Online Lending Hitting A Rough Patch by PitchBook
While consumers and business owners quickly saw the internet as a convenient way to monitor their finances, it took several decades for the option of entirely bypassing brick and mortar banks to materialize. E-Loan, founded in 1997, offered an online platform for consumers to compare loan terms across multiple lenders while slashing broker fees; for a time the company also offered direct origination mortgages, as well as CDs. The platform popularized consumer access to FICO scores, a then-opaque metric used by banks as a standardized measure of creditworthiness. Wall Street’s voracious pre-crisis appetite for mortgage-backed securities prompted investment banks to turn to nonbank originators for loans to securitize. Though not all of these entities operated online, non-banks accounted for over 30% of all residential mortgages in the years immediately preceding the financial crisis. Quicken Loans became the market leader among non-bank originators by offering mortgages and lending products through an online portal.
Other than aggregation of mortgage originators and credit card issuers, online platforms for lending directly did not take off until after the financial crisis. The downturn not only caused material losses from certain credit instruments, but the monetary policy response of slashing interest rates to the zero bound reduced the future expected returns in fixed income portfolios. Retail investors’ newfound distrust in financial institutions further bolstered the conditions for unproven investment platforms to attract interest. While VC-backed Prosper pioneered peer-to-peer lending in 2006, it took until after the crisis for retail investors to trust online platforms.
A wave of upstarts began to facilitate direct investments by retail investors in slices of online-originated loans in amounts as low as $25. There was ample opportunity to profit from compressing the spread between borrowing and lending. Renaud Laplanche became inspired to found Lending Club after realizing that his credit card would charge him 18% interest while he earned less than 1% on his savings account. Prosper and later Lending Club and others experienced exponential growth when many early retail investors in peer-to-peer reported solid doubledigit returns. Subsequently, an entire ecosystem developed around peerto-peer lending, providing reporting, analytics and secondary markets. This attracted the interest of institutions that wanted to leverage their resources to generate outsized returns in the asset class.
Basic Business Models
The new wave of online lenders emerged initially under two distinct business models: balance sheet lenders and marketplace lenders. In addition to the use of novel technology, both business models rely on non-deposit funding. Marketplace lenders continue to evolve as peer-to-peer scales beyond what retail investors can support, pushing platforms to increasingly solicit institutional capital. These companies match buyers and sellers while minimizing their own balance sheet risk. Revenue comes from the collection of an up-front origination fee, as well as a servicing fee throughout the duration of the loan. These deals come with lower margin per loan, thus requiring substantial need for external investment. A lack of visibility into lending models has caused compression in the spreads these platforms are able to generate in fees due to investor uncertainty. Much of the spread they are able to collect goes toward customer acquisition since a large share of the revenue comes from non-recurring sources. Using the public financials of Lending Club as an example, origination fees average 4.47% per loan, accounting for a whopping 87% of the company’s revenue. Furthermore, expenditures on customer acquisition may not pay off in the long run. The target market of debt consolidation, with the goal of getting totally out of debt, does not lend itself to repeat customers.
Prosper took eight years to issue its first $1 billion in loans, relying overwhelmingly on retail investors. Once it tapped into institutional capital, the company took only six months to issue the second billion. When peer-to-peer lending platforms first emerged, these loans were entirely fractional, i.e. small investments were pooled and lent to a single borrower. In 2012 as the asset class matured and demand increased from institutional investors, Lending Club and Prosper began marketing whole loans to single investors. This has evolved into full-blown securitizations. PeerIQ, a marketplace lending analytics platform focusing on the securitizations market, notes a rapidly increasing average size of securitizations, growing from $64 million to $267 million from 2013 to 2016.
Balance sheet lenders originate loans from their own capital or raise funds from Industrial Lending Corporations (ILCs). One popular ILC is Utah-based WebBank, fully owned by Warren Lichtenstein’s Steel Partner Holdings (NYSE: SPLP). Balance sheet lenders such as Avant or Marlette Funding hold the loans on their balance sheets and collect the net interest margin (NIM) or spread between cost of capital and yield. This strategy brings in greater cashflow to the company over the life of the loan, but comes with risks from charge-offs and defaults, as well as exposure to capital markets. To mitigate duration risk, these players tend to focus on high-interest, short-term loans. These firms serve as banklike financial intermediaries, but without the high-friction cost structures such as the expense of maintaining physical branches.
Most of these emerging online lenders have provided credit to segments directly impacted by post-crisis legislation, which became neglected or mispriced by banking and government institutions. These target markets include consumer unsecured credit, small business lending, student loan refinance and high earning millennials with limited credit history. Further on, we’ll dive into each of these segments and how upstart lending platforms find novel ways to price risk, mitigate defaults and spur much-needed credit creation. These methods include the integration of alternative data sets and analytics, applied behavioral finance and nontraditional repayment schedules.
Market Applications & Segments
Student & Consumer Loans
It’s no secret that rising higher education costs in the US have burdened graduates with boatloads of student debt. According to the Brookings Institution, outstanding federal student loan debt quadrupled between 2000 and 2014 to reach $1.1 trillion. Federal Stafford Loans account for over 90% of outstanding loans and pay a fixed interest rate of 4.66% to all undergrads and 6.21% to graduate students, irrespective of indicators about ability to repay such as the institution attended or degree earned. More than 70% of federal loan defaults are made by borrowers from for-profit institutions such as DeVry or University of Phoenix. Traditional lenders offer private loans at a floating rate spread + LIBOR, typically around 8%.
Online student loan refinancers have focused on regulatory arbitrage of offering better rates to recent grads with strong career prospects but low FICO scores due to limited credit history. These lenders emerged as peer-to-peer lending platforms for alumni of elite institutions such as Wharton and Stanford, to lend directly to current students. SoFi Founder and CEO Mike Cagney refers to the ideal borrowers as HENRYs—high earners not rich yet. These represent the top 5-10% of earners aged 25 to 40 with high free cash flow and the potential to earn more. Student loans are also an ideal clientele since debt-laden digitally savvy millennials prefer operating online.
While all of these lenders have promised to bring banking relationships back to their interpersonal roots, they have also doubled down on increasing the accuracy of predictive analytics. Traditional FICO scores can be misleading for borrowers with limited credit history. Online lenders have augmented traditional credit scoring with alternative datapoints including