Institutional Money and Dirty Platforms

Multi-lender P2P-lending platforms expose individual investors to more risk and uncertainty about their investments than many are aware of. An economic recession could spread panic among institutional investors and spark a liquidity crisis.

Voltaire once quipped that the Holy Roman Empire was “neither holy, nor Roman, nor an empire”. The perceptions of Peer-to-Peer (P2P) lending are currently undergoing a similar shift.

One of the “peers” (the typical “mom-and-pop investor”) has already lost ground to institutional lenders like the sharks at hedge funds. At the same time, the new-fangled “multi-lender” platforms have severed the relationship with the other “peer” (the borrowers) too, some of whom may not even be aware that their loans are resold on such platforms by opaque middlemen. Appalled by this lack of transparency and the dangers of becoming addicted to institutional money – investors are starting to ask whether P2P-lending is still about lending and borrowing among peers, or has it become something more akin to gambling. Many are now paying attention to these previously little-considered systemic risks.

Divided by religion, not quite Roman, the loose confederation of principalities eventually collapsed under the weight of its contradictions. The unholy segments of the P2P-lending industry seem to be heading the same way.

So what’s happening?

Lending is a spread business. Every banker knows some variant of the humorous “3-6-3 rule”: borrow at 3%; lend at 6%; and tee off at the golf course by 3 pm. But the first 3% always proved difficult for many P2P-lending platforms. Banks could rely on a steady supply of cheap government-guaranteed deposits, whereas P2P-lending platforms found themselves in a cut-throat competition over the savings of retail investors. Inexperienced investors needed to be acquainted with an unfamiliar investment product and convinced that high-returns from P2P-loans were worth foregoing deposit insurance protections. For all the hand-holding, some P2P-lending platforms still struggled to find enough individual investors to meet the demand. To sustain their growth momentum, many went wholesale.

Today, an ever-larger share of P2P-loans – bundled or divided into risk trenches – is snapped up by the likes of asset managers, banks, family offices and hedge funds. In 2018, a report by the Cambridge Centre for Alternative Finance reckoned that some 40% of the funding for P2P-loans in the UK comes from institutional investors – up from just 5% in 2014. Today, it’s reasonable to expect that most P2P loans in the UK are not financed by the general public anymore.

That proportion is significantly larger in the US. In 2018, institutional investors swallowed as much as 90% and 94% of the new loans issued by the two biggest US-based P2P lenders – Prosper and Lending club – respectively. The influx of institutional money has effectively pushed one of the “peers” out. “Peer-to-peer lending” became known as “marketplace lending”.

Peer-less lending

Already, the shift away from pure P2P-lending has made it difficult for those Fintech disruptors to present themselves as markedly different from the incumbents. But some platforms went further and have cut the other “peer” out of the picture too. Attracting borrowers, after all, was costly too. Many P2P platforms continue to spend lavishly on ads, usually competing for the same tech-savvy cohort of borrowers. Some wondered how much better it would be if they didn’t have to look for the borrowers themselves. What is now known as a “multi-lender P2P platform” is a troublesome offspring of that idea.

A traditional P2P-lending model involves 3 parties: investors, borrowers and the platform which facilitates transactions between the two. By contrast, multi-lender P2P platforms – the likes of Mintos, PeerBerry or Viventor – bring in other non-bank financial institutions called “loan originators” to solicit potential new borrowers. Outsourcing allows platforms to process higher volumes of loans, and thus rake in more fees. But adding more middlemen makes the whole process murky.

Traditional P2P-lending platforms are loan originators themselves, so they almost always have a direct investment structure – investors are buying direct claim rights against the borrowers. Meanwhile, the investment structure at many multi-lender platforms is indirect:  investments are pooled together at the loan originator, which itself owns the loans, but promises to return the principal and a slice of the interest back to investors. To keep loan originators from facilitating large quantities of doubtful loans many platforms require “buyback guarantees” – they ask loan originators to repurchase any of their non-performing loans back from investors.

What looks like a clever way to assure investors, actually represents a major systemic risk to the entire industry. Buyback guarantees create an illusion of a risk-free, 0% defaults environment. But when transparency is low and liability structure complex – investors are unaware just how much exposure they’re taking on until the music stops playing. Because buybacks hurt their bottom line, loan originators are under pressure to issue more loans. After all, if they double their loan books, a 20% default rate will become 10%, and it will be some time before the defaults spike again. Increased leverage might be sustainable if new loans were of high quality – but there are good reasons to expect that some loan originators are already over-leveraged and have succumbed to the temptation of relaxing their standards.

A sustainably-unsustainable business model

In 2017, investors watched with uneasiness as Eurocent, a Polish lender on Mintos, defaulted on its buyback commitments. While Eurocent was not a big lender (reported loan book value of €2m), investors since then have begun to pay close attention to the previously little-considered risk of a lender collapse. In hindsight, concerns should’ve been raised earlier. In an investor presentation, Eurocent exaggerated their revenues and inflated the size of their loan book. In an email to investors, Mintos didn’t mention the company’s equity or profitability – a blurry financial statement in Polish was deemed sufficient. Eurocent issued doubtful loans at reported 81-107% APR, for which investors got a meagre ~10%. With reported defaults at 30%, it should’ve been clear that investors were relying solely on unsustainable buyback guarantees for their investments to make sense. Since the collapse, most investors have not received a single penny because of court delays.

Since then, more low-quality, loss-making lenders with negative equity balances joined the action. Financial inexperience of some loan originators is similarly blatant. Financial reports tend to be infrequent and of poor quality. Most loan originators on Viventor and nearly half on Mintos are unaudited. Investor presentations feature royalty free business images and meaningless promises of sustainable lending but little information on lending performance and no contingency plans for an orderly bankruptcy. Late last year some of Mintos’ loan originators operating in Russia and Kosovo ran into regulatory problems and lost their lending licenses. Recently, Finland, Norway and Denmark moved to cap interest payments on consumer loans, which seem destined to kill the payday lending business model in Scandinavia, on which some loan originators on Mintos depend.

If unsustainable lending, financial inexperience or regulatory issues cause loan originators to run out of capital and default on their buyback commitments – investors can only count on delays and uncertainty at court.

Outrunning a recession

Thought up in an era of lax monetary conditions, the P2P-lending industry has never experienced the chaos of a tanking economy. Assured by the longest economic expansion to date, P2P-lending platforms have heaped on debt but many are only marginally profitable, or are yet to be profitable at all. Times of plenty paper over the cracks, but a credit shock would batter companies which rely on institutional money, and would scar the reputation of multi-lender platforms which skimped on their due diligence.

Even a recession that originates outside the financial sector – say, a pandemic – would be testing. Demand for loans is cyclical and heavily reliant on overall consumer and business spending. Defaults spike during economic downturns as people choose to default on unsecured debt, rather than stop paying their electricity bills. The fear is one of a downward spiral: an uptick in default rates could spook investors and eventually lead to a liquidity crisis. The popularity of multi-lender platforms and the increasing reliance on institutional money is gasoline to the fire of such fears.

Hedge funds tend to demand higher yields. Given that platforms do not take the hit from defaults directly, more institutional money puts pressure on marketplace lenders to loosen their underwriting standards. At the same time, those hedge funds are subject to binding short-term portfolio metrics. If defaults spike, “mark-to-market” valuation of their P2P investments will fall, and institutional investors will have to liquidate their exposures. Exits by some investors would trigger further sales and price falls. Secondary markets would become clogged. Self-reinforcing withdrawal of capital would leave many return customers – who take out P2P-loans to refinance previous P2P-loans – unable to find investors willing to renew their commitments and thus pushed to default as well.

Back in the days when platforms still emphasised the ideal of “collaborative finance” with an emphasis on transparency and horizontal reciprocity among peers – many thought of P2P-lending as a new pillar of financial stability. P2P-lending was supposed to provide additional loss-absorbing funding for consumer loans, with risks assumed not by the taxpayers, but individual investors. However, if illiquid P2P-loans are gobbled up by institutional investors, who then refinance their positions in the short-term money markets – the situation would be reminiscent of the unstable short-term repo and ABCP money market funding of subprime mortgage-backed securities that triggered the Financial Crisis of 2007-09. That should give marketplace lenders a pause.

A liquidity crisis of the sort described above would also expose how buyback-guarantees hide the real risk assumed by the lowest denominator on multi-lender platforms – the retail investor. In pursuit of a meagre return, many will be caught off guard once the over-leveraged loan originators default on their buyback commitments. Some will spot the smoke signals: delayed financial updates and dwindling lending volumes – but such retail investors are few and far between. Regulators in the UK, worried about the unsophisticated investors taking up too much risk, are putting limits on how much they can invest in P2P-loans. Ironically such regulations will only further increase platform reliance on institutional money.

Debt-for-bread exchange anyone?

Nevertheless, an economic recession would also have winners. The platforms that continue to profitably lend in a downturn will earn more trust from investors and will be rewarded by a lower future cost of capital. At every office, the downturn will be framed as a test of the company’s culture. But whether companies persevere will mostly depend on the health of their balance-sheets and the viability of the chosen P2P-lending model.

Those who have chased risky high-returns will only find high-losses in a downturn. Those who have stretched their underwriting standards too far will wake up with muscle strain. Those who have relied too much on yield-hungry hedge funds will find themselves thin on capital. And those who have lost control over their loan originators’ will find that they’ve lost the confidence of their investors too.

The platforms that thrive will be those that shy away from financial gymnastics and fund the majority of their loans by retail money (retail investors tend to be “stickier” – providing the much-needed capital in times of uncertainty). The winners will be those that stuck to niches of creditworthy but underbanked borrowers, did not lose control over their underwriting standards, and have not spent more on advertising than they could afford.

For now, the roulette wheel is spinning and everyone’s cheering it along. But these times will not last.

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