Todd Baker argued in a recent editorial in American banker that market lenders represent systemic risk and need tighter regulation. Although his intentions are good, his reasoning is wrong.
MPLs are already regulated by several agencies. They reduce the leverage of the financial system, provide greater financial transparency, and ultimately provide a better product for consumers and investors. In fact, the product is so much better that banks are among the biggest buyers of MPL loans.
MPLs are very diverse. Lending Club and Prosper have historically focused on debt consolidation. OnDeck and Funding Circle have focused on small business loans. SoFi and CommonBond have embarked on the refinancing of student loans. Credit quality ranges from subprime to superprime. Some companies have state lending licenses, others use banking partners. They are all regulated by the Consumer Financial Protection Bureau, and those with state licenses are additionally overseen by the states in which they operate. The common characteristic of MPLs is that they are not banks ?? they do not collect deposits and they do not have national lending licenses.
As the name suggests, MPLs operate marketplaces. They create loans and sell them to buyers through retail and institutional channels. Companies like Lending Club and Prosper use very little of their balance sheets for loans. Baker’s claim that MPLs “can operate at levels of leverage unprecedented in the banking industry” is simply false. Lending Club, for example, has no real leverage. It creates loans and offsets them with loan-related notes. Although these appear on the balance sheet, the company has negligible credit risk. Lending Club is less than once leveraged on loans for which it has credit exposure. Compare that to Wells Fargo 9.1x or 10.2x JPMorgan’s balance sheet leverage and it’s clear where there is greater financial risk.
Some companies ?? like OnDeck and SoFi ?? use their balance sheets to aggregate loans for transactions such as securitizations. During these brief periods, both companies have limited exposure to their balance sheets. But these are very different models of the victims of specialized finance of the 2008 crisis that Baker cites. For example, CIT had over $ 60 billion in loans on its balance sheet in 2006, funded in part by $ 58 billion in debt. Any MPL that came close to these numbers would no longer be a real market. As a prospect, my company, SoFi, has made nearly $ 5 billion in loans and never had more than $ 700 million in balance at a time. What killed the niche lenders of the past was a combination of poor quality underwriting, vulnerable funding facilities, and excessive leverage. And the crisis has affected more than specialized finance companies ?? many banks were either wiped out or forced to rely on government bailout money to survive.
The beauty of marketplaces lies in the feedback of information in real time. If there are too many buyers, the loan rates are too high. If there is not enough, they are too low. In both cases, the MPL adjusts. Baker says:
If an MPL cannot issue new loans ?? what will happen every time investors refuse to buy loans in the MPL market ?? the transaction fees which are the main source of income and cash for MPLs will disappear instantly, while expenses will continue to rise. An MPL must continue to issue loans to survive.
The scenario he describes cannot happen. It is true that an MPL needs a buyer to create loans ?? without one, the market must raise rates until a buyer emerges. If there is no buyer, MPL simply stop lending ?? they’re not going to start making submarine loans. MPLs cannot expand their balance sheets and leverage like banks do, because they cannot afford to do so. The reason MPLs command high valuations is not because investors “rush to take advantage of the expected windfall”, as Baker writes, but because these companies use equity much more efficiently than investors. banks using their balance sheets for limited purposes.
It is questionable why MPLs exist when banks are apparently willing to lend to borrowers. Is this the adverse selection suggested by Baker? The reality is that after the 2008 crisis, banks moved away from large swathes of consumer credit, not just card consolidation. For example, in 2011 my company, SoFi, pioneered the refinancing of student loans, an entirely new opportunity ignored by banks. Today, several major banks are actively competing in the space, including Citizens. Companies like Lending Club, Prosper, SoFi and Funding Circle now have significant bank holdings in their respective markets. They wouldn’t be there if the credit was bad.
Market lenders have been a disruptive force in financial services ?? for the best of all involved. MPLs have delivered innovative products that consumers want through channels such as mobile that consumers prefer. They did so with exceptional service and extensive outreach to borrowers and investors, reducing acquisition costs. And they provided transparency and a deleveraged financial model to the markets while working closely with state and federal regulators to continue to improve their model.
There is work to be done in areas such as building even more diverse liabilities and promoting financial literacy among borrowers. But is there one thing about MPLs ?? or, for that matter, consumers, businesses and the economy ?? no need: for MPLs to become banks.
Mike Cagney is the CEO and co-founder of SoFi.