like Blue Elephant. Anyone who has followed the Elephant is aware that we’d become cautious on marketplace lending. We haven’t made a meaningful marketplace consumer loan investment since September of last year. It seemed to us that the alignment of interest was skewed against us, as the platforms were focused on growth instead of loan quality. Lower rates and weaker underwriting is a clear recipe for lower returns. Turns out, we were correct in that view. Our returns have been lower over the past two quarters partially because we’ve cut risk and partially because the loans we purchased in the middle of last year have not performed as well as we expected. The loans issued later in the year that we did not buy will have even weaker performance. Before the Lending Club news, the environment had already started to turn in favor of loan investors. Lending Club has raised rates three times … Continue reading
Staying Focused on High-Quality Lending
Given the recent headlines regarding the struggles in performance of Lending Club’s models, I wanted to revisit some of our closely-held views on loan investing. Over the last two years, I have been focused on two major themes – both of which were met with a lot of skepticism. First, I was convinced that we were mid-to-late in the economic cycle, meaning that economic weakness was more likely than explosive growth. While the Fed managed to sneak in a rate hike, the capital markets have spoken and most investors are starting to believe that the cycle is turning. The second belief, connected in many ways for the first, was that marketplace lenders would overextend themselves, making too many risky loans at low yields. The Lending Club article confirms what we have been telling our investors for months – stay focused on high-quality lending. The first decision we made when looking at emerging lenders was that investing in high quality loans was likely to provide better returns than equity. Venture capital firms had already driven up the valuations of “marketplace lenders” to levels at which we couldn’t realize return on an annual basis like we could from investing in the loans. … Continue reading