By Ryan Weeks on Tuesday 26 April 2016
The marketplace lending “ecosystem” is something that you'll often hear talked about at industry events. The term “ecosystem” refers to an array of auxiliary tools that together serve to streamline the way that investors interact with the marketplace lending asset class. It could be argued that the vast majority of these “ecosystem” tools are targeted at the creation of a secondary market and the functions that support it.
The existing ecosystem is distinctly nascent. It gets as much airtime as it does because sector veterans – belonging to both platforms and institutions – recognise that its development is crucial to the maturation of the industry. As Prosper President Ron Suber put it during a keynote speech at LendIt USA 2016:
“We need to encourage the development of a sophisticated ecosystem for our industry that improves data visualization, transparency, standardization and liquidity. Firms like Orchard, PeerIQ, DV01 and Monja are already helping to pioneer this ecosystem.”
But there’s a problem. The world’s major marketplace lending platforms are not “pure marketplaces” – and rightly so. The marketplace itself (the “platform”) is in control. Working closely with borrowers and investors, the marketplace platforms curate who may borrow and at what rate of interest, and which types of investor are eligible to supply that demand. That’s why credit underwriting is of such fundamental importance within the industry. The ability of a given marketplace to price assets accurately is the key factor in determining whether the investments that it facilitates will be successful.
“Effective April 20, 2016 Lending Club is updating loss forecasts and increasing interest rates by a weighted average total of 23 bps, concentrated in Grades D through G. The new loss forecasts and interest rate revisions released today incorporate both the impact of underperforming pockets and our prudent stance on the economic outlook.”
Lending Club also raised interest rates by 25 basis points in late 2015 in response to the Fed rate hike, and a further 32 basis points (on average) in January to provide more loss coverage to investors, in anticipation of a possible slowdown in the economy. Rates for riskier loans climbed by significantly more than they did for less risky grades. The most recent hike saw no changes to the average rates charged on A, B and C grade loans, a 0.07% increase for D loans and jumps of over one hundred basis points for the platform’s E, F and G grades. The company effects these changes using what it refers to as “marketplace levers”. Putting to one side, for now, whatever negative implications these successive hikes may or may not have for the asset class (they arguably ought not to have any, so long as pricing is accurate), the point here is that Lending Club is very much in control of the marketplace, as a function of the control that it exerts over the pricing of the “primary” market.
However… The emergence of an ever more sophisticated ecosystem will mean that pricing power exists, not only within, but also outside of the primary marketplace platforms that originate loans. Securitisation, secondary markets and synthetic marketplaces will each produce their own view of how marketplace lending assets ought to be priced (for previously originated cohorts) and that view may well deviate from the opinion of the originators. It is also likely that secondary market pricing will influence primary market investors, as with any other capital markets asset class. So the crucial question is this: are the marketplace lending platforms willing to relinquish control?
Here we turn back to Prosper. Prosper worked together with Citigroup in order to package up approximately $377m of securitised loans in July last year. Moody’s rated the three different tranches of the securitisation A3, Baa3 and Ba3. According to a recent Bloomberg article, Moody’s is now considering cutting its assessment of the riskier part of the deal. Amy Tobey, a senior credit officer at Moody’s, told Bloomberg: “Charge-offs have been coming in at a higher rate than expected, very simply.” This led Josh Tonderys, Chief Operating Officer at Prosper, to leap to the defence of the platform’s underwriting process:
“We take pride in our ability to accurately forecast our loan performance and are always looking at the current environment and calibrating our loss rates appropriately.”
Citigroup sold four batches of bonds backed by Prosper loans between August 2015 and April this year. The underlying loans were equal to around $1.45 billion, according to Kroll Bond Rating Agency. The Wall Street Journal reported in late March that a Prosper loans-backed bond offering had received a “cold reception” with investors, who had demanded yields as much as 5 percentage points higher than had been attached to a similar deal in late 2015.
“When we don’t have alignment with our investors, when groups sell our loans into the market no matter what, if the market’s not ready, it’s not good. And we learned that at Prosper this year.”
Here we have a prime example of ecosystem tension. Although Prosper had originated the underlying loans in the bonds which took a cold shoulder from investors in March, control over how and when to sell those assets had since been ceded to Citigroup. Nevertheless it was Prosper that bore the brunt of the resultant scrutiny, and clearly there were those at the company who disagreed with Citigroup’s methods. This from the Wall Street Journal’s coverage of the Prosper-Citigroup divorce:
“Some at Prosper felt that Citigroup shouldn’t have sold the loans when the market was under pressure and demand was weak, according to a person familiar with the firm’s thinking.”
“Tensions may emerge if pricing in the secondary market deviates from pricing in the primary market. As we saw in Q1 of this year, episodes of market volatility can provoke a wave of risk aversion which results in the deterioration of pricing to levels that suggest a worse credit experience than can actually be justified by the facts. To some extent this is normal – markets preempt the future and sometimes become fearful that conditions may be set to deteriorate. However, to the extent that this could impinge on the ability of platforms to deliver consistent funding to borrowers, it would be unwelcome. Better data can go a long way towards mitigating any dislocation by better informing the market of the actual prevailing condition of the underlying credits. This will not prevent occasional dislocations but it will lessen their impact. If a transparent market is structured around diversified pools of loans, and underpinned by timely and accurate data, one would hope that a stable secondary market can develop.”
Now try to imagine a marketplace lending sector where securitisation, secondary markets and synthetic marketplaces are firing on all cylinders.
Clearly there is a long way to go. Securitisation is at the very outset of its ascendancy. We’ve seen just one bond issued in Europe – a bundle of Funding Circle loans, facilitated by Deutsche Bank. There are a large number of combatants vying to contribute to the development of a sector-wide secondary market. Ldger, for example, completed its inaugural whole loan trading auction of Prosper loans earlier this month. AltFi Data, Orchard, PeerIQ, MonJa and DV01 are all lurking around in the “ecosystem” space. Some are focusing solely on data aggregation and analytics, whilst others are also playing a role in the allocation process. Tens of millions of dollars in equity capital have been raised between these businesses. SLMX is quietly working on a synthetic marketplace that will allow investors to take a position on the marketplace lending sector without having to own any of the underlying assets – assuming another investor can be found to take the other side of the trade.
These ecosystem participants have some pretty thorny issues to overcome. Uniformity of pricing promises to be nightmarishly difficult to achieve. The underlying assets involved in marketplace lending are enormously varied, featuring everything from unsecured consumer debt to property development loans to unpaid invoice finance. The differences in credit process among the many platforms stand as another massive hurdle.
In spite of these challenges, marketplace lenders should be rooting for the winners (whomever they may be) among the ecosystem companies. They have a pivotal role to play in broadening the appeal of the asset class – whether it be through the opening up of familiar modes of access, or through the provision of institution-grade analytical tools, or simply by offering secondary market liquidity. Broadening the asset class by necessity entails the loss of absolute autonomy, but that’s just part of growing up.
Mr. Taylor again offered his thoughts:
“It is in the interests of all industry participants that marketplace lending achieves scale. As in any disruptive industry, scale will allow the price and service benefits that marketplace lending offers to its consumers to be spread most widely. Equally the platforms themselves, and their equity investors, need to achieve scale to deliver profitability. Meanwhile, loan investors are attracted to the deepest pools of loan origination that offer the best opportunities to deploy capital. As a result the development of a functioning secondary market, which takes the asset class from “hold to maturity only” to a liquid market for the underlying loans is essential and should be in the interests of all participants. But tensions may emerge if the evolution results in disconnects between primary and secondary market pricing. At AltFi Data, we believe that it is important that structural conflicts are avoided. As such we are happy to serve as an independent provider of quality data without conflating the role of pricing arbiter with any other function. We believe that allowing investors to make informed decisions on value will facilitate the development of healthy secondary markets that serve the asset class.”