Why Alternative Lending Platforms Should Not Own the Loans They Originate — And the Danger of Asset Backed Securities

Marketplace lenders (or P2P lenders) typically do not and should not hold the loans they originate on their own balance sheet.

My rationale is below:

A company has three options to fund the loans it originates

(1) Raise enough venture capital to originate and underwrite a loan, hold that loan on your own books and service the loan until it’s completely paid back (this is really tough because if you are originating enough volume you’d have to raise a ton of venture capital to keep up. It usually takes time to get fully paid back).

In short, this is not an option.

(2) Raise debt capital to fund the loans. But companies shouldn’t spend their time trying to manage a revolving credit line, and again, this only scales to a point. Companies should focus on their core competency of origination, underwriting and servicing — not managing their credit holders.

Again, this is not an option.

(3) The best option is to create an agreement with a financial institution (such as a direct lending fund, a hedge fund, a family office, etc.) to purchase the loans you originate off your platform. The agreements involved would look something like this:

• Company signs an agreement with the borrower that has “assignability” giving marketplace lender the ability to sell that loan off to someone else.
• The company then has an “investor purchase agreement” with the fund that’s purchasing the loans off the platform, saying “If we underwrite a loan of XYZ characteristics you will purchase up to $ABC of those loans.

The marketplace lender then makes an “origination fee” for sourcing the loan and a “servicing fee” for making sure the loan gets paid back. This is the source of that company’s revenue (as opposed to interest income, which would require taking on balance sheet risk).

This is the best model, the most scalable model, but begs the question: “Aren’t interests misaligned?!” If the marketplace lender is making money simply by originating loans and servicing them, shouldn’t the marketplace lender be encouraged to originate as many as possible without regard of whether or not they’ll get paid back?

Typically these “investor purchase agreements” are strict about what types of loans will get purchased — so this puts some guidelines behind the underwriting. There are also often termination triggers that mean the marketplace will have lost its loan purchasers if default rates reach a specified number. And finally, the marketplace lender will lose its reputation and have trouble sourcing more “debt capital.”

One way to solve this even more soundly is to keep at least some of the loan on a marketplace lender’s balance sheet. This helps ensure they will incur losses if the debt investor does and forces them to put “skin in the game” without forcing them to raise an overwhelming about of equity capital to do so.

The Danger of Asset Backed Securities

I came across two articles in DealBook and the NYT that got me thinking about the danger of when the “debt investor” also owns the “lender” when the debt security is backed by an asset.

In the case of these two articles the mortgage lender (which makes money the same way a marketplace lender does) is owned by a private equity firm that purchases and holds the mortgages. In this case, there is a really scary potential outcome for a homeowner.

The mortgage lender may become liberal in making loans (chasing volume, originating fees and servicing fees) knowing that even if the loan defaults, the private equity firm or the hedge fund can then go claim the equity of the house at a huge discount and potentially make money by flipping it on the back end.

This means that as a homeowner you may be encouraged to take out a mortgage you can’t afford and then deal with a servicer who quickly wants to put you in foreclosure (probably a lot more quickly than if the servicer wasn’t owned by the holder of your mortgage!). I can’t figure out why this screwed up incentive wouldn’t relate to any other originator of an asset backed security (any debt security where the debt holder claims an asset in the event of a default).

There are a number of new P2P lenders who are looking at mortgage lending. LendingHome is one of them, SoFi is doing it and I think it’s really healthy that they are creating a marketplace of funders to avoid that type of mis-aligned incentive. The important piece will be that they don’t get purchased by a major private equity firm/loan purchaser in the future.

Selling Whole Loans is Becoming Harder-Forcing an Alignment of Interests

Selling “whole loans” is going to become harder, especially on high yielding paper. Madden vs. Midland was a court case in which the 2nd circuit of NY (the court that is basically a thought leader for all other courts) said non-bank assignees of whole loans cannot enforce interest rates above state usury laws (and that they can’t rely on federal exemptions).

What this means is that if a non-bank purchases a “whole loan” (meaning the bank did not hold on to any of the loan) they cannot enforce the repayment if the interest rate is higher than any particular state’s usury law. In New York that rate is 16%, but it varies in each state. This is going to make it hard for any marketplace lenders to participate in the sub-prime market (and quite honestly probably hurts the underbanked or sub-prime borrowers who need access to credit and because of this case, may not get it).

The upside is that it might mean these marketplace lenders (1) will have to get a lending license and (2) will have to hold some of the loans on their own balance sheet to keep some skin in the game in order to help their debt capital partners to enforce interest rates above state limits.

The downside is it limits access to capital markets for a demographic that’s been underserved and will likely continue to be underserved for some time.

Where I come Out

Net-net, I’m excited by the fact that marketplace lenders can act independently and if an investor purchase agreement and the mechanics of an agreement are written correctly, incentives can be appropriately aligned, making the financial world more stable and fair for everyone.