Brian Weinstein is the CIO of Blue Elephant Capital Management
During our time in the alternative lending space we’ve heard countless arguments for and against the asset class from investors, lenders, banks and lawyers. Below, we summarize the reasons we get excited and the issues that still cause us concern.
A few decades ago, those needing to borrow money would walk into a local bank and speak to an underwriter. Often, their families, businesses and credit histories were known personally by the banker or easily tracked down through the community. A combination of technology, regulation and time has significantly changed that equation. Today, there are a smaller (and declining) number of community banks, leaving the banking system dominated by large institutions. There are several problems with the large bank model for small borrowers, of which I will highlight two. First, large banks have plenty of broad consumer exposure through credit card, mortgage and other primary banking functions, leaving them with little need to make additional loans to similar borrowers. Second, it is much more cost effective for a large bank to underwrite large balance loans, leaving little economic reason to grow the small loan book. With large institutions not incentivized to make low balance loans, non-bank lenders are needed to fill the void.
In addition to underwriting loans, banks use their capital to hold loan risk on balance sheet. Large banks hold significant risk exposure to consumers through mortgage and credit card portfolios. With smaller banks disappearing, new capital is required to grow the lending markets. Non-bank lenders do not have the same access to capital as traditional banks. They need to make sure that they have a diversity of funding sources as part of their business model. At any time, there are different combinations of retail, dedicated funds, pension funds, endowments, large asset managers and banks committing capital to these lenders. This mix will shift over time in response to opportunities in the broad capital markets. This avoids the situation where four or five large institutions are the only drivers of capital for loan markets.
From a borrower’s standpoint, technology makes the application process quick and easy. Applications are completed online, most times without ever having to speak to an underwriter. Credit decisions are returned in anywhere from a few seconds to a few days, depending on the loan type. This ease of use is driving borrowers from traditional banks toward non-bank lenders. For loan investors, there is data transparency on the underlying credit of a potential investment. While lenders generally do not share their entire underwriting algorithms, investors have access to the same credit information as the underwriter and can therefore make an informed investment decision. As time goes on, open source lending will allow for smarter models, deeper pools of available capital and more efficient capital markets.
Technology has not solved the lending problem. There will always be credit cycles – technology cannot change this. In some cases, there simply isn’t enough data to predict how loans will perform, especially if they are made in high volumes or in markets that lenders have traditionally avoided. Even the best credit models will fail when the economy changes. It is important not to think of “non-bank lending” as one category. Every lender is different. Investors must analyze the methodologies used to make loans and how judge the level of risk inherent within each model before making an investment. Even then, constant surveillance is necessary.
With a large number of non-bank lenders emerging, there is a notable lack of policy cohesiveness. What are the representations and warranties that the lender should make for each loan? How are loans being serviced? How are platforms estimating risk and returns for loans? Without standards, the diligence process necessary to get comfortable with a lender is cumbersome. In addition to getting comfortable with credit and servicing procedures, investors must be careful on the legal side since few standards exist. Investors cannot take anything for granted and must do their own diligence before taking risk.
Many non-bank lenders sell 100 per cent of the loans that they originate to investors. In this model, profits are made through origination and servicing fees, not from earning the coupon on the loans themselves. In this model, the incentive for the loan originator is to underwrite as many loans as possible – not necessarily as many good loans as possible. This would be different if every loan originator had to keep a certain percentage of loans on their balance sheet. Investors must stay on top of loan performance metrics and make sure that lenders do not ease lending standards without notice.
The lending markets are changing rapidly. Our team at Blue Elephant Capital Management has spent more than four years investing in non-bank origination, and we have done due diligence on over 100 non-bank lenders. Our experience and quantitative capabilities allow us to serve as a fiduciary to those wanting to invest in loans directly. Please reach out to us at email@example.com or visit our website www.bluelep.com for more details.