What is Going On With Lending Club — And Why Now is a Great Time to Start Investing in Alternative Lending Again
It’s finally a good time to begin making investments again in marketplace lending.
Why? Because the concept of marketplace lending is still awesome — nothing fundamental has changed about that, yet the critics of marketplace lenders have finally had their “I Told You So” moment; which is making everyone on the sidelines (and even some of those still in the ring) nervous. Which means equity prices will finally come back down to earth, or might even get cheap. Which means I’m screaming “buy, buy, buy!”
So What Happened with LendingClub? Why are They in the News?
As you probably know, LendingClub finds people who want to borrow, decides if they are worthy of a loan and if so at what rate, and then sells those loans to investors (Jefferies being one of those buyers).
LendingClub makes money via that last part: the “selling of the loan.” This means they don’t hold risk (in most cases) if the loan goes to zero. You can imagine this creates mis-alignment between the investors and the originator (*reminder, LendingClub is the “originator”).
What many of the big investors will do is say: “look guys, I want to buy millions of dollars worth of your loans because I think they’re awesome. But I only want to buy loans of X, Y and Z characteristics. (X might represent FICO scores, Y might mean interest rate and Z might represent certain covenants within the loan).
And LendingClub built a bunch of trust with people by always selling investors exactly what they wanted. So much so, that some of these investors probably stopped paying close attention to make sure they were getting the type of stuff they were supposed to and kept hitting the “accept” button without paying much attention.
But — here’s the juicy part — LendingClub started selling loans to Jefferies that didn’t have X, Y or Z in them (I bet it was Z, investors usually are careful enough to look at the default rates and interest rates — it’s the covenants and detail that get yuh.).
Apparently it was a pretty minor deviation from what Jefferies was accepting, but they bought $3,000,000 of those loans with “minor errors” in them out of a pool worth $22,000,000.
Here’s the “small error to big error formula.” (get out your calculators):
*A small error multiplied by 3 million times == big error*
So Why is This an “I Told You So” Moment?
You might be thinking: “well, okay that’s bad, but doesn’t seem like the worst thing a startup has ever done, right?”
Well, eh, not really, it’s pretty f*cked up.
The reason is this reinforces everyone’s fears about marketplace lenders:
(1) They are fairly unregulated — so it’s theoretically possible for them to get away with doing bad things (like selling the wrong type of loans to people).
(2) People don’t know how to underwrite online lenders, and this is every investor’s worst nightmare.
(3) It reinforces why an originator that doesn’t hold everything on its own balance sheet might feel less inclined to be as careful about the loans they are originating because they are being held by someone else.
(4) It reinforces that LendingClub was probably chasing growth a bit too desperately, which is why things started to break.
It’s been getting harder to sell loans to the market as yields were coming up compared to the last couple of years — and when people get desperate to grow they start paying more attention to their equity value than to the paper they’re originating. And they got sloppy in what paper they were selling to whom.
(5) It could get worse… this is the only incident we know about, but is this happening elsewhere on LendingClub (especially to less sophisticated retail investors?) Or on other platforms?!
(6) Credit investors are way more anal than equity investors. They have to be — and small errors are huge deals in their world. In equity investing you’re in the business of “making money.” In the credit investing you’re in the business of “not losing it.” So credit investors freak out about any small error, discrepancy or crack in the system. They wake up every day thinking “how am I getting screwed?” and this just gave them a big HERE’S HOW!
(7) The banking world and financial world is built on trust, more so than perhaps any other industry outside of healthcare.
What Does This Mean for the Industry?
(1) It means yields across the industry are going to come up. Debt investors on marketplace lenders require a premium over the yields they get in traditional lending because the loans are: new, illiquid, and only being purchased by a subset of the financial world — and less buyers means less competition to buy. That new part just got a lot more important because LendingClub just proved we don’t know what we don’t know.
(2) The companies that originate paper that yields lower than mid-teens may have to use their own equity capital to hold their initial loans longer, to gather the data required to give debt investors comfort investing in a lower yielding product. (the more data you have on default rates, the lower the rates people will offer you).
This means more dilution for founders…
(3) A lot of equity investors are going to get scared — and while there is still major opportunity in marketplace lending a lot of investors are going to say “alright squad, we’re putting the pause button on for a while to see how this plays out.” Equity will get cheaper.
(4) The due diligence debt investors do before investing on these platforms is about to get a lot more thorough. Credit investors have realized that these deals have gotten competitive and have rushed through much of their diligence processes to adapt to the speed of startup land. I think people are going to get a little more patient, the power will come back to the investor, and FOMO will play less of a roll.
(5) Regulators will start moving faster in terms of setting up rules marketplace lenders must follow.
(6) A new wave of startups will emerge (as we predicted in our end of year letter) to begin regulating or auditing these marketplace lenders that are difficult to monitor manually based on their scale and speed.
We’re Really Excited
Marketplace lending still is a great idea. These companies first found a more efficient way to originate loans, and today are using technology to observe previously unobservable data points to materially improve the underwriting process. Companies like Square and Even do this well. Companies like Produce Pay are creating credit where’s never even existed before.
And nothing about the LendingClub incident refutes the business model or fundamental thesis around marketplace lending. It just highlights the need for a different kind of underwriting of the loans, and paranoia on the part of the debt investors — and will likely increase the expected yields required.
So in our world:
(1) yields of loans we’re already buying will go up
(2) the equity will be cheaper
So… life doesn’t suck.