Hope springs eternal, but math is merciless.
Financial innovation makes us hope for better outcomes for all. We hope that the securitization of mortgages leads to more people being able to afford to own their own homes. Seven years after the subprime mortgage meltdown, we hope that P2P Lending will enable people and small businesses to “make ends meet”.
That is the hope and the hope is always based on a hypothesis that has enough truth for it to be credible.
It is hard to remember that Countrywide Financial was once seen as an innovator that was bringing down the cost of mortgages for poor people. Hindsight is always 20/20.
The hopeful hypothesis in the P2P Lending story is that by automation and cutting out the spreads charged by banks, we can dramatically reduce the cost of borrowing money. When financial institutions can borrow at “almost zero cost” in our central bank driven Zero Interest Rate Policy (ZIRP) and we can let machines do the hard work of credit analysis at almost zero cost, why should consumers and small businesses pay such high rates?
The simple populist answer is always “banker greed”.
The reality is more complex. Credit analysis is complex. Lending has limited upside and lots of downside, so the math has to be right. In equities, you get big upside with the big downside risk, so it is less about math and more about potential in technology, markets and management. Lending is easy when the data is there, as it is for mainstream consumers that have a healthy FICO score and as it is for Corporate Bonds. It is much harder in markets where lenders cannot simply plug in a credit score from companies such as FICO, Moodies and S&P into their models. These are hard data problems and complex algorithms.
For the Alternative Finance P2P marketplaces, the math is still merciless. If a consumer is poor and cannot make it from payday to payday, the credit risk is tough. That merciless math has already brought Wonga into the headlines in a bad way. The reality for many bricks and mortar retailers and Merchant Cash Advance companies is equally tough.
Alternative Finance P2P marketplaces cannot solve the fundamental problems in the economy. However, because of the popular hope created by these marketplaces, the sentiment and brand damage when those hopes are dashed will be dangerous for those marketplaces (and will lead to more regulation).
The simple takeaway from the Subprime Mortgage blow out was:
“It’s the Transparency, Stupid!”
Or to be more accurate, it was the lack of transparency. Lenders were being asked to trust credit rating labels that were paid for by the firms selling the loans. Actually the data was there, but many lenders chose to simply trust a surface rating rather than do the hard analysis.
As the Who sang: “Won’t get fooled again”
Institutional Lenders that lend into Alternative Finance P2P marketplaces now do the hard analysis and the marketplaces give them the tools to do this. Marketplaces want transactions but they are also fully aware that too many bad transactions will put their business in peril.
So, hope does spring eternal. Data can solve the problem because economic incentives are aligned to that.
However the danger lies in the P2P part of Alternative Finance P2P marketplaces. This was how the concept originated, but the reality today is that the lenders are mostly institutional funds. The retail lender can be divided into two types:
- “Day Lenders”.They are like the day traders in the late 1990s and they are as savvy as the institutional lenders, with high speed trading rigs, tech and data analysis skills and a tough, fast moving trading mentality.This article from Lending Memo is good at explaining how they work. TL;DR summary, make sure you know how to code to an API. High Frequency Trading (HFT) sidelined the day traders, because they could not afford the co-located servers at the Exchanges. In Feb of this year, the FT reported on Lending Club and Prosper installing “speed bumps” (paywall link) in order to prevent this happening to P2P lending.
- Retail Investors looking for extra income. The average consumer sees a headline rate and a credit badge put on by the marketplace and is so excited by that compared to what they get from a bank, money market fund or bond funds that they ignore the mandatory small print warnings. This is where a subprime mortgage type meltdown risk lurks.
Alternative Finance P2P marketplaces are currently in the fast money phase.
This is the world of Hedge Funds and tech savvy retail traders. They are are doing well on these marketplaces because the markets are still inefficient and opaque. They are arbitragers and that is a good business that rewards those who are fast, tech savvy, smart and tough. That is a good phase to go through. The next phase is where the big and more patient money will come in and that will bring down interest rates and the arbitragers will move onto the next inefficient and opaque marketplace. Efficiency, transparency and regulation is the big win for the Alternative Finance P2P marketplaces because they don’t care about the actual interest rate; all they care about is the volume of transactions from which they make their fee.
The upcoming IPO of Lending Club is bringing lots of new money into new marketplaces. Not all of them will be equally vigilant about protecting both sides of the marketplace. Most of them will fail because marketplaces always consolidate down to a few big ones (think NYSE vs NASDAQ). The danger to the whole ecosystem is that some nasty scandals from some unscrupulous players bring the whole concept into disrepute.