Technologies will emancipate long-term investors from high-cost intermediaries. I’m convinced of this fact, and I think it is particularly true in the domain of credit, where peer-to-peer platforms offer scalable direct investment opportunities of high quality. These new(ish) platforms, which are powered by robust technical risk engines, will challenge a plethora of finance industries and products, from auto loans and credit cards to mortgages and property loans. The future, I believe, is bright, which is why I’ve been evangelizing the P2P space to my friends down on the Avenue of Giants.
Given my cheerleading, you can imagine the tone of my in-box upon the news that Moody’s Investors Service placed three P2P bonds on a downgrade watch list after it was discovered that the debt underpinning the bonds was being repaid slower than expected. Was it wrong of me to suggest to investors that they should be looking at these platforms as replacements for overpriced managers? Is this the beginning of a negative downturn that will severely damage the P2P industry?
Nah. The marketplace lending world is, for the most part, doing well. To be sure, there’s a growing amount of bundling happening, which gives everybody flashbacks to the subprime meltdown and fears of having to watch Brad Pitt and Christian Bale act like a couple of nerds again. Deep breaths. Unicorns don’t exist in the real world, and, sorry to say, neither do the fairy tales some people (see: venture capitalists) were telling about the P2P space. The low rates, low volatility and infinite venture funding were never going to stick around forever.
So, allow me to dispel — with some brain augmentation from friend of the show and credit guru Perry Rahbar — some myths driving the current anxiety over marketplace platforms. We will, however, replace your unfounded fears with some actual scary things to be worried about. Sound good?
Let’s start with things you should not be worried about:
Write-offs. In the credit business, just like on bumper stickers, write-offs happen. That’s part of the business and should be baked into price. There’s no doubt that there are some problems with write-offs (also known as charge-offs), but the problems aren’t as bad as Moody’s is making out. In fact, for investors, any uptick in charge-offs has been met with better returns because some of the larger players, such as Prosper and Lending Club, are now selling their charge-offs in bulk for 10 to 14 cents on the dollar, which is much better than the 0- to 1-cent recoveries from collections previously. This should be taken as a sign of their maturation and growth as servicers — that is, a good sign.
Pricing. People are worried about securitization pricing, but the first quarter of this year beat up credit markets globally, and particularly structured products like commercial mortgage-backed securities and collateralized loan obligations. So that’s not unique to marketplace lending securitizations. The problem is that these platforms have not yet figured out how to dynamically alter their loan rates, which is — to be blunt — crazy. If they had more pricing flexibility, the securitizations wouldn’t be as troublesome. If execution via securitization is variable, pricing cannot be fixed. Pricing has to be a dynamic process that gives lenders the ability to effectively account for changes in fundamentals (loan risk) and technicals (market risk). The capital markets get this, but the P2P and marketplace crowds don’t. That means some education is needed.
Those are the things that financial media are saying we should worry about. Don’t. Neither of these is an existential risk facing P2P. But let us now give you some things you should be worried about, as the growing number of lenders and origination volumes in an unregulated, nonstandardized and increasingly niche space is enough to give any investor pause. (Parents: You may want to have the children leave the room.)
Real Money. Marketplace lenders haven’t yet cracked the real-money problem. They need to attract larger pools of lower cost funding, such as insurance companies, pensions and endowments. Yet, despite Ashby’s pressure, they haven’t done it. The only platform we’ve identified that has a real-money backer is Earnest, which has a partnership with New York Life. Whether this lack of interest is a regulatory thing, an educational thing or a combination of the above factors, online lenders need to make attracting long-term investors a priority. Why? Because they have to wean themselves off any dependence on hedge fund money, which can disappear quickly and often comes with a variety of negative incentives. Also, many platforms will fail because they don’t have secure funding, and quarters like this past one are sure to end a lot of companies in the future. There’s nothing wrong with that; in fact, it’s probably a healthy thing since there are way too many of them.
Standardization. One of the main forces behind the financial crisis was a lack of transparency in the consumer and mortgage lending markets. No one understood how bad things were because nobody knew what was going on. Oddly, the P2P space, when it comes to securitization, has been far more opaque than you would imagine, given that technology platforms are generally associated with more transparency and efficiency, not less. The market is saturated with countless lenders, originating niche loans across various asset classes and without common conventions around servicing and data reporting. Loans are then packaged into securitizations by different banks, all of which have different processes and views on how to bring deals to market. This creates complexity for investors and makes owning loan assets more difficult. Why is this bad? Because in a challenging market, liquidity for these assets will evaporate as a lack of transparency makes it hard for investors to differentiate between good and bad. Part of the reason the Moody’s downgrade had such a huge impact is that it’s not easy to know what’s inside that one deal versus all the other deals done off Prosper loans by different underwriters. Most of the problems we’re seeing in P2P boil down to a lack of data standardization. This is ironic because we’ve spent the past five years meeting with start-ups in Silicon Valley trying to help Wall Street figure out how to do data. But now — please pass Ashby a serving of crow — Wall Street is having to educate Silicon Valley on how to do data in the credit space. And that’s required, because without standardization it’ll be very hard to scale and mature the industry.
In sum, marketplace lenders are having some growing pains. This is natural. Consider how nascent this industry really is: The entire P2P space represents only about $40 billion out of a $12 trillion lending marketplace; that’s one third of 1 percent. Whatever is happening now is not a big problem. What is, however, is that we’re not putting the infrastructure in place to position this aligned and creatively destructive technology on a path to success. Without transparency, data standardization and long-term investment capital, we’re not making the lending capital markets any better in 2016 than they were in 2007.
We need a new, modern infrastructure for the loans, and it can start in the P2P space. In our experience, however, the best fintech platforms maintain harmony between the technology and finance industries. The recent woes of P2P platforms are a useful reminder of this fact.
Co-authored by Perry Rahbar, CEO of dv01, a marketplace lending analytics company.
