There has been a lot of excitement recently in online lending circles in the UK over a speech. Specifically a speech by Lord Adair Turner, the former financial services authority chairman who famously rubbished the sector back in February. At the LendIt Europe conference last week he stood up and said: ‘alright fine maybe the sector doesn’t like totally suck’.
Such optimism is in short supply on the other side of the Atlantic. On Wednesday, Warren Kornfeld and team at ratings agency Moody’s put out a note with the message: ‘no! it definitely totally does!’:
US online lenders have quickly seized opportunities to meet demand for more targeted, easy-to-access digital financial services, raising the possibility of a fundamental transformation in the way financial services are delivered. Given the competitive advantages of streamlined and nimble online lenders, some commentators have predicted a broad displacement of banks. In our view, however, inherent weaknesses in the online lender business model – in particular, low recurring revenue and a reliance on wholesale, confidence-sensitive funding – will likely limit them to a small segment of the overall lending market. We expect online lenders to primarily focus on underserved niche markets, while banks defend their entrenched position in consumer and commercial lending, in part by adopting some of the best practices of online lenders to improve the delivery of their lending products.
It’s punchy stuff and the sort of thing more commonly seen in the writings of arch-critic Todd Baker of Broadmoor Consulting.
The thrust of the argument is the absence of stable deposit funding and the reliance on non-recurring fee revenue makes online lenders worryingly similar to the securitisation-funded monolines of the pre-crisis world. “We’ve seen these companies come and go through many many cycles over the last 20 to 25 years,” Kornfeld told us on a call.
We’ve seen these problems play out this year in the aftermath of the scandal at Lending Club. Fear drove away investors, leading to steep drops in origination and painful lay-offs. A key thesis of the pure marketplace model is that platforms can expand and contract with origination volumes, something that is a little harder in practice than in theory.
“The originators try to resize their expense base but frequently revenues drop faster than their ability to go and right size,” says Kornfeld, though he says one thing he does say differentiates venture-capital backed online lenders from their ignominious predecessors is that they have a bit more cash lying around.
“The level of capital and the quality of that capital, of a lot of the current generation of fintech lenders is higher and stronger,” he says.
The full note is in the usual place, but below are a few choice snippets.
Like this useful history lesson for techies:
Online lenders bear close resemblance to previous, securitization-funded monolines
Starting in the late 1980s and continuing up to the financial crisis, there was a large increase in lending volume from rapidly growing monoline finance companies in a range of markets including residential mortgages, auto loans, equipment leasing and credit cards . These monolines relied heavily on the securitization markets for funding and were the “Fintechs” of the pre-crisis era . Their business models were similarly built on unstable foundations, and this resulted in them occupying niche markets, being absorbed into more stable institutions, or failing, rather than fundamentally transforming the lending landscape.
Monolines, like online lenders today, successfully identified a value proposition to both borrowers and investors that traditional banks and finance companies did not. Similar to the online lenders, the monoline lenders provided borrowers with simpler application processes and shorter approval times, as well as relied on new financing technologies (securitization in the case of the monolines) that presented the prospect of competitive returns and an alternative investment vehicle to investors. These advantages allowed upstarts to differentiate themselves from incumbents.
Also similar to the online lenders, the monolines had high valuations based on growth expectations. They booked non-recurring revenues from gains on the sale of their originated loans into securitization vehicles. In order to maintain their growth trajectory, they needed ever-increasing origination volumes. Given this pressure to grow, underwriting standards inevitably declined.
Monolines relied heavily on confidence-sensitive securitization and warehouse funding. As securitizations utilize bankruptcy-remote special-purpose entities to issue debt, many market participants believed access to the securitization markets would be stable. However, during periods of market stress, such as the late 1990s Russian bond crisis or 2007-09 financial crisis, or when weaknesses in underwriting and governance were exposed, like other confidence-sensitive funding, securitization funding dried up.
Reduced funding required the monolines to make significant reductions in originations which, in turn, resulted in a large drop in nonrecurring gain-on-sale revenue. The monolines tried to re-size their expense base; however, revenues dropped much faster than their ability to right-size.
The monolines’ high leverage and low levels of tangible equity gave them little flexibility to weather a crisis in confidence. Given their unsteady foundations, the market stress led to a significant contraction in the monoline finance market.
And this criticism of relying on fee income, which is a core feature of the pure marketplace model used by everyone from Lending Club and Prosper in the US to Funding Circle and Zopa in the UK:
Many online lenders have a high proportion of non-recurring, gain-on-sale or fee income generated from selling newly originated loans. The recurring net revenue as a percent of operating expenses was just 10% for Lending Club and 15% for Prosper in the first half of 2016. At 55%, OnDeck has a much higher level of recurring revenues owing to its greater emphasis on portfolio lending. In contrast to online lenders such as Lending Club and Prosper, banks and traditional finance companies have high levels of recurring revenues; in particular, net interest income generated from their loan portfolios.
In order to continue to originate loans and generate revenues, online lenders need to obtain funding just as would any traditional lender, whether they use marketplace funding or access more traditional funding sources. The companies also face the very same funding constraints during times of uncertainty when confidence-sensitive funding can become unavailable. Funding disruptions can occur because of either actual or perceived threats to an online lender’s performance, ranging from the tangible declines in asset performance and governance weaknesses that Lending Club recently experienced, to systemic issues such as weak macroeconomic or funding environments, regulatory uncertainty or competitive threats to the industry. Along with potential funding disruptions, borrower dissatisfaction is another potential risk to origination volume and, in turn, non-recurring revenue.
The combination of wholesale, confidence-sensitive funding reliance and high percentages of non-recurring revenue that is dependent upon this funding makes these firms particularly vulnerable since revenues can decline far more rapidly than their expense bases.
(One UK fintech, Ratesetter, has tried to mitigate this issue by spreading its fee income over the lifetime of a loan.)
And finally this bit of bell ringing about losses and the vulnerability of Prosper Marketplace in particular:
All three companies experienced sizeable losses in the first half of 2016, as industry origination volumes declined, in large part because of the industry concerns as exemplified by the issues surrounding Lending Club this past spring. Lending Club lost $77 million, or 8.4% of their tangible common equity, and OnDeck $32 million, or 10.3% of tangible common equity (Exhibit 8). Prosper lost $53 million. Prosper has negative tangible equity and just $121 million of tangible capital, including their preferred equity, increasing its vulnerability to revenue declines. Although many online lenders have recently announced staff and expense reductions, we believe profitability will remain quite constrained as the companies continue striving to achieve greater scale.
Who’s afraid of Goldman’s Marcus? — FT Alphaville
Lending Club’s latest results tell us a lot about the online credit business model — FT Alphaville
Lending Club, securitisations and proper loan due diligence — FT Alphaville
The online lending hangover, part three — FT Alphaville
Lending Club’s woes stem from a deeper issue with online lending — FT Alphaville
There are bigger questions for Lending Club to answer — FT Alphaville
If the music’s playing, keep on lending — FT Alphaville
It’s a hard knock deposit-less life for online lenders — FT Alphaville
Unanswered questions in online lending — FT Alphaville
US online lending credit is deteriorating, here’s the data — FT Alphaville