“Big banks forgot about technology and new things. They’re culturally and politically geared against innovation.” - Peter Thiel
Last week I attended and spoke at a breakout session for the 2016 LendIt USA conference in San Francisco. For those that don’t already know, LendIt is a two day conference centering on the rapidly growing FinTech (financial technology) industry. LendIt was first launched in 2013, around the time we were starting to explore peer-to-peer (P2P) lending, with a total of 350 people in attendance. Last week 3,500 people were in attendance from 49 different countries. The event drew some fairly well know speakers, such as famed investor Peter Theil, and was covered by established media outlets such as Bloomberg and CNBC. All this to say, the interest in and legitimacy of the new FinTech industry has grown significantly over the past several years.
According to a recent study, alternative finance has grown by 9x over the past two years from a $4.5 billion industry in 2013 to a $36.5 billion industry in 2015. Fifty percent of millennials expect tech startups to change the way they bank and 33% think they will not need a bank at all soon. This industry is experiencing explosive growth and is still only scratching the surface of the banking industry here in the US alone. Even though Lending Club and Prosper pioneered this industry almost a decade ago with a simple peer-to-peer model, today alternative finance includes platforms and services for home mortgages, school loans, small business loans, and more. That being said, P2P consumer loans still account for the vast majority of the activity (roughly 70%) in this growing industry.
One interesting dynamic that I noticed at the conference was how alternative financing has grown to include a good number of “balance sheet lenders,” which are using their own capital to make loans rather than a platform to connect borrowers and lenders (e.g. marketplace lending). A balance sheet lender operates in the same way as a bank (not so alternative really) where all the potential reward and risk of the loan is born by the company as opposed to the platform model which underwrites loans, connects borrowers and lenders, and then makes money servicing the loans (e.g. Lending Club, Prosper, etc.). The only advantage a balance sheet lender has over a traditional bank is their overhead and the utilization of faster underwriting techniques brought about by technological advancements. Even though balance sheet lending only accounts for around 10% of the industry, the recent emergence further solidifies the legitimacy of FinTech as capital continues to flow into the space at the expense of the traditional banking model.
Of all the different talks and breakout sessions I attended during the event, I found the opening talk by Renaud Laplanche, Lending Club Founder & CEO, to be the most interesting. Some people who are unfamiliar with the P2P lending space believe that the only people borrowing money on these platforms are those of bad credit who have already been rejected by traditional banks. The fact of the matter is that the average borrower on Lending Club’s platform is well qualified with a FICO score of 699, debt-to-income ratio of only 18.1%, over $75k in income (top 10% of US), and over 16 years of credit history. The real reason borrowers come to Lending Club for the loan is savings. In his talk, Laplanche stated that borrowers seeking a loan through Lending Club in order to refinance their existing bank/credit card debt save around 35% or 6.4% a year in interest on average.
Laplanche also addressed the two main questions at the front of most P2P investor’s minds: how will a hike in interest rates or an economic recession effect my returns? On the interest rate question, Renaud explained the difference between consumer loans and corporate debt. Consumer loans, similar to those being issued on Lending Club, are typically priced at a spread to Federal Funds rate. So as the Federal Reserve raises the Fed Fund rate, so too will Lending Club raise their rates. We already saw this in action as Lending Club raised rates in December, January, and February partially in response to the Fed’s first rate hike in close to a decade. As such, a diversified portfolio of consumer loans should actually fair better during a rate hike environment than a portfolio of corporate bonds as long as interest and principal repayments are being reinvested in new loans at the then higher rates. This was illustrated in the chart below which shows how the rates at Lending Club would have mirrored (purely theoretical since LC started in 2006) the change in the Fed Funds and done much better than corporate bonds during the last two rate hiking cycles (1993-95 & 2004-06).
The second big question Renaud addressed was what happens to an investor’s portfolio and to Lending Club as a business when the next economic recession rolls around? Since Lending Club was launched in 2006, he was able to point to actual results for loan performance during the 2007-09 recession. The default rate for any investor’s portfolio is highly dependent on mix of loan grades as well as the selection of which loans make it into the portfolio. As such it is impossible to give a default number which applies to everyone’s portfolio, but the rule of thumb I heard mentioned several times during the conference is expect your current default rate to double. For our Lending Club portfolios that means defaults going from 6%-8% up to 12%-16%. Since we start by building a portfolio around a 16% gross yield (before defaults), that means our expected return during a recession should be fairly close to breakeven, which on a relative basis will look really good versus the long list of other “risk assets” which typically sell-off during a recession.
In addition to attending a variety of talks and breakout sessions, I also had the opportunity to tour the Lending Club offices and to sit on a panel during a breakout session to provide an advisor’s view on marketplace lending. Overall I enjoyed the two day event and came away from the conference with a better understanding of how FinTech is growing and changing some of the ways people do business. Like any other young, rapidly growing industry, I would expect there to be some consolidation and wash out amongst some of the late mover start-ups in this space, but I am very bullish on the future of the industry as a whole as well as the roll of these types of investments in our client portfolios.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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