Alternative lending—broadly defined as the issuance of loans by nonbanks through online platforms—has been one of the biggest success stories in the booming financial technology (fintech) space. Headlined by the IPOs of Lending Club and OnDeck Capital and highlighted by SoFi’s recent $5 million Super Bowl ad, the alternative lending sector appears to be firing on all cylinders.
However, as many have observed, appearances can be deceiving.
Despite the success that Lending Club, OnDeck, and SoFi have experienced up to this point, there are reasons to suspect that 2016 might be a more challenging year.
A Challenging Economic Environment
Orchard Platform—a marketplace for alternative lending investors—recently published a blog post examining the economic trends underlying the potential growth of marketplace lending in 2016. It found that while broad economic indicators like the unemployment rate and consumer debt-to-income ratios have continued to improve, the delinquency rates for marketplace-funded consumer loans have started to inch up over the last couple of months. In response to this increase in delinquency rates (and to the Fed’s interest rate hike), marketplace lenders like Prosper and Lending Club have increased the interest rates on their loans in order to keep their products competitive for investors.
But trying to keep their products competitive for investors leads to a corresponding challenge for alternative lending platforms—growth. The same steps taken to appeal to investors—higher interest rates and tighter underwriting standards—can have a deleterious effect on growth rates on the borrower side of the business. These deleterious effects can be most clearly observed in the share prices for Lending Club and OnDeck Capital, which have fallen from their post-IPO highs by roughly 66% and 73% respectively. The consensus from Wall Street seems to be that Lending Club and OnDeck, which have both continued to ramp up expenses and consistently failed to meet the market’s revenue growth expectations, have not yet figured out how to transition from being high-growth tech start-ups to mainstream financial services providers.
It will be particularly interesting to see how OnDeck responds to the market’s insistence on short-term growth. Long term, the company’s plan appears to be transitioning to become more of a bank technology provider—a strategy being referred to as OnDeck-as-a-Service. However, the company has acknowledged that significant revenue from those efforts likely won’t manifest until at least 2017. In the meantime, it’s tempting to wonder if OnDeck may slip back into some of its less savory customer acquisition practices in order to hit short-term growth targets in its direct lending business.
Legal and Regulatory Uncertainty
It’s not yet clear exactly how federal regulators will choose to act when it comes to defining and regulating the alternative lending space. We know it is coming. The Treasury Department has gathered industry feedback through a request for information issued in July 2015 and we are waiting to see what new rules or regulatory guidance may result from that endeavor.
In the meantime, the Madden v. Midland Funding ruling made by the 2nd Circuit Court of Appeals just keeps getting more interesting. I’ll let Kevin Wack of American Banker explain:
Madden v. Midland Funding involves the sale of charged-off credit card debt by a Bank of America subsidiary. The appeals court found that the bank's legal authority to charge an interest rate in excess of state usury caps did not transfer to the debt buyer.
The decision has negative ramifications for marketplace lenders such as Lending Club and Prosper Marketplace because they issue their loans through banks. The purpose of that setup is to allow the nonbank firms to avoid complying with state-level interest rate caps, since banks can apply their home states' rules on loans made across the country.
For the last nine months, marketplace lenders have been hoping the Supreme Court would save them from [the] lower-court ruling that raised fundamental questions about their business model.
But following the unexpected death of Justice Antonin Scalia, the nation's highest court suddenly appears less likely to come to the industry's aid.
"His passing marks a potential blow to the chances of the case being heard and ultimately overturned," said Brian Korn, a lawyer at Manatt, Phelps & Phillips.
The legal uncertainty brought on by Madden v. Midland Funding has led some industry lawyers to recommend that alternative lenders expend the extra time and money to acquire state lending licenses rather than continuing to rely on third-party bank partnerships. The move to a state-by-state lending model would certainly impose additional costs on alternative lenders and perhaps lead to some consolidation within the industry. This wouldn’t necessarily be a bad thing because…
It’s Getting a Bit Crowded in Here
Do you need a loan to purchase solar panels? How about a mortgage? How about some receivables financing for your small business? Maybe a loan to refinance your credit card debt? Or student lending debt? Or medical debt? Maybe you just need a short-term loan but you are a little uncomfortable going to that payday lender down the street?
Good news! The alternative lending industry has a solution for you. In fact, it has dozens of solutions for you from a wide spectrum of different providers (as shown in the graphic from Orchard Platform below).
The alternative lending sector, which continues to benefit from the influx of significant amounts of venture capital (VC) funding, is expanding rapidly into every niche and underserved nook in the financial industry. The law of diminishing returns suggests that this level of VC investment isn’t sustainable. At some point, perhaps soon, investments in alternative lending will slow to a trickle. This is especially likely if investors continue to see platforms like Lending club and OnDeck struggle to perform as publicly traded companies.