“What is even more exciting is the potential of where we are headed. I feel that our competitive advantage compared to traditional banks is really long lasting because, again, it is grounded in technology and cost, not something they can react to."
· Renaud Laplanche, Former CEO of Lending Club, in a 2013 interview
Those were the good old days of Lending Club, a Silicon Valley darling that was the next big thing in lending. Those big banking dinosaurs that were still reeling from the financial crisis were the target that hundreds of millions of investor dollars were focused on, intent on putting the JPMorgan Chases out to pasture, just like Netflix did to Blockbuster. Lending Club was the poster child of that alt lending movement.
“The kinds of people who come to work at Lending Club are those who say, “I want to transform the banking industry. I want to create something new and innovative.” With a very different talent pool you end up with a very different outcome,” Laplanche noted — a statement that did turn out to be accurate, though in a somewhat different way than he may have initially expected.
Put a pin in that for just a moment.
Laplanche, as LendingClub’s founder and CEO, was bullish on the future of alternative lending in the new online marketplaces. He was far from alone. Even Jamie Dimon wrote in a 2014 letter to investors of the danger online lenders posed, a new class of innovator that was coming to “eat our lunch.”
And for at least two years, it seemed that one could not read a collection of payments headlines without coming upon another account of another marketplace lender bringing in another heap of cash by willing investors trying to prove Mr. Dimon correct.
Today — in the wake of Laplanche’s rapid ouster at the hands of his board — after an internal investigation turned up a string of unnerving revelations, the narrative around marketplace lending is very different. And rather worrisome.
“I think it is fair to say, that they believed the platform had built the a better mousetrap and priced risk very differently thant the existing issuers of consumer credit were pricing it. The assumption was they were going to be better at underwriting the risk of those consumers.” Continental Advosor’s Paul Purcell told PYMNTs in an interview shortly after the news broke.
“If that doesn’t play out, you could see a pretty nasty turn of events because you can mask deterioration of credit, especially if you're growing at the rates these guys were growing. But if you stop or start shrinking, it is a whole different game and could be the beginning of a very rough patch should credit turn .”
Or as we like to say, network effects in reverse.
With the recent hits all of the big names in marketplace lending have hit lately, it seems that better mousetrap isn’t doing as well as expected. But more worrisome, notes Purcell, is that yesterday’s revelations around Lending Club — and its founding CEO’s rapid disappearing act — and what it will mean as these businesses attempt to operate going forward.
Though the events of the last several weeks in general, and the last 24 hours in particular, have certainly sent the wires to buzzing, the reality is that the skeptical drumbeat has been building around the miracle of marketplace lending for some time.
Karen Webster noted in a commentary in February, before the high-speed train had careened off the tracks, that marketplace lenders had grown fast because they were fueled by some unusual and unusually ideal market conditions that uniquely benefited their business model. The problem? Those conditions were not well set to last, and the marketplace lenders were likely not built to last without them.
“The marketplace lending model is designed to offload the most pernicious risk in the lending business – credit risk – to the investors who buy the loans from them. And, when all works well – e.g. the credit underwriting is spot on, borrowers repay their loans as promised and capital is plentiful – everyone makes money and the happy and virtuous circle of platforms works well,” Webster said.
Party hats? Not quite — you see this model only works when things remain ideal. As in Lending Club guesses right on lender reliability, and borrowers default less than expected life is grand. But when that happens in reverse and/or Lending Club has to lend to riskier borrowers at higher interest rates to keep investors also getting a higher rate of return on those investments, well, things start to wobble. Borrowers default, investors are left holding the bag, and they decide not to invest anymore. And Lending Club has no money to lend to borrowers.
Network effects in reverse.
“No investor money means no ability for marketplace lenders to acquire new customers since they have no other access to capital to extend credit to borrowers. Unlike banks, marketplace lenders don’t have deposits on hand that can be turned into loans. And since they don’t have the loans on their books and the repayments from those loans to turn into capital to lend either, without investor capital, there’s simply no capital,” she said.
And that is where things go very, very wrong — because that nimbleness, that “not being a bank” comes home to roost — and suddenly that marketplace lender's greatest strength becomes its greatest weakness.
“Pesky little things those deposits can be that fund loans,” Purcell noted. “Go all the way back to George Bailey trying to withstand the run on his savings and loan. Take a dollar in and lend it out (many times over) – that is a zero cost deposit or a very low cost deposit for an institution. These marketplace entities never had that and as much as people want to change the mechanism of modern financial operations it doesn't always play the way it looks like it should on paper.”
And that inherent structural difficulty is only part of the problem, notes Purcell. There are also the more esoteric difficulties that the Lending Club announcements point to as well.
Lending Club’s Troubling Internal Audit
“I don’t think anyone with straight face on Friday afternoon would have predicted Renaud's resignation today,” Purcell noted of the first headline announcement on the day. And also, possibly an unsusualy tough one for the already embattled marketplace lending sector, given Laplanche’ status within it.
“It is obviously bad when you lose that lighthouse individual that really helps stand up a new group of operators. But if you look at the cycle, it is rare that those individuals stay at the top of the stack.”
Still, the specific issues turned up in the internal investigation are certainly giving investors segment-wide pause.
The first big reveal of the day was allegations that Lending Club and some of its officers and/or directors violated a specific section of the Securities Exchange Act after the company sold an investor $22 million worth of sub-prime loans that were linked to consumers with poor credit scores. This practice, reportedly, violated the specific instructions from that investor.
The board’s investigation - which included outside legal experts - determined that there were employees at Lending Club who allowed this sale, even though they knew the sale did not meet the terms of what the investor expected. Furthermore, there are reports that the date on the loans were tampered with to ensure they were within compliance requirements.
In that instance it is not clear in Laplanche had direct knowledge of the sale or the compliance violations.
A second issue also turned up in the independent audit that indicates that Laplanche guided Lending Club’s board and Risk Team toward the firm's purchase of a 15 percent limited-partnership interest in Cirrix this year for $10 million last year - without disclosing that he himself is an investor in the firm - as is LendingClub board member (and former Morgan Stanley CEO) John Mack.
Cirrix invests in online marketplace loans, including those from Lending Club. Collectively, Mack and Laplanche own 31 percent of Cirrix.
“Fixing these problems isn’t going to be easy,” Purcell noted. “This is a probably a very fine example of how these emerging companies don’t have the compliance and control environments necessary to operate in these markets.”
The SEC is also reportedly gearing up to investigate the Cirrix investment.
Though Lending Club’s issues today are clearly pretty specific to their internal workings, it’s not as if the outlook for the other players in the space is all wine and roses either. OnDeck's model is different but its stock price is taking a beating too – losing 68 percent of its market value since the IPO. It’s keeping Lending Club company in the sub-$5.00 stock price category. Prosper isn’t publicly traded but last week announced that it was cutting 28 percent of its staff, amidst a slowing demand for loans, due to a slowing spigot of capital.
None of these things represent good news to come in the segment, Purcell notes.
“I’m not surprised that these entities are having trouble - I am surprised at the speed of the unraveling and that speed is what should have people very concerned. It can make one really worry that credit could be the next shoe to drop.”
Because as the credit markets are tightening - and the virtuous circle is becoming the vicious one Karen Webster described in February - change is going to have to come to marketplace lenders.
And it will not be a change they can all survive.
“What I think will happen is that many of the private companies will all disappear,,” Purcell said. “Many of the funds that have been deploying capital haven’t retrenched fully and at this point are probably going to continue to retrench.”
“The challenge for the industry at that point will be to find a different funding mechanism for originating these products or loans. If that is not possible then they have a serious problem, if it is, then the cost of doing such will have to be balanced with what they can pass on to the consumer or small businesses.
Are marketplace lenders willing to make that change - and even if they are will they be able to?
We have a feeling there will be much to talk about as this moves forward.