One of the frequently touted benefits of peer to peer/marketplace lending is the heightened transparency associated with loan originations processed online. The financial crisis of the last decade was in part fueled by the disconnect between lender and borrower. As mortgages were securitized, sliced and diced, a gap grew between investors expectations and affiliated risk. Investors, including many banks, too frequently had little comprehension of what exactly they were purchasing. When the music stopped an asset spiral kicked in, and the rest is history (so we all hope).
Peer to peer lending, as originally conceived, is starkly different. Simply put, multiple investors fund a single loan with each benefiting from the interest paid back by the borrower. If a borrower defaults on a loan, each investor shares in the loss. The originating platform shoulders little of this risk. Thus systemic peril is diluted.
Today, many online lenders are providing credit from their own balance sheet or doing hybrid lending, perhaps using retail and institutional money. So in some respects, online lending is becoming less transparent than the early days, but these multiple capital channels are helping to propel sector growth. Arguably this added complexity comes with solid benefits and additional cost.
At Lendit Europe this past October, Lord Adair Turner, the former Chair of the FSA (predecessor to the FCA), asked the question if direct lending will make the financial system more stable? His answer: “it might.”
To accomplish this goal, Lord Turner said;
“The answer is keep it simple, and keep it transparent.”
With these words in mind, Crowdfund Insider started to ask around if online lending could possibly address the systemic weaknesses engendered by the complexity of debt markets during the Great Recession. One person suggested we speak to Frank Rotman because he was the “smartest person they knew” in the online lending sector.
Rotman earned his stripes at Capital One and is considered an expert in credit risk and portfolio management. Today he is the founding partner of QED Investors, an investment firm with stakes in Prosper, Avant, SoFi CAN Capital, etc. Pretty much, the gangs all there. So he knows his stuff. While Rotman cautioned that there is a difference between the past and present because regulators have hammered the banking industry, he shared some unique insight.
Asked if the distributed model of online lending is superior, regarding systemic risk, Rotman explained there is no obvious conclusion. This is because execution will always trump structure;
“Every originator and every lender have their own product structures and credit policies. They find ways of originating demand and then say ‘yes’ to some of the applicants. Saying yes to the right customers using the right policies and products should result in a very resilient portfolio of loans regardless of whether you’re holding the loans or selling them downstream.”
But what about the leverage banks utilize to make the loans? In pure P2P, there is may be limited leverage – something that may reduce returns but can also mitigate risk;
“One truth that’s worth noting is that leverage creates risk,” says Rotman. “It was common practice 10 years ago for a Bank to hold very little capital against loans. In the case of unsecured personal loans, holding 6%-10% equity against a portfolio wasn’t uncommon. This meant that a portfolio that generated a 1-2% ROA produced above hurdle rate ROEs. This also meant that small shifts upwards in losses had a dramatic impact on the profitability of the portfolio which we witnessed in the 2008-2009 period. Today Banks have to hold much more equity which reduces leverage, but they still are more levered than the players in the distributed model space.”
Rotman is not overly enthusiastic about banks these days. He believes they resemble utilities. Banks must hold higher levels of capital and endure steep overhead costs that are offset with products with a low ROA. All in an attempt to achieve a low return on equity. The positive to all of this is that a bank can survive if profits fall to zero. For online lenders it’s different, “…zero for marketplace lenders is bad and negative ROA is toxic.”
“If you really want to simplify things, almost every marketplace lender is really just a specialty originations company that structures cash flows backed by loans for people who want to buy them,” explains Rotman. “Many of these originators represent themselves as tech companies, but in reality, they will live and die based on how well they structure cash flows more so than the tech behind the scenes. Structured finance first. Tech second.”
Recently the most prominent investment banking firm in the world jumped into the online lending space. Goldman Sachs came out with their own consumer credit provider in the form of online lender Marcus backed by the purchase of a retail bank. Rotman calls Goldman “interesting.”
“They think they can do everything that the marketplace lenders do with the added benefit of having bought a very large deposit base. On paper, it all makes sense but like most things in life the devil is in the details.”
So is Goldman the one online lender to rule them all? Walking the line between disruptive Fintech lender and traditional retail bank? Rotman has his doubts;
“You have to ask the important questions. Does Goldman have enough consumer DNA? Can they hire the right people? Can they ship code? Can they keep up with the pace of innovation in the market? No one knows but we’ll all find out soon!”