In the early days of online lending, the big appeal was access to funds for potential borrowers with few, if any, options for securing capital.
Now, the tech-driven underwriting models that promised to assess risk more accurately, and extend credit more efficiently, may be confirmation that traditional risk and lending business models may have more going for them than their new, FinTech challengers once thought.
The Coming Risk Assessment Reset
According to recent reports, some of the largest marketplace lending players in the field — SoFi, LendingClub, Avant, Prosper — are being pushed by their investors to batten down their credit hatches and demand better credit scores from their borrowers, as well as shorter maturities so they can make more attractive offerings to investors as they look to repackage those loans into asset-backed securities.
The move comes in the face of growing evidence that the loans they have sold and secured have not quite performed up to par. The wave of borrower defaults has forced many such platforms to pivot toward a quality borrower-focused future.
“They all had a pretty tough time and took losses a lot more than expected,” said Henry Song, a portfolio manager at Diamond Hill Capital Management Inc. “Some dropped certain grades, and the mentality of grabbing market share to be profitable has shifted.”
Some of the trouble, Bill Kassul — a principal at Ranger Capital Group in Dallas — told Bloomberg in an interview, is that the marketplace consumer lenders are all essentially trawling in the same waters, looking for millennial borrowers who are comfortable with borrowing online and have been traditionally underserved. Of late, it seems they have also added the criteria: must be at least somewhat likely to pay back their loan.
The problem, according to Kassul, is that, since everyone is running after the same, rather thin slice of the customer pie, the firms ended up in a race to the bottom, which ended with some unsustainable results. Kassul noted his firm used to invest in ABS from the lending marketplaces but, eventually, there just wasn’t enough profit in it.
“Yields were going down, a lot of that was due to competition. They were lowering rates just to stay competitive with each other,” he said.
Pushing For Quality
Realizing that the race to the bottom isn’t a competition that can be won, it seems the marketplace lenders are being forced to take on a new strategy, according to Kroll Bond Rating Agency (KBRA). This, in turn, has led to firms raising their rates, turning back lower credit consumers and shortening the terms of their loans.
Rosemary Kelley, a senior managing director at KBRA, said in an interview, “We have seen many of the platforms tightening their underwriting or essentially eliminating certain segments. They are changing certain criteria in order to move up-tier somewhat in terms of the credit that they’re taking.”
According to KBRA, the number of asset-backed securities issues by online lenders, that saw performance triggers activated by missed payments, declined last year. As that falloff occurred, total loan losses rose, which signaled an increase in overall quality in the securities, according to KBRA.
That experience echoes among at least some lenders that say their risk profile has changed quite a bit over the last few quarters.
According to KBRA, the weighted average of FICO credit scores of Prosper’s loans, packaged in ABS, increased to 717 in a March 2018 deal from 704 in a sale two years earlier. And they weren’t the only lender to see its average score go up — SoFi, increased the weighted average of its FICO credit scores to 744 in a sale earlier this year from 732 in a deal at the start of last year.
LendingClub had no new figures to offer, but Jessie Szymanski, senior director of LendingClub, told Bloomberg in a phone interview that it has been eliminating the riskiest borrowers in its loan offerings.
“Investors are changing their behavior on the margin and tending to gravitate toward higher-quality, lower-risk grades,” she said.
With a new paradigm in mind, most experts expect that more securitized loans are coming — "the sector is expected to increase the amount of loans it turns into securities by 29 percent from a year earlier to $18 billion this year, according to New York-based research firm PeerIQ."
Will those securities pay?
Tracy Chen, a Philadelphia-based portfolio manager at Brandywine Global Investment Management, says her firm isn’t ready to bet on securities from the segment yet because it has not yet functioned all the way through a boom-and-bust cycle. They know how these firms did in a boom but “this market hasn’t gone through a credit crisis, so it’s hard to find conviction of how it will perform,” Chen said.
Plus, these firms are already pushing fairly deep into prime credit today. It remains to be seen who they could expand their lending to — if a credit crunch occurs.