Key themes discussed as marketplace lending sector evolves

Representatives from Orchard Platform, MountainView and Global Debt Registry joined SCI over the summer to discuss marketplace lending developments. This Q&A article highlights some of the main talking points from the session, including the importance of thorough due diligence and data verification, regulatory developments and the prospect of market consolidation. The full webinar can be viewed here.

Q: In an eventful year for the marketplace lending industry - during which growth has been rapid, but not without setbacks - which key themes stand out?
Chris Kennedy, md, MountainView: The market has seen incredible growth up to this stage. Part of the process of a growing market is pull-backs and right now we are experiencing some of that, but this is still a huge opportunity for growth for investors - both investors in loans and in platforms. Unsecured consumer debt and unsecured small business debt is a US$1.2trn opportunity - at least - as US banks are over-regulated and do not have the economics to make these loans effectively.

SoFi was able to get away a first consumer ABS over the summer, with a US$380m deal. SoFi is a platform which was able to raise capital when the markets were open, so it has a significant balance sheet relative to the other platforms - which gives greater flexibility to invest not only in the student loans space where it started out, but now also in the consumer and mortgage spaces. I would expect SoFi to be a regular issuer and that is positive, because the platform's interests are aligned with investors; SoFi is retaining the residuals and verifying the income and assets on 100% of its loans because, along with their investors, it is an investor in these loans as well.

Right now the M&A shake-out will only help the larger players grow market share and self-regulate to a certain extent, developing common standards with regard to being a data furnisher to the credit bureaus and really focusing on what works. I think everyone will realise that lending into the prime space, as SoFi does, works. These borrowers perform and the loans are good loans, so relative to global yield curves, these are above-average opportunities.

To step back five years, Lending Club back then originated US$41m in loans in its first quarter, 1Q11. In 1Q16, it originated US$2.75bn. There are enormous growth opportunities for investors in loans and platforms.

Q: The importance of thorough due diligence has come to the fore this year. What is driving this?
Charles Moore, chief commercial officer, Global Debt Registry: This year has really put due diligence under the spotlight. It has always been important, but the specific issue of due diligence that has really come into focus has been loan verification.

There was some blame of loan verification in 2008 from a process perspective, which did lead to some improvements post Dodd-Frank. However, loan verification tools as part of the due diligence process has not really evolved very much for a couple of decades - and certainly has not kept pace with the innovation we have seen in fintech and the digital lending landscape.

Currently, the loan verification approach taken is generally to compare a loan tape to a loan agreement. The challenge in marketplace lending is that they are both electronic documents that are both provided by the seller of the asset, which represents something of a conflict of interest and is not a particularly robust model. That was being questioned last year by some of the risk departments, but I think this year is when it has really been brought to the front office and become part of the deal conversation.

Investors need to know that they can trust the loan level information they are provided with and know that there is the right kind of independent data integrity provided by the platforms associated with these loans. Investors need to know the data has not been manipulated. We believe the only way to address issues such as those is through real validation, going externally out through APIs back to the original external data sources to validate all of that underlying data by the investor.

A whole host of loan validation services are now being requested by the larger investors and by the warehouse lenders providing credit into this space, and the industry is starting to recognise the need for technology to provide a much more robust risk management process around due diligence and loan level validation for these assets.

Q: The concept of 'trust but verify' has been increasingly discussed in marketplace lending. Why is data standardisation important in this regard?
Brady Akers, director, Orchard Platform: Orchard is a data and technology company focused on building systems and standardising data to power the interactions between institutional investors and online lenders. Data standardisation across loan originators is a core focus of ours.

Trust and verification are critically important, especially for this emerging industry to grow, and transparency is a necessity. I think it will take a coordinated effort for participants across the industry, and companies like Global Debt Registry, PwC and Thomson Reuters will play a vital role in due diligence and validating that borrowers actually exist, and that the data is accurate.

Orchard's focus on data standardisation means that after loans have been originated, it is our job to ensure that data reported to prospective and current investors is consistent and of a high quality. That includes the credit variables, loan-level details and also the ongoing payment-level data.

Institutional investors looking to enter this space, or deploy more capital, begin their research with data analysis. Right now, that is a very difficult and expensive process because datasets are not consistent across lenders. A lot of what Orchard is doing is working towards creating an industry-wide dataset for both credit and payment variables for investors to easily compare opportunities across multiple lenders.

Q: Regulatory initiatives are changing the market. What are the implications of this from an audit perspective?
CK: From an auditor's perspective, we are starting to see some requests that not only lenders but also platforms go out and seek independent third-party fair value marks - not only on the loan portfolios, but also the servicing assets of these platforms. On the loan side, it has been a pretty simplistic model of holding the loans at par and adding monthly adjustment for accrued interest and layering in some loss provision. Talking to investors and platforms, we have said that you really want to bake in a more robust approach and move to a discounted cashflow methodology.

One thing I continue to hear from market participants is that there is no historical data. While the larger platforms like Lending Club and Prosper have data going back pre-crisis, the credit bureaus are also a wealth of data and have data products addressing this market segment, so there is data out there you can purchase for benchmarking purposes. We are still in the early innings of this process, but I think it is one that is going to help the market.

Q: There is a lot of debate about what constitutes 'true' marketplace lending. This is made even more complicated by the way funding models are changing. What are the developments in this space?
BA: We are seeing the change happen before our eyes. Many platforms are exploring a so-called hybrid funding model, where the lender uses multiple sources of capital to fund loans. The thought is that by diversifying the source of capital, a platform may improve their chances of weathering adverse market conditions. The idea caught on, particularly in the US, as institutional investors - who had become the main source of funding for many loan originators - slowed purchasing in the first half of 2016 and, as a result, origination volumes suffered.

These hybrid models consist of balance sheet lending, loan securitisations, credit facilities and whole loan purchase agreements by institutional investors. They make sure that interests are aligned, that your funding sources are diversified, your revenue streams are diversified and ultimately you can keep each channel honest and drive down the cost of capital in the long run.

I think the UK is more focused on the original 'marketplace model' and funding loans by retail investors, partly due to regulatory clarity and support.

Q: How much of an issue is loan stacking and should market participants be worried about it?
CK: Loan stacking is nothing new. It is called shot-gunning in the US mortgage market, where it has affected all investors, including Fannie and Freddie.

The process is really understanding and tracking borrowers, so platforms will need to work with the credit bureaus to create some kind of data exchange. However, loan stacking is only affecting something like 5%-10% of the market.

A lot of the platforms are trying to address it by looking at bank statements for any large deposits. The fundamental problem though is that not every platform is a data source for the credit bureaus, so that is a risk in the system.

Platforms are aware of it and trying to create solutions to it. In the mortgage market, one of the uses of MERS is that it has an application date, borrower name and social security number, so before a loan closes you can check there are no other applications. The marketplace lending association that was recently created has the opportunity to create something like this, working with the credit bureaus and creating some kind of data exchange.

Q: If there is market consolidation over the next year or two, what will be the implications for data verification?
CM: The Treasury has called for a registry, which would be useful in the development of a secondary market and in an economic downturn of MPL consolidation and borrower delinquency. It also helps cross-checking applications and avoiding loan stacking.

There is an inevitability to industry consolidation. There are 250-plus platforms in the US and many do not have critical mass and so will fall by the wayside.

The question is how orderly that process will be and given the relatively limited investor controls around loan data integrity. That is considered when there is an opportunity for some bad things to occur. That is when real loan validation and external third-party checking back to the original data sources - rather than relying on the loan tape and loan agreements from the platforms themselves - will really come into its own.

In terms of getting a secondary market up and running, in order to have confidence in an asset that is being purchased in the secondary market, you really need that independent validation of all of the underlying loan-level information (including ownership rights) to give you certainty, because the reps and warrants will always struggle to scale - particularly when they are not backed up by billion-dollar balance sheets.

JL