By Kadhim Shubber (Financial Times): Updated Feb 22, 2016
In recent months, both Lending Club and Prosper Marketplace have hiked the rates they charge their borrowers. The conversation about this has largely focussed on what it says about online lending. Have they been underwriting badly and so now are scrabbling to account for past mistakes? Are they having to offer higher returns to investors who are tempted to put their money elsewhere? Is this the sign of stress that will bring the whole digital house of cards tumbling down?
Forget all of that for a moment and suppose that Lending Club or Prosper loans are just like any other consumer loan. Now ask yourself this question: what do the actions of those lenders say about the US economy itself? The answer isn’t re-assuring.
Lending Club moved first, raising rates by 25 basis points shortly after the Fed hiked in December. It hiked again in January and is now charging borrowers 47 basis points more on average than it was in November. But as Tracy Alloway pointed out last month, “that average conceals a bifurcation: Rates on loans deemed higher quality by the company ticked down 3 bps, while rates on lower quality ones rose by about 67 bps.”
Prosper was slower. Last week, it finally raised rates but it did so more dramatically, with rates jumping an average 140 basis points. But again, rates on the safer credit rose relatively little, while rates on the riskier credit rose quite a bit. Rates on the loans Prosper rates as AA or A rose just 20 basis points, according to an email sent to investors. Rates on the C, D, E and HR [high-risk] loans rose 70, 130, 180 and 130 basis points respectively.
So what are Lending Club and Prosper reacting to?
Maybe late last year both companies hired a new underwriting whizz who came in and said, “oh jeez you’re doing this all wrong. Rates are way below where they should be. Hike you fools!” Another explanation is that they are having to do more to persuade investors to buy their loans purely on a competitive basis i.e. they’re trying to make their loans attractive relative to other assets.
But maybe something about their borrowers changed.
Ram Ahluwalia, chief executive of risk analytics platform PeerIQ, tracks credit across the online lending sector. He has seen “delinquencies uptick mildly in the [second half] of 2015”.
“All things being equal, credit risk is vintage specific, and the most recent vintage has a somewhat higher delinquency rate than prior vintages,” he says, with lower-FICO loans experiencing a 2 or 3 times bigger rise than higher-quality credit.
This isn’t a massive blowout, it’s an uptick, but it’s there nonetheless, even when seasonality and geography is taken into consideration, and it’s across the consumer loan originators PeerIQ tracks. And again the uptick is higher for riskier borrowers than it is for less risky borrowers.
Moody’s has also spotted something going on with the performance of online-originated loans. Earlier this month it put three bonds backed by Prosper loans and sold by Citigroup on review for downgrade. The move was prompted “by a faster buildup of delinquencies and charge-offs than expected in transactions backed by Prosper-originated loans”. Around the same time Moody’s also revised up its loss assumptions for sp,e Blackrock bonds, also backed by Prosper loans.
Brian Weinstein, a former Blackrock fixed income guy who is now chief investment officer at Blue Elephant Capital Management, has a bearish thesis about all of this: people who have borrowed from online lenders are finding it harder to pay their bills now than they were this time last year.
Blue Elephant buys loans from the likes of Prosper and Funding Circle, typically higher quality credit. Weinstein says that defaults have been ticking up since about August last year and that they have moved “rapidly higher” for the lower quality credit. This, he says, is why Lending Club and Prosper have raised rates. And it’s why the rates have jumped up so much faster for riskier borrowers than for less risky borrowers. There will be more hikes to come, he argues, as the companies respond to the deterioration in credit.
“I think it’s very simple. If you look at our book, [for] the higher quality borrower, the default rates have moved slightly higher. If you look at the lower quality stuff, the default rates have moved rapidly higher.”
The conclusion he draws is that there is “a legitimate economic slowdown that’s affecting the lower credit quality borrowers in the United States”.
That’s all assuming that there isn’t just something going wrong with online lending in particular. It’s possible – perhaps this is a false signal and we should be more worried than we already are about the ability of this new crop of companies to underwrite.
But consider that the business models of Lending Club and Prosper is to pass-through loans direct from borrowers to institutional investors (largely) and remember that there is more attention on these companies and their credit than most. It’s not inconceivable that they might respond faster and more publicly to changes in credit because they are deeply sensitive to any suggestion that they are asleep at the steering wheel.
It’s one we’ll be keeping our eye on. Perhaps it’s a blip. But perhaps it’s indicating a real slowdown in growth.
We’ll leave you with this thought from Weinstein on the lenders who don’t have the name recognition of Prosper and Lending Club.
“I’ve seen some of the loan tapes from other competitors … I’ve seen the guys who take the rejects and the performance is horrific”
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