Why Lending Club has shunned securitisations

For some people, securitisations are irredeemably tainted. Pooling loans, slicing up their cash flow and then selling it off in bonds of varying risk is an act of alchemy that can only end in disasters like, for example, a global financial crisis.

But for fintech companies trying to take the loan market by storm, a securitisation is not only a source of relatively cheap capital, it’s a badge of honour. A securitisation rated by one of the big ratings agency is a sign that the startup is playing in the big league with the pros.

However, one name is conspicuously absent from the stream of press releases announcing securitisations of loans that have been originated online: Lending Club, the world’s largest marketplace lender (depending on how you treat the various Chinese lenders).

This curious fact is not just a facet of the company’s strategy, it’s also a window into the evolving nature of marketplace lending and the question marks that still hang over the sector.

Last October, Lending Club was hit by the departure of one of its biggest loan buyers, Santander USA. Under pressure from regulators, the bank said it was exiting the consumer loan business and was selling all of its Lending Club loans – their agreement in March 2013 had give Santander the right to buy as much as a quarter of Lending Club’s loans for three years and it had built up a $1bn portfolio. Lending Club was able to replace Santander “pretty much overnight,” chief executive Renaud Laplanche later told the FT.

One way for a bank to get risk off its balance sheet is a securitisation. In this case, Santander seems to be have been forced to hive off the loans wholesale. As early as November 2014, Tracy Alloway reported that Santander was working to securitise its Lending Club loans. Here’s a report a year later in Asset Backed that touches on why that process fell apart (emphasis ours):

Santander Consumer had been working since January on a securitization of marketplace loans originated by Lending Club. But the planned offering ran into roadblocks, including the inability to gain a double-A rating for the most senior bonds and a disagreement over which entity should stand behind the representations and warranties of the collateral loans. Sources said Lending Club, which provides its own reps and warranties, wanted Santander to offer additional investor protections — similar to the ones Citigroup provides for its securitized loans originated by Prosper Marketplace.

But Santander’s agreement with the Fed barred it from taking on additional risk, and for that reason Santander decided over the summer to cancel the offering. During its third-quarter earnings conference call on Oct. 29, Santander announced it was getting out of the unsecured consumer-lending business and would focus instead on its core auto-finance program, including Chrysler Capital, Santander’s joint venture with Chrysler Group.

“Representations and warranties” basically refers to the promises that a seller makes to enable the deal to go ahead, or alternatively, it’s the stuff that investors’ lawyers will whack you over the head with if something goes wrong. If you’re an investor, you want as many strict reps and warranties as possible. If you’re a platform, you want as few as possible. There is also a cost element — a deal girded by strong reps and warranties for investors will be more favourably priced for the platform, and vice versa.

Laplanche says the Lending Club isn’t “willing to take more risk to do a securitisation than we would through the normal operation of the platform”.

“Our business is not about taking credit risk,” he adds. “We’re more conservative on that than smaller marketplaces that maybe have less choices than we do.”

So Lending Club didn’t want to make any further promises to investors and Santander USA basically couldn’t because regulators were breathing down their neck, which is far from the sort of reassurances you would want as an investor.

But it’s worth looking at exactly what Lending Club is “more conservative” about. When you sign up as an investor on Lending Club you are asked to consent to their “Investor Agreement”, which lays out your obligations and theirs. As a marketplace that connects borrowers and lenders, Lending Club tries to limit its obligations, and therefore its risk.

For example, it makes no promises about the accuracy of the borrower information. Instead it just says that it has made “commercially reasonable efforts” to verify “the identity” of borrowers. What’s more, while it promises that it has obeyed all relevant laws about the sale of the loan to you, the investor, it doesn’t make any promises about the origination of the loan in the first place. Indeed it makes investors take on the risk associated with violating borrower discrimination laws.

Compare that with the terms rival Prosper Marketplace agreed to in the Citigroup backed securitisation of its loans. According to Fitch, Prosper not only vouches that “the most recent Borrower-supplied information regarding such Loan identified as verified by the Seller [Prosper] or its Affiliates was true and correct in all material respects,” it even pledges to buy back any loans that default within the first 30 days of securitisation deal closing. Those two broad areas — buybacks and data verification — are what investors focus on the most, according to Albert Periu, global co-head of capital markets at Funding Circle, which is working towards its first securitisation deal this year.

In all, Prosper’s reps and warrants in the Citigroup securitisation run to almost 2,000 words, while Lending Club’s standard reps and warrants don’t even breach 300.

Of course there are many sources of capital for marketplace lending with various benefits and downsides, as discussed in this recent American Banker feature. Lending Club has made a point of focussing on retail investors, for example. “We are showing that we can scale without the securitisation market,” says Laplanche. The company is targeting at least $14bn in loans this year, he says, adding that there have been small, private securitisations of Lending Club loans from time to time, but not any “meaningful amount”. (Eaglewood Capital, for example, has securitised Lending Club loans in the past.) It’s also worth noting that one of reasons Laplanche is able to be relaxed about this is that investor demand for marketplace loans is outstripping originations — the bottleneck is on the consumer end.

So why does this matter? Well it’s an important antidote to much of the chatter around marketplace lending.

What started as “peer to peer” lending has become deeply immeshed in the machinery of Wall Street. But in becoming entwined with old finance, many of the purported benefits of online lending have quickly disappeared. So despite the talk of “transparency”, the sort of granular loan level data available through a marketplace lender’s website or API disappears in a securitisation, where you just have another pool of loans with all the typical risks around borrower data and the incentives for a lender that makes most of its money from churning out new loans to loosen its underwriting standards. So as marketplace lending interacts with old finance, its deficiencies are exposed and investors ask for protection.

In other words, a good way of getting perspective on fintech is to see what happens when the capital markets are asked to buy the hype.