There have been a number of articles and opinion pieces written lately about marketplace lending and whether it can survive or sustain itself. Opinions on the subject vary, but few writers focus on the critical issue in the survival of marketplace lending: underwriting consumers who do not have super-prime credit.
The Origin of Marketplace Lending
To fully understand the issue, we must start with some history of the space. In 2006, a small number of peer-to-peer lenders entered the space with a specific target market and goal in mind: to make unsecured medium and larger sized loans to prime and super-prime consumers who would use the proceeds to displace high-APR credit card debt. These consumers could eliminate credit cards with interest rates of 12 to 36 percent and replace them with installment loans at 5 to 12 percent.
By virtue of the consumer’s prime or super-prime credit score, there was little chance the lender would not be repaid. The lender made money on loan fees, servicing and/or the interest on the money they loaned. With this arrangement, everyone won.
Fast forward 12-18 months. The success of the industry resulted in equity shops pouring lending capital into the space and the emergence of self-proclaimed big data experts.
However, there was a problem. The number of super-prime consumers looking for loans to displace credit card debt was finite. The market found itself flooded with lenders sitting on millions of dollars in lending capital with no way to put the dollars to work.
Underwriting for Various Markets
Lenders needed to find a new outlet for their capital. Having already saturated the prime and super-prime markets, the only option was to pursue consumers with lower credit scores who pose a higher credit risk.
For some in the industry, the underwriting and risk mitigation process is easier than for others.
For example, imagine the process for applying for a bank credit card. A consumer goes online, completes the form and the issuer approves it. Since the issuer is going to mail the card, they have a number of days to reconsider or reevaluate the account before the customer is in a position to pull any proceeds from the card.
Going forward, each time the consumer uses the card, the issuer can reevaluate utilization and risk. If a consumer’s first attempted use of a new card is to max it out with a cash advance, it’s very likely the transaction would fail. Credit card issuers have a greater opportunity to routinely evaluate consumers and their card usage in order to significantly mitigate their losses.
There are also underwriting advantages of a consumer-present transaction (storefront lending). If the consumer is literally standing in a lender’s place of business and the consumer’s residence is local to the business, there is an improved likelihood of repayment. It is also easier for a lender to mount a collection effort if necessary.
Unfortunately, neither of these scenarios apply to marketplace lending.
The Reality of Online Unsecured Installment Lending
Online unsecured installment lending (consumer-not-present), is one of the most difficult underwriting scenarios in the financial services business, given that there is no collateral to collect on.
Let’s say a consumer goes online and applies for a $5,000 loan. The online lender completes their underwriting process and the customer is approved for credit. In all likelihood, the loan will be funded directly to a bank account overnight via an ACH transaction. In terms of the lender assuming and accepting the full risk for the transaction, this is the point of no return.
There is no chance to collect the money back, no collateral to repossess, no credit card transaction to decline. The entire loaned amount is gone. To compound the problem, collections on non-performing loans can be more challenging since the consumer and the lender could be located on different coasts. The only tools lenders have for collection efforts are a customer’s mobile phone number and email address, both of which are easy to screen and avoid if the customer so chooses.
Online unsecured loans can also reveal a consumer behavior that lenders typically do not encounter with super-prime consumers; therefore, they don’t know how to identify it or underwrite for it. It becomes more significant the further the lender moves down the credit risk spectrum: consumer intent-to-not-pay.
Regulators and consumer advocates spend a great deal of time focusing on consumers’ ability to pay. And although it’s an important issue, intent-to-not-pay will have a greater impact on loan default rates than ability to pay issues.
Given that online, unsecured lending is the most difficult type of underwriting, it’s understandable that the marketplace lenders who are moving down the credit risk curve would experience some growing pains and higher default rates.
A number of lenders have been successfully offering online single-payment (payday) and higher-APR installment loans for the past 10-15 years. They experienced the market upheaval and discovered that the key to survival is simply a matter of innovative underwriting.
As marketplace lenders learn more about the non-prime consumer and discover the underwriting solutions available to help them, they’ll be back on track and thriving once again.
Tim Ranney is president and CEO of Clarity Services, Inc., a real-time credit bureau specializing in underwriting and fraud solutions for the subprime industry. Prior to founding Clarity in 2008, Ranney spent 20 years as a leader in Internet security and risk management, serving as COO of an industry leader and senior executive for both Network Solutions and VeriSign.