BankTech

The Blind Growth of Alternative Lending Is About to Backfire

MEDICI

Clear skies for alternative lending companies seem to be getting clouded after the news on Lending Club and OnDeck—some of the largest alternative lenders—witnessing a massive crash of their share prices over a little more than a year. In the last couple days, the situation was just as dramatic as professionals noticed more than a 30% drop in OnDeck's share prices on Tuesday, hitting $5.50. Wednesday wasn’t better either since the price keeps shrinking.

ondeck and lending club share prices

Whether it’s a result of Q1 2016 “earnings” or something else, it probably speaks of the state of the whole industry as well. Alternative lending was never a “cure from cancer” for small businesses and individuals with no hope on banks since it carries certain risks for everyone. However, it gained an outstanding traction and companies like Lending Club, OnDeck, Prosper, SoFi and others managed to make some waves in the market.

P2P and SME lending have been especially successful among alternative lenders. And one of the reasons the model is successful is because it is fueled by banks and it offers quick, painless loans. In fact, in the US, around 80–90% of the capital lent through the two largest P2P lenders – Prosper and Lending Club – is institutional money. It means when a lender originates a loan on a platform (even P2P platform), it is most likely secured by an institutional player.

JPMorgan Chase and OnDeck is an example of a loan mine for an institutional player. According to the WSJ, JPMorgan Chase spent about $8 billion in 2015 on technology. But when it came to developing a new online loan for small business, the bank turned to OnDeck helping the company to originate loans for part of the bank’s four million small-business customers.

Financing the originated loans by selling them out to the financially powerful and maybe struggling counterparts has been quite a successful model so far. And it would continue to be if the largest alternative lenders won’t start having a hard time selling the loans. According to Fortune’s findings, in Q1 2016 the percentage of loans sold by OnDeck to investors has shrunk from 40% to 26% in the same period last year. Furthermore, the lender was able to make lesser profits from the loans sold in Q1 2016 compared to a year ago.

Another alternative lender going through some hardships is Prosper. The company has recently announced to lay off almost 30% of its workforce, realizing that investors aren’t as eager to fund loans after years of rapid growth.

The company is reported to have difficulties funding the loans it originates. The burden didn’t get any lighter after the news from Citigroup less than a month ago when the bank announced that it would stop buying loans from Prosper to package into securities. The reported reason is that investors demanded a higher premium on the bonds.

The core problem with any bank-buyers of the loans could be in the loans themselves. For example, OnDeck’s financial results of Q1 2016 indicate that the origination volume increased to a record $570 million for the quarter, reflecting 37% growth over the prior year period. Its rival, Lending Club, has reported hitting more than 90% growth in loan origination in 2015 in comparison to previous year.

But what kind of loans do those companies originate at such a pace? The quality of loans means a great deal to institutional investors as they are the face of the industry and can’t afford high loan default levels. Given that customer credit default rate has been declining over the past three years (less than 1%), alternative lenders are not an attractive investment prospect for banks with their cheap and easy loans with high risks.

default rates for banks

While certain business lenders have a default rate around 6–7%, small-business default rates for incumbent banks were less than 1%. While  alternative lenders are busy actively growing and attracting borrowers (primarily the risky segment), they seem to forget about the long-term sustainability and potential failure of the business model itself.

Blind hunger for growth can’t lead to anything good for alternative lenders – both banks and regulators have started being more attentive to large lenders.

MEDICI Team

MEDICI

MEDICI Team is a group of content writers, bloggers, journalists, researchers, and editors from the MEDICI team who collaborate to create FinTech insights.

Apply to Become a Contributor