We’ve written quite a bit about P2P or, more accurately, "marketplace" lending over the years.
Most recently, we noted that write-offs for five-year LendingClub loans were coming in at between 7% and 8% as opposed to the forecast range of between 4% and 6%. “Their business is to take data and use that to underwrite risk,” Compass Point’s Michael Tarkan told Bloomberg by phone. “If you’re an investor in the loans on the platform, this creates a concern around that underwriting model.”
Or, as we put it, “the algorithms LendingClub uses to assess credit risk aren't working. Plain and simple.”
We also recently checked in on Prosper, the P2P site that inadvertently (we hope) financed Syed Farook and Tashfeen Malik’s San Bernardino jihad with a $28,000 loan. Prosper is raising rates to an average of 14.9% from 13.5% and last month told investors in a letter that estimated losses on loans have been increasing over the last six months.
That came on the heels of a warning from Moody’s who said some Prosper-linked bonds could face downgrades as the loans backing the deals began to go sour. “Charge-offs have been coming in at a higher rate than expected, very simply,” Amy Tobey, a senior credit officer at the ratings agency remarked at the time. “It is not a two-month blip,” she added.
No, it’s not, and concerns about the health of the US economy and the true state of the labor market will likely mean that demand for marketplace-backed paper won’t exactly be what one would call “robust” going forward. Of course that’s a problem for lenders like SoFi, which pools its loans and sells them to free up space on the books for still more loans. It’s the same “originate to sell” model that was used in the lead-up to the housing crisis and that’s now a part of the subprime auto space (although Citi will tell you that it’s not endemic there).
These companies need to be able to offload the loans in order to keep the model running, and if they can't tap the securitization market, their ability to lend will suffer. But don’t worry, because SoFi - which originates billions in personal loans - has an idea. They will start a hedge fund and buy their own loans.
No, really.
“Social Finance Inc., a rapidly growing online lender, is hoping to stoke investor demand for the debt it originates by starting a hedge fund that will buy its own loans -- and potentially those of its competitors,” Bloomberg reports.
The fund, called SoFi Credit Opportunities Fund, has raised $15 million so far. “It’s seeking to attract more money from wealthy individuals, funds of hedge funds and other institutional investors that may not want to buy whole loans directly from the company or securities backed by the debt,” Bloomberg goes on to note.
According to a company spokeswoman, there’s no annual fee and the fund will simply charge 25% on anything above a 3% return. The fund may also look to buy loans sold by other online lenders, in what certainly sounds like the beginning of an absurd P2P merry-go-round where everyone is selling loans to each each other.
SoFi Credit Opportunities could eventually grow to a $500 million to $1 billion fund, WSJ, who originally reported the story said. The company brought its first ABS deal of the year to market this month, but the rate investors demanded on the highest rated tranche was notably higher than it was last year, reflecting market angst. Rather than argue with the market, the company figures it can get around the issue with the hedge fund idea. "[This is] a real chance to solve the balance-sheet problems facing the industry," Chief Executive Mike Cagney said. Along with CFO Nino Fanlo, Cagney worked at Wells' prop trading desk, and still works part-time at macro-focused Cabezon Investment Group.
(Cagney)
Now obviously, there are any number of things that can and probably will go on here. First the incestuous relationship not just among the fund and Sofi itself, but between the fund and the rest of the industry (assuming they do indeed decide to buy loans from other P2P lenders) means the entire thing is self-referential.
If losses on these loans continue to rise, the hedge fund obviously shouldn't keep buying them, but they're putting themselves in a position where they'll have to, unless lending at SoFi were to grind to a halt. ABS issuance in the space will dry up altogether in a stress scenario and so, the only way for the model to keep going will be for Sofi to keep giving itself money to loan to other people. That will embed more and more bad loans in the hedge fund, which would then invariably see an investor exodus on poor performance. After that, if the securitzation market is slammed shut, it's not clear what happens next.
Further, although as WSJ goes on to write, "Mr. Cagney said the fund has an independent trustee who must approve purchases of SoFi’s loans to head off conflicts of interest," both he and Fanlo "sit on an investment committee that must approve trades."
Obviously, when the going gets tough, Cagney's not going to not favor SoFi if his company needs money to keep making loans. As a reminder, this entire thing depends on non-deposit funding.
At the end of Q4, Peer IQ wrote that the Marketplace ABS market was hardly shutting down. In fact Q4 was "a busy one" for securitizations.
But that won't continue in perpetuity if charge-offs continue to rise.
It's worth noting that LendingClub has a subsidiary called LC Advisors which does something similar to what SoFi is doing, but technically, LC isn't a hedge fund. We hope LC hasn't been buying the parent's five-year loans.
Consider the following excerpts from EuroMoney:
Take the peer-to-peer lending industry, which is often anything but. As the size and number of participants has grown, it has morphed into marketplace lending with banks originating the loans, selling them to marketplace intermediaries who subsequently sell to institutional investors. If that doesn’t sound a million miles away from originate-to-distribute, it is because it isn’t.
There are now more than 100 marketplace lenders in the US, the largest of which are Lending Club and Prosper Marketplace. Both of these firms have relied on a small, Salt Lake City-based lender, WebBank, for much of their business. Lending Club disbursed more than $4 billion in 2014, most of which was originated by WebBank and Prosper Marketplace used WebBank to source $1.6 billion of lending last year.
The bank, which has an ROE of 44%, originates the loan but immediately sells the risk on to the marketplace lender. It all sounds eerily reminiscent of banks originating sub-prime mortgages and selling them to third party vehicles to securitise.
Exactly. And now, in addition to the securitizations which are likely to experience waves of downgrades, you have the lenders starting their own hedge funds just to keep the model going.
This will one day seem like a laughably bad idea in retrospect. Especially when people start figuring out what the borrowers were spending the loans on.
Finally, if you needed another reason to not trust SoFi's new hedge fund, here you go (again, from Bloomberg): "Last month, SoFi said it had hired former Deutsche Bank AG co-Chief Executive Officer Anshu Jain as an adviser."