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Fed flags online lending as subprime redux, but market hits back


The ABS market was abuzz this week after a controversial report from the Cleveland Federal Reserve compared online consumer lending to the pre-crisis subprime mortgage market, drawing criticism from market players for its “inflammatory” assessment. But the report comes at a time of increasing loss rates on consumer loans and a rush by lenders to adjust their loss expectations, writes Sasha Padbidri.

ABS participants, speaking with GlobalCapital this week, hit back at the report, written by Yuliya Demyanyk, senior research economist, Daniel Kolliner, research analyst, both of the Cleveland Fed; and Elena Loutskina a professor of business administration at the University of Virginia’s Darden School of Business, and contributing author at the Cleveland Fed. 

The authors challenge the belief that peer-to-peer (P2P) loans have expanded credit to borrowers with limited access to debt since the financial crisis.

“There is a perception out there that P2P loans have certain beneficial qualities to consumers, such as being a solution for underbanked borrowers, or improving your credit score. But when we did an analysis, our data didn’t support any of those claims, and indicates that these loans may not be in the best interest of those consumers and in that sense, it follows the definition of predatory lending,” Demyanyk told GlobalCapital.

The study compiles data from TransUnion on 90,000 borrowers who received their first P2P loan from 2007 to 2012. The analysis showcases a pattern of risk growing each year with each loan vintage, similar to what was observed in the subprime mortgage market before the crisis.

“There are a variety of platforms now compared to 2006, but if you compare the market to subprime mortgage loans, each subsequent vintage is riskier than the year before, because the loan defaults systematically increase with each vintage. That is the parallel we saw between P2P and the subprime mortgage loans,” added Demyanyk.

More granularity needed

The report is a departure from previous Fed comments on the marketplace loan industry. Sources say the central bank has been “fairly complimentary” of the industry for enabling underserved borrowers to obtain “ lower priced credit”. Apart from the tone of the commentary, people in the market also raised issue with the timeframe of the data.

Josh Tonderys, chief executive at Marlette Funding, told GlobalCapital that the report did not take into account that marketplace lending has radically changed since 2012.

“If you look at the amount of loans from 2007-2012, there were really only two lenders during that time period — mainly Prosper and Lending Club. There was only $1.6bn of loans issued by those two platforms then, compared to at least $30bn per year in all of unsecured consumer credit [ since]. ” he said.

However, an ABS investor agreed that some deep subprime consumer loans have shown similar characteristics with pre-crisis Home Equity Lines of Credit (HELOCs).

“They don’t have enough data to draw parallels, but marketplace loans, especially those made to subprime customers with thin credit files, kind of look like HELOCs before the crisis,” he said, comparing subprime consumer credit to the pre-crisis practice of homeowners borrowing against the equity they had in their homes, resulting in many borrowers amassing more debt than their homes were ultimately worth.

Joseph Cioffi, partner at the law firm Davis & Gilbert, disagreed with the comparison with predatory lending and with the parallels to the subprime mortgage crisis drawn in the Fed report.

“We can assume some of the effects of these loans on the disadvantaged segment of the population, but you can’t just jump from there to predatory lending,” he said. “‘Predatory lending’ doesn’t just encompass the vulnerable segment of the population, but also dishonest and deceptive practices to facilitate [borrowers] taking out loans that they can’t afford.”

He added that more granular or segmented data was needed to have “productive conversations” about the market.

“The comparison to subprime mortgages was solely based on default trends, and that alone isn’t enough," he added. “I don’t think we could compare this to subprime mortgages just based on the fact that defaults seem to be edging up in a way that’s similar to the run-up to the financial crisis.”

A central argument of the Fed's report was that sector has not done much to expand access to debt for borrowers with low credit scores.

In securitization , subprime consumer ABS has thinned since the crisis. For the five major credit card issuers, the years 2008-2016 saw revolving credit available to US borrowers with a Fico score of less than 660 reduced by approximately $142bn, according to data published by online lender Elevate earlier this year.

Even portfolios backing recent marketplace loan ABS have a weighted average Fico score above 680, the level that defines so-called ‘near prime’ credits, despite the notable dip in collateral quality. Marlette, for example, had an average score of 705 for its most recent transaction which was priced in October, while Prosper had a weighted average Fico score of 709, according to data from Kroll Bond Rating Agency.

“If you look at the larger players in the space, they usually require a minimum [Fico score of 680] from the borrower,” said Kathy Holland, executive vice-president at Elevate, an online lender that serves non-prime borrowers. “The Fico requirements might have gone down a little bit but that’s still targeting near-prime consumers and not non-prime consumers. Most lenders have not really offered a lot of non-prime options,” she added.

In contrast to the assumptions made in the Fed report, Holland and Cioffi disagreed with the conclusion that the industry lacked a “specific regulatory body dedicated to overseeing P2P lending practices”.

“The P2P lenders aren’t wholly unregulated as the report suggests it is,” said Cioffi. “It’s more of an enforcement issue. Further, in a bank partnership model where a bank is funding the underlying loan, there would be some consumer protection. There are so many types of lending, and this report really seems to focus on peer-to-peer, among many different loan types and I think that limits [its] value,” said Cioffi.

Holland noted that Elevate, which is looking to partner with a third-party bank to launch a credit card next year, has to comply with regulatory scrutiny from both national and state regulators.

“We are subject to annual audits to make sure [predatory lending] is not happening. If lenders are not already doing that, then they should. But I’d be surprised if they’re not — their bank partners would expect that of them,” she said.

Credit normalisation plays out

Sources acknowledged that the report comes at a time when credit “renormalisation” is playing out across consumer loan sectors, including marketplace lending. Although loan performance is still stronger than pre-crisis levels, overall loss rates on recent loan vintages have been increasing. The late 2015 and 2016 loan vintages have been flagged as the worst performing cohort, according to a third quarter marketplace lending tracker from PeerIQ .

“Credit normalisation has been happening for a couple of quarters. The way we see credit normalisation playing out is loan loss reserves are increasing at a faster rate than the growth seen in loan portfolios. We are seeing this trend across different consumer sectors. We’ve had a very benign credit and economic environment, and lenders are provisioning for higher losses going forward,” PeerIQ’s head of research, Ashish Dole, told GlobalCapital.

“Issuers are continually updating their credit models and are taking more factors into account to predict borrower performance,” Dole added.

Given the performance of recent vintage marketplace loans, many online lenders have been quick to tighten underwriting standards and limit the amount of riskier loans they sell to investors. Lending Club, for example, announced on November 7 that it would stop selling the lowest two tiers of its consumer loans to investors.

Marlette’s Tonderys added that as credit normalises, a key challenge for lenders will be to find a way to stay ahead of the credit cycle while offering competitively priced loans to borrowers.

“That said, we’re watching really closely and looking out for populations that we find are underperforming and we’re removing them,” he said. “It’s a different skillset at this point in the cycle. Lenders need to figure out how to stay ahead of credit trends — which are going in a negative way — while still trying to provide borrowers with an attractive product in a competitive market.”

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