There Are No Universal Truths in Marketplace Lending

"We live in a financial age, not a technological age." — Marc Andreessen

Online lenders believe they are all operating in the same universe, subject to the same fundamental laws. Among other things, the new crop of digital lenders believe: Faster is better for consumers and loan buyers; everything should be automated; millennials are one homogenous group who need to be coddled with an unbelievable customer experience; credit risk is to be avoided; they are technology companies first and lenders second; and that they are marketplaces, while their borrowers are members.

However, I believe the opposite is true. Each lending product and service is unique and in its own universe; thus, attempting to impose the fundamental laws of a particular lending universe on another will lead to an eventual collapse of a particular firm or industry segment.

Just look at the recent carnage in the marketplace lending industry. Kicked off by some issues related to Lending Club, the damage to investor confidence was significant, and most likely, it will prove fatal to some of the platforms. For example, touting your company as a "marketplace" that doesn't take credit risk and then ramping up growth through the originate-and-sell model to hot institutional money proved unsustainable. This model proved to be brittle and with nothing to fall back on; there was no flexibility in the system.

Physics is a good metaphor to make the point clear. Multiverses is the concept that not only does our universe exist, but that others exist in dimensions we cannot experience given our adaptation to our own universe. By random chance, a universe will support life and the fundamental laws of nature may only be specific to that specific universe. The term "accidental universe" states that our universe just happens to be an accident, given our specific physical circumstances.

The best coherent description of the unsecured personal loan accidental universe is in a white paper by Frank Rotman, a partner with QED Investors. In the piece, Rotman does a great job of describing the right circumstances of finance that made the rise of firms like Lending Club and Prosper possible. If you read his paper with the idea that if certain aspects of the then-world were not present, then you will see the importance of accidental initial conditions. For instance, Lending Club and Prosper may not have been possible if banks weren't pulling out of unsecured consumer lending, stockpiling liquidity and pulling back on credit card offers, among other factors. The key, as Rotman has shown, is being able to clearly see the initial conditions.

For example, given the "success" of automating the origination and underwriting of consumer loans, other lending products are trying to automate their entire processes from A to Z, with varying levels of success. Small business loans seem to be benefitting from such automation, real estate not so much. If you accept that automation is now a fundamental law of the new financial order, then you will raise a lot of money, hire a lot of engineers (not necessarily subject matter experts), throw in a dash of big data, leaven with some algorithms, and think you are good to go. When your firm is struggling to make a profit come its B Round, then a relook at the model will be necessary if you make it that far.

Extrapolating the accidental universe Rotman describes leads a future lending startup to believe that what works, or worked, for Lending Club should work for them. We have all seen companies describe themselves as "The Lending Club of ______" (fill in the blank with your debt product of choice). I'm sure those comparisons ended the moment Lending Club's chief executive stepped down.

Rather than the lemming approach, the focus of online lenders should be on the specific processes and procedures, financial engineering and market positioning that makes each product possible (in the right regulatory context at the right time) and profitable in the not-too-distant long run.

What is happening now is that everybody is clustering around the same ideas — automated, instant, and convenient. These are lofty goals. The last decade's subprime residential loans could arguably be described as having these same attributes of automated (i.e., everybody was approved), instant and convenient — and we are still paying the price.

But in consumer lending, this has brought about loan stacking, less-than-optimal verification of loan customer data, the onslaught of a regulatory juggernaut, and in many cases, lending products that are not sustainable at a profit.

So, how to survive? New lending firms will survive by finding the faults and vulnerabilities of the existing firms, incorporating the solutions into their own business models, and exploiting them for maximum leverage. Combine this with incorporating what is working with incumbent firms and you have the classic mutation, which ensures the survival of the nimblest. There are firms and there are models. Keep this distinction in mind — go long the model and short the firm.

Peter Currie, a former chief financial officer of AOL, has said, in relation to AOL, to a somewhat dour conclusion:

Maybe the best way to think about it is as a classic tech story: a company creates, invests, succeeds — and gets bypassed.

The same holds true for all fintech lending companies. Again, focus on the model, not the company.  

Loren Picard is managing executive of G5, a development and consulting firm in the marketplace lending industry focused on creating products and platforms for financial intermediaries and investors.