Is The Bloom Off The Alt Lending Rose?

Alternative lending is such a part of the mainstream that it’s easy to forget just how fast it has gotten so big.

A decade ago it almost didn’t exist – today it’s billions of dollars in loan volume to tens of millions of consumers and small businesses worldwide, totally changing the face of how lending operates.

And while once considered a niche subsection of financial services, the explosive growth in this alternative to existing lenders has made some very big players sit up and take notice.

JPMorgan Chase CEO Jamie Dimon in his annual April letter to shareholders warned “Silicon Valley is coming,” using a more apocalyptic tone than average for a CEO missive. But, it is quite clear that his concern that mainstream bankers face some painful disruption at the hands of startup innovators is quite acute.

“There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking,” Dimon wrote. “The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and — these entities believe — effectively by using Big Data to enhance credit underwriting.”

And, according to comments Dimon made in the same letter in 2014, it is not good news for mainstream banks.

“They all want to eat our lunch. Every single one of them is going to try,” he wrote.

And while that invitation to lunch is not necessarily the one that the traditional banks like to get, the prevailing wisdom is that it is good for innovation – and that innovation does great stuff for both the marketplace and the consumers in it.

Let’s not forget, too, that the timing of alternative lending’s explosive arrival on the scene is not exactly accidental — it emerged in the wake of international financial meltdown tipped off by bad lending practices.

[bctt tweet=”Alt lending’s explosive arrival isn’t accidental, it’s response to the financial crisis and credit crunch”]

The resulting credit crunch left large swaths of small business and ostensibly creditworthy consumers suddenly without access to credit, or with restricted, slow and expensive access. Alternative lenders emerged as the technologically enhanced alternative — operating entirely online, using cloud-based infrastructure and proprietary underwriting algorithms that screen for creditworthiness using a more diverse variety of metrics than traditional banks. The net result? Consumers and businesses can get loans faster, in a more straightforward manner and often with more favorable terms.

And while, in general, the marketplace has been applauded thus far by consumer groups and regulators – or at least prone to being treated gently because of the necessary role it serves, recent reports in The New York Times indicate that the “everyone wins with alternative lending” narrative is perhaps a bit imperilled by concerns that it might not necessarily be as good for the consumer, or the market, as initially hyped.

Some Less Than Satisfied Customers

Mohammad Mansour is a Queens accountant, according to The NY Times, who makes about $64K a year. His adventures in alternative lending started with a $7,680 loan from Lending Club, which he later followed up with another $10K from Prosper. Two more loans later, Mansour is a little more than $31K in the hole.

And Mansour is certainly not the only with a tragic tale of when lending goes wrong. Vella Parker took out a loan intending to consolidate her credit card debt, but instead of putting her Lending Club loan toward debt, she used it to cover expenses (Parker is out of work on disability).

“I fell into the same trap as before,” said Parker, who lives in the Bronx and also had a previous bankruptcy.

She has stopped making her payments.

Lisa Giordano has also stopped paying her debts to Lending Club, as she was unable to keep up with monthly payments of $740. Unable to persuade the company to grant her a permanent loan modification, she stopped making her payments last year.

Parker’s lawyer, Charles Juntikka, said an increasing number of his bankruptcy clients had marketplace loans.

“Up until a few months ago, I had never heard of these companies,” he said.

Lending Club said it tries to work with struggling borrowers, including Giordano, who lives in Brooklyn. But it is also obligated to investors to honor the terms of their investments.

Collection Questions

Alternative lenders are also taking some flack from consumer groups for how debts are repaid, generally by direct debit for a customer (or business’s) checking account.  Lenders claim that access to customer accounts is necessary — as quickly delivering funds is part of their essential value proposition, as well as a mechanism for keeping their costs in check.

They further note that the direct withdrawl of payments on the loan is intended to be a convenience, and indeed many loan customers count it as one.

“I liked that it wasn’t a bank,” said Eric Kim, told The Times. Kim, who works in retail operations, took out a $21,000 loan from Lending Club with a roughly 9 percent interest rate to clear out his credit card debt. “It adds a level of responsibility, and I don’t have to monitor it,” he said.

And many marketplaces do allow customers to opt out of direct debit, but it comes at a cost. Lending Club, for example, charges an additional $7 per payment made by check, as opposed to debit. CEO Renaud Laplanche noted that the difference in price represents the difference in cost for Lending Club.

“It is more cost-efficient for us, and we pass those savings along to borrowers,” he said.

In the form of a lower interest rate.

However, borrowers don’t always know that opting out is an option, which can lead to difficulties.

“It can lead to people feeling trapped,” said Peter Barker-Huelster, a lawyer at MFY Legal Services in New York, who has advised clients with marketplace loans. “They don’t approach the lender to work out a lower payment because they think there is no way around it.”

And, sometimes there is really no way to opt out, even when, legally speaking, that should an option. SMB lender OnDeck recently found itself on the wrong side of the law over what some have characterized as “aggressive” collection practices.

The first issue popped up when New Innovative Products took out a $70,000 loan in December from OnDeck. The terms of that loan allowed OnDeck to withdraw $604 from the company’s bank account each day. However, the company went bankrupt — and OnDeck kept withdrawing payments despite a claim that they had been informed of the company’s status multiple times. A bankruptcy judge eventually ordered the lender to return the money. A different judge in North Carolina further chided OnDeck for collecting money from a different bankrupt company – even after they allegedly had gone to the additional step of opening a new bank account to protect themselves from continued withdrawals.

The judge called the move “particularly willful and malicious,” in his order to OnDeck to return those funds.

In a statement, OnDeck said: “We are taking all corrective actions to rectify the situation, including complying with the court and making any required payments. Additionally, we have instituted further internal process improvements and controls to prevent such lapses in the future.”

Concerns For The Marketplace

Some are concerned that the marketplace model employed by many alternative lenders presents an outsized risk to the economy. Unlike balance sheet lenders, marketplaces like Lending Club match borrowers to lenders, but do not lend out any funds. Those lender/investors are often hedge funds, mutual funds or individuals who use the loans to balance out their portfolios.

According to Moody’s Investors Service, the credit-rating firm, that model bears a somewhat concerning resemblence to the mortgage lending industry – right before that, mortgages tanked the international economy. Like their real-estate lending forbearers, Moody’s warns that many alternative financial firms market the loans and approve them quickly to sell them to investors. Because they do not directly feel the sting of defaults, they have incentive to lower their standards.

Alt lenders, however, note the comparison is not quite apt. Things going wrong affect their bottom line quickly. Lending Club, like many other marketplace lenders, only collects its loan servicing fees if the loans stay good – and those fees are 20 percent of Lending Club’s revenue.

[bctt tweet=”Unlike early 2000’s mortgage underwriters , alt lenders risk tangible financial loss if their loans go bad.”]

More importantly, investors will stop buying the loans if the company takes too many risks.

That said, about $12 billion in marketplace loans were issued last year, with billions more flowing in from hedge funds and Wall Street, creating capacity (and thus pressure) to underwrite more loans.

“By and large, our borrowers are using us responsibly,” Laplanche said. “Some people will make bad decisions or they are in a situation where they will have to make bad decisions.”

The End Of The Era Of Feeling Good?

“I do believe there is promise here, but the industry needs monitoring,” said Gary Kalman, executive vice president at the Center for Responsible Lending, which is based in Durham, N.C. “The question is whether these companies will continue to use technology to provide fair loans or use it to gouge people like traditional small-dollar lenders.”

Now it does bear noting that all of the stories told by The Times, while sad, were also tales of people who used their marketplace loans exactly incorrectly — to dig themselves further into a debt hole, instead of out of one.

Mansour, the Queens accountant, directly mentioned to The NYT that taking out four loans within 19 months in addition to his multiple credit cards was probably a financial mistake for someone trying to raise two children on a single salary in New York. He has since filed for bankruptcy.

But where there are unhappy consumers — with stories about getting trapped in cycles of debt — the CFPB is often soon to follow, and for some months there have been forecasts that regulators’ salutary neglect of alternative lending might be coming to an end.

And that could mean tough times ahead for some alt lenders, as facing the same regulations that banks face ( like rules on how much capital they must set aside for potential losses) could be very bad for business.

And, perhaps the consumers they were intended – and have, for the most part, served very well.