Fintech Needs to Expand the Club

By Michael Regan for Bloomberg

The Treasury Department’s white paper on marketplace lenders like LendingClub and On Deck Capital was called a “‘welcome to the real world’ moment” by analyst Ian Katz at Capital Alpha.

That’s the logical takeaway from other observers as well — the notion that the industry was overdue for a critical look from regulators such as the Securities and Exchange Commission and the Consumer Financial Protection Bureau. That’s fair, and true enough. How long, for example, did anyone really expect On Deck to get away with annual percentage rates as high as 98.4 percent without someone in Washington taking notice?

But there’s another “welcome to the real world” moment in the Treasury’s report that isn’t receiving as much attention, and it’s this: How long does anyone expect investors to continue buying loans from these companies without being able to sell them into a secondary market? As the Treasury put it, summing up responses to its request for information, or RFI:

Secondary Market for Loans is Undeveloped: Although loan originations are growing at high rates, the secondary market for whole loans originated by online marketplace lenders is limited. RFI commenters agreed that active growth of a securitization market will require transparency and significant repeat issuances.

Gyan Sinha, chief investment officer of Godolphin Capital Management, wrote in his response to the Treasury: “Secondary liquidity in these assets can at best be described as poor … a large pool of loans purchased by an institutional buyer is unlikely to find readily available liquidity.” In other words, if you invested in loans from a marketplace lender, good luck reselling your investment if you need to raise some cash.

LendingClub does partner with the broker-dealer Folio Investing, which offers a trading platform for investors interested in purchasing notes in the secondary market, though it acknowledges the dollar volume of trading is minuscule. Otherwise, opportunities to trade in marketplace debt are scarce. To help the industry grow into its true potential, what’s needed is a venue (or venues) for investors to trade debt from all of the many marketplace lenders.

Imagine buying a stock or bond but not being able to resell it whenever you wanted. That’s the industry’s main drawback and it’s most likely preventing many investors from participating. It’s also a flaw that’s not going to be easy to fix. Orchard Platform, which makes software for both sides of the peer-to-peer marketplace, is working on developing a secondary market. But a lot of roadblocks exist.

For example, Orchard pointed out in its letter to the Treasury, many products require the loan originator’s consent for transfer and continued servicing. The Madden v. Midland Funding decision and another lawsuit have fueled worries about whether loan investors will be able to collect interest that in some cases is higher than what usury laws allow in some states. Many investors will be reluctant to touch the securities unless they’re rated by credit-rating companies, which have been slow to grade them. And could you blame them, given the lack of historical data in an asset class that’s still in its infancy and the blame ratings firms shouldered for failing to warn of the mortgage-backed-securities crisis?

Still, the advantages of a robust secondary market are such that fostering one should be a priority for the industry, especially now that the unceremonious and inscrutable ouster of LendingClub’s chief executive officer and worries of credit deterioration further undermine confidence among investors.

Being able to liquidate the investments when needed will lure a much larger group of investors. Regular trading of the assets will allow the funds that buy them to more accurately mark their values to market and help reduce the number of questions regarding their worth for all involved. For borrowers, more dollars from a wider group of investors would mean greater competition from originators and therefore more attractive interest rates, as well as more options for loans with longer terms.

Whether it’s Orchard or even a more well-established Wall Street player, creating a secondary market won’t be easy. But the industry would be smart to help the process along by taking the Treasury up on some of its recommendations, including establishing standards on reporting data for loans and pools of loans, as well as creating a registry for tracking transactions.

The eye-popping growth of loan originations by marketplace lenders shows that there truly is a neglected market of consumers and small businesses. The vigorous response to the Treasury’s request for information from the National Pawnbrokers Association shows what the alternatives are. (If there were a National Loan Sharks Association, we’d guess they would have made a vigorous response, too.) For the industry to continue to flourish, it’s time to meet the needs of investors on the other side of the equation as well.