Moody's take on Risk in P2P Securitizations

Securitization is a way for peer-to-peer loans to be accessed by a wider investor base and to increase liquidity in the asset class. It is unsurprising that platforms are using this method to help grow their loan books.

However, there are risks involved as the investor no longer chooses individual loans to invest in but instead invests in a bundle of loans that have varying degrees of credit risk.

This week Moody’s released a report entitled “Understand the Risks of Marketplace Lending Securitizations”.

The report highlighted four main risks:

• Performance history
• Operational plumbing
• Alignment of interests
• Regulatory Resilience

Performance history: Due to the age of the sector the platforms have a limited track record for investors to view, many of the companies have been around for just a couple of years, “their business models have not been ‘battle’ tested”.

The report stated that some companies back test their lending algorithms to the historical performance of consumer assets with similar characteristics (e.g. credit cards) to try and compensate for the lack of performance history. This leads back to the often talked about fear that the platforms have not been tested during a crisis and the credit environment post crisis “has been notably benign”.  

Operational Plumbing: According to the report this refers to “important back offices services, including: collections, loan servicing, customer service and cash management.” As the companies grow and seek broader sources of capital, including securitization, the need for strong operational plumbing becomes increasingly important. 

William Black, a Moody's Managing Director and team leader of the ABS group, commented:

"The operational framework is the backbone of securitization because its goal is to provide for uninterrupted cash flow payment to investors, even if the originator fails. If these lenders do not develop their operational structure at the same rate as their rapid growth, there is increased risk that the securitization would not survive an originator failure."

Alignment of interests: Compared to traditional lenders, marketplace lenders have relatively weaker alignments of interest, as so far marketplace lenders have not sponsored their own securitizations. This means they have not retained a direct economic interest in the securitization’s performance. This lack of “skin in the game” poses an increased performance risk for investors. Although, it is in the platform’s interests to see the securitization perform well as the viability of their business can be predicted through the securitization. 

Regulatory Resilience: Marketplace lenders have, so far, managed to escape the same degree of regulatory scrutiny as some of the larger, traditional lenders. It is highly likely that regulatory burden on the marketplace lenders will grow quickly as they scale. The report highlights one particular example:

“As non-bank entities, some of the most prominent marketplace lenders rely on third-party bank relationships to originate loans, which the bank typically sells to the marketplace lender two or three days after origination. In this way, the marketplace lender, through the bank partner, can take advantage of “rate exportation” laws, and obviate certain state licenses and other state-specific lending restrictions. This arrangement calls into question whether the bank or the marketplace lender is the “true lender” of the loans, a possible weak link in the transactions.”

This legal uncertainty could mean that if a court determined the marketplace lender, and not the bank, to be the true lender, some of the loans originated could be unenforceable.

However, the large amounts of data that marketplace lenders provide does help to mitigate the risks that investors are exposed to. The platforms tend to provide superior data transparency concerning their asset characteristics compared to many of the more established consumer lenders.

Black added:

"They amass, organize and share this data with retail and institutional investors alike, whereas traditional lenders are typically more guarded with their data."

Although, as platforms grow they may start to reveal less of their data. Certainly the biggest US platform’s Prosper and Lending Club now release data quarterly, making it less useful and less revealing for investors.

So far activity in peer-to-peer securitizations has mainly been confined to the US. SoFi is one platform that has been particularly active in this space; in November it closed a $303 million+ securitization for refinanced student loans. This was the company’s third S&P rated securitisation. Back in September last year US consumer lender CircleBack Lending partnered with Jefferies to facilitate the sale and securitization of up to $500 million in loans. And in October Eaglewood Capital Management completed a $75 million securitization of peer-to-peer loans, originated via Lending Club.   

The rise of securitisation has promoted comparisons of the marketplace lending industry to the subprime mortgage industry pre-2008. This kind of comparison is obviously hugely damaging for the nascent marketplace lending industry as people are still forming their opinions on the sector and it does not help it to be tarred with the same brush as the subprime mortgage industry. 

Michael Solomon, CEO of CircleBack Lending, explained:  

“When you mention the word ‘securitisation’ people think it’s the next mortgage crisis,” says Mr Solomon, referring to the subprime mortgage bonds that wreaked havoc in the run-up to 2008. “The reason there was a mortgage crisis is because people were making loans to dogs and prisoners. We’re not making loans to dogs and prisoners.”

Mr Solomon warns that while securitising P2P loans is not a bad thing, there is a danger the asset-class grows riskier as more bankers and investors pile-in and pressure to expand the sector increases: “At some point you’re going to have yield-chasers moving down the credit curve.”

The securitisations are indicative of the growth in the marketplace lending space and reflect the level of institutional demand for the asset class. But as the Moody’s report states there are many risks with securitizations. So long as investors are aware they can take advantage of the high yields this asset offers compared to other forms of investment.