Marketplace Lending and the Great Vampire Squid

Last month, Goldman Sachs announced plans to enter the online lending space. Since that time, there have been couple of articles and thought pieces contemplating what this means for the marketplace lending eco-system. In her July 7th article on thestreet.com, Jennifer Tekneci even suggested that Lending Club might be better off finding an acquirer to avoid future battles with incumbent, traditional lenders. Here, I share my historical perspective and thoughts on how the space has evolved from P2P Lending, a market originally funded by retail investors, to one that has become increasingly dominated by the institutional investing community.

Over the past year, I have spent a fair amount of time with marketplace lenders, technology vendors, service providers, and institutional investment professionals determining what impact online lending would have on how we borrow and lend money. As a former Fixed Income salesman, my interest lies in the origination of these loans, and what it would eventually mean for securitized products. Would this area of FinTech truly disrupt finance as we know it? During this time, I have watched as many of my peers at sell-side and buy-side firms alike have gone from scoffing at this notion to ultimately (sometimes begrudgingly) attempting to understand how to embrace this new frontier.

Lenders of First Resort

As markets recovered from the Global Credit Crisis of 2008, alternative lenders rose to fill a credit void left by traditional financial institutions. Increased regulatory oversight, heightened capital constraints, and a mountain of losses stemming from poorly underwritten loans would combine to choke off the banks’ ability to provide credit to their customers. Firms like Prosper, Lending Club, and OnDeck rose to prominence as they touted the virtues of Peer-to-Peer (P2P) Lending. Borne of the same core concept as microfinance, crowdfunding, and crowdsourcing, P2P lending offered the promise of providing lending capacity without the intermediation (and hassles) of a traditional financial institution. To be clear, these concepts are not one and the same.

P2P lenders slowly acquired loan origination market share as it appeared to consumers that banks were fleeing them just when they needed them most. This experience led to an erosion in the trust that had been placed in the banking system and people’s overall satisfaction with their banks. In 2012, US P2P loan origination was estimated at $870 million. Over the next 2 years, loan origination volumes exploded as the number of online lending platforms and capital providers multiplied. PWC estimates that in 2014, US P2P platforms issued approximately $5.5 billion in loans.

Nowhere to Run

As financial institutions adjusted to their new world order, institutional investors were facing their own unique set of challenges. New regulations and capital requirements changed the dynamics of the fixed income trading landscape as broker-dealers trimmed balance sheet and focused on the largest and most profitable trades. Yields tightened as trading volumes and volatility shrank, structured credit losses abated, and prepayments streamed in.

Shrugging off everything from natural disasters (2011 Tohoku Eqrthquake), large government and bank portfolio unwinds (ING, AIG/Maiden Lane, RBS—too many more to name), a 2-year running battle over the US debt crisis over the Fiscal Cliff, PIIGS and BRICS, Institutional investors needed new sources for yield . Through all of these events, Mortgage- and Asset-Backed Credit yields rallied from low double-digits (10-12%) to their current 5-8% range.

Online marketplace lending presents a variation on a theme that investors have seen many times before. When credit markets are tight, volatility is low, and there is plenty of yield-seeking investment capital, direct lending is viewed as a "safe" proxy for Fixed Income. Through online marketplace lending, institutional investors saw an opportunity to originate diversified portfolios of loans with plenty of the yield they needed. For the online lenders, this meant larger funding lines and the ability to originate more loans.

In the year or so in which institutional investors have ramped up their activity in the space, it has truly outgrown its P2P nomenclature. Institutional investors have advanced the evolution of the market from pure investment in loan portfolios to the bifurcation of risk, the packaging of derivative and structured products, and attempts at indexing the sector.

FinTech: Friend or Foe?

As Institutional Investors sought to learn more about online marketplace lending and how they could get involved, Wall Street firms have evolved in their approach as well. As I mentioned previously, a year ago many of my peers scoffed at the notion that start-ups could disrupt the world of finance. Fast forward to the present and very few are taking the space lightly.

"They all want to eat our lunch . . .Every single one of them is going to try. 

                                                                                                             - Jamie Dimon

In his 2014 annual letter to JP Morgan shareholders, CEO Jamie Dimon warned of the competitive threat posed by FinTech start-ups in online lending, payments, and investment portfolio services. From his comments in the press and the thoughts he has shared with investors, it is clear that he is concerned about how JP Morgan (and other traditional financial institutions) will deal with their more nimble FinTech competitors.

For online marketplace lenders, their success in building a loyal customer base and the ease by which they have originated loans in various sectors has led to close examination by the very firms that originally gave them little credence. 

Enter Goldman Sachs 

The first thing you need to know about Goldman Sachs is that it's everywhere. The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.

                                                                                                              - Matt Taibbi  

Last month, Goldman Sachs announced it was working on its own business unit to offer consumer and small business loans by 2016. It should come as no surprise that the company would want to replace shrinking business lines (trading, securitization, etc.) with new revenue sources. All indications point to the online lending space as a market that could fill those revenue needs. In a February 2015 report, PWC estimates that the market could reach $150 billion or higher by 2025. As a Bank Holding Company, Goldman’s ability to tap the Fed Funds Market and other low-cost funding sources give it a huge advantage over current marketplace lenders.

Will that funding advantage be enough for Goldman to succeed? While they have the means to build the technology, they have never been a true retail, consumer-facing organization (Private Wealth Management doesn’t count). How does this bode for the future of established online lenders and start-ups? Do other Wall Street firms follow suit and attempt to build platforms on their own as well? As Matt Taibbi so eloquently illustrated, Goldman has a knack for following the money. While it is perhaps the highest profile bank to do so, there are plenty of other traditional financial institutions attempting to figure out how they secure their own slice of the pie.

History has shown that Wall Street has not had a great track record at innovation, but that hasn’t stopped it from trying. At a FinTech Start-Up conference this past April, Brad Katsuyama, President and CEO of IEX Group, illustrated Wall Street’s approach to innovation and why it has failed in the past. For years, Wall Street firms have convinced themselves that they can innovate from within. This is due partly to the fact that the space has been unable to attract true innovators as they hate scandal, something that Wall Street is not unfamiliar with. Brad continued to illustrate the vicious cycle as follows: scandal creates regulation, regulation creates loopholes, and loopholes get exploited until a new scandal creates another regulation. This is a pattern that anybody that has worked on Wall Street has most likely seen. 

One could argue that this cycle is what has allowed alternative lenders to prosper in the wake of the new regulatory and capital environment in banking. Is the online lenders’ ability to underwrite loans based on economic efficiency and “better” underwriting? Or was their prominence built on loopholes (the fact that they are not currently regulated like the banks) that were exploited to fill a need? As banks and other traditional financial institutions enter the online lending space, does regulation catch up with these entities and hamstring them equally?

I tend to think that the relationship between traditional financial institutions and FinTech start-ups continues to evolve. Given Wall Street’s history at innovation and the success that FinTech start-ups have been able to demonstrate thus far, both communities offer complementary competitive advantages. The woes of the banking industry will not be fully solved by technology, but it will surely be bettered by the innovation.  Traditional financial institutions would allow the online lending platforms to access low cost capital and large networks of existing customers, while the online lending platforms would be able to share their innovative successes in improving the customer experience and more expedient underwriting.  The regulatory landscape is certainly one that needs to be monitored as this is potentially the key to enabling (or disabling) the success of marketplace lending platforms and partnerships going forward.

Your thoughts and comments are welcomed.

Jeff Gapusan
Head of Capital Markets
jgapusan@traderocket.net