It was just three days ago when I asked the following question: “does the disaster at LendingClub foretell the demise of marketplace lending?”
While it’s ultimately too early to know the answer, it’s worth noting what’s happened since then.
If you read that post, came away bearish, and acted on your newfound pessimism, you’d have capitalized on a further 20% move to the downside.
You’re encouraged to read the original post for the whole story, but here, briefly, is what happened: LC shares fell by more than a third on Monday to close at just $4.62 following revelations that CEO Renaud Laplanche failed to tell the board everything he knew about the falsification of documents tied to some $22 million in near-prime loans sold to Jefferies. Laplanche made another rather egregious "error": he lobbied the board's risk committee on investing in a fund (Cirrix Capital) that buys LendingClub loans, but failed to mention that he himself had a 2% stake in said fund.
Not all corporate scandals are directly related to the relevant company’s business model, let alone to an entire industry. But in this particular case, there was a read through for marketplace lending in general. Both the sale to Jefferies and the investment in Cirrix reflect a fundamental problem with marketplace lenders: they’re reliant on the “originate to sell” model. That’s the same model that drove subprime housing and the same model that’s kept subprime auto afloat (so far anyway). It’s a pretty simple concept. Here’s how I described it earlier this week:
“...you make a loan (whether a home loan, a car loan, or in this case, a marketplace loan via an online platform) and then you simply sell it to someone else. In many cases, that "someone" is Wall Street, and they're not just buying one loan, they're buying a bunch of loans. They then securitize them and sell them to investors.”
Presto. Just like that, the loan isn’t your problem anymore, your balance sheet is unencumbered, and you’re free to make more loans.
Make no mistake, this is almost guaranteed to end in tears no matter where it’s tried (and yes, that means there’s a big red caveat emptor on that $1 billion Santander Consumer DRIVE 2016-B deal that’s in premarketing right now). It ends one of two ways: 1) the pool of creditworthy borrowers dries up leading lenders to relax underwriting standards on the way to lending to people who eventually default, or 2) ABS buyers get spooked, the issuance door slams shut, and suddenly, no one can offload risk. It’s looking more and more like the latter scenario is going to play out across the marketplace lending space.
Indeed, it was just hours after I warned on LendingClub that Goldman and Jefferies announced they were halting purchases of the company’s loans. Well don’t look now, but a group of 200 community banks that has so far bought some $200 million in LendingClub loans has suspended its purchases as well. Here’s WSJ with more:
“A consortium of 200 small banks has temporarily suspended a program of loan purchases from LendingClub Corp. as the banks review the events that led to the ouster of the online lender’s chief executive.
“BancAlliance entered into the program with LendingClub last year. In the deal, the alliance facilitates purchases by community banks of LendingClub loans.
“Banks are a significant source of funds for LendingClub. In February, Mr. Laplanche said banks provide about 25% of the capital for LendingClub loans. In the first quarter, that amount rose to more than one-third, as LendingClub funding from banks stood at $947 million, more than double the amount in the first quarter of 2015.”
So the obvious question here is this: what happens when one-third of LendingClub’s funding dries up? That’s compounded by this equally obvious follow-up question: what happens when LendingClub has to hold this credit risk on its books and things start to go sour?
As it turns out, at least one rather famous short seller had similar reservations some time ago. “We had problems with the model,” Jim Chanos told Bloomberg this week, explaining why he was short LendingClub going into this debacle.
“The model” isn’t just problematic because it relies on “originate to sell.” It’s defective for two other reasons. First, it’s a magnet for regulatory scrutiny due to high APRs (see table below from the Treasury’s recent report). Second, in many cases these loans are pitched as a way for borrowers to pay off other debt. In other words, it’s similar to the scenario that plays out when someone pays off an old credit card with a new one. Only we all know how that turns out: the borrower ends up maxing out both cards. That’s fine if the card issuers are both large banks with essentially unlimited access to wholesale funding. There’s essentially no risk. But it’s not fine when the lender is a Silicon Valley startup that’s just lost access to the ABS market.
The moral of the story here is that there may indeed be far more downside for the marketplace lenders.
That’s not to say that anyone should necessarily bet their shirt on a short or out-of-the-money puts. It’s simply to say that as Citi recently put it, there are “too many questions” here.