Online lending is becoming huge thanks to a practice blamed for the financial crisis

caption
Consumers aren’t dialing in to try and repair their credit woes lately, so much as they’re going online to get new loans and refinancings.
source
By TheTruthAbout on flickr

Online lending is already big, but the inflow of funds from large investors into the sector could make it huge.

The money is coming in two ways: investment in the startups, and the securitization of loans, according to a Keefe, Bruyette & Woods report. Startups like SoFi and Commonbond are repackaging consumer loans into asset-backed securities (bonds) and selling them onto investors including hedge funds and banks. Proceeds from the bond sales are turned into more loans. Asset-backed securities were also used to bundle mortgages during the run-up to the financial crisis – and blamed for excessive risk taking by mortgage lenders who offloaded the debt to other investors. KBW says most of the loans right now are “A-rated,” meaning that they are of high quality – a factor that’s drawing in the investors. Still KBW’s analysts caution that – even if lending standards stay high – one risk of relying on the ABS market is that investors can get spooked and stop buying:

“A thriving asset-based securitization market can be robust until demand drops dramatically given concerns about asset quality and corresponding risk. While we are not trying to draw the comparison to the last financial crisis … we believe these thriving upstarts could find a significant change in their business models in the future if institutional investors were to pull back.”

The cash is flowing into lending startups another way. Online lenders are raising hundreds of millions of dollars at enormous valuations. Last week, SoFi took on a whopping $1 billion round led by SoftBank – the single biggest fintech startup investment ever – and Avant, a lender that aims to provide credit to consumers with lower scores, also took on funding that values the company at $2 billion.


The volume of loans could nearly triple in the next three years, KBW predicts.

source
Keefe, Bruyette & Woods report: FinTech Revolution: When the Wind of Change Blows, Some Build Walls and Others Build Windmills

The KBW report uses three online lenders (Lending Club, Prosper, OnDeck) as a proxy for the industry. It estimates that they generated $7 billion in loans last year, but says the industry overall generated about $14 billion counting consumer and small business loans together. The analysts predict just three startups could generate $38 billion in loans by 2018.


OnDeck illustrates the increasing institutional involvement in loans.

source
KBW report: When the Wind of Change Blows, Some Build Walls & Others Build Windmills

Institutional involvement in online lending has already been on the rise. This chart points out marketplace sales to institutional buyers, like hedge funds. As investors seek improved returns, hedge funds are increasingly seeking out consumer credit portfolios for what is expected to be stable returns. Since 2014, institutional buyers have been more and more eager to buy much more of what lending startups have to sell – namely, ABS containing consumer, small business and student loans.


A look at how much of SoFi’s loans can be securitized highlights the opportunity for Wall Street banks.

source
Keefe, Bruyette & Woods report: FinTech Revolution: When the Wind of Change Blows, Some Build Walls and Others Build Windmills

Startups can push much of their loans into asset-backed securities (ABS), which means they are packaging the loan that pays a percentage into a group of similar loans, and then selling them to hedge funds and other institutions. Much of the loans generated by student lender SoFi are “A-rated,” meaning that they are of high quality. In other words, SoFi’s ABS packages would be mostly coveted by institutional investors like hedge funds.


Fintech deals and investments have also been on the rise post-crisis.

source
Keefe, Bruyette & Woods report: FinTech Revolution: When the Wind of Change Blows, Some Build Walls and Others Build Windmills

The growth in Americans’ web usage coincides with more investing in new financial technology. Startups like SoFi and Avant have raised billions in capital. After a huge 2014 for fintech startups, there might even be a greater influx of capital into the budding industry this year.


The ABS market hasn’t fully healed from the financial crisis, however.

source
Keefe, Bruyette & Woods report: FinTech Revolution: When the Wind of Change Blows, Some Build Walls and Others Build Windmills

Part of what’s fueling the rise in online lending is the expansion of the ABS market. ABS issuance has been recovering from the financial crisis. But they haven’t yet gotten back to pre-crisis levels. Asset backed securities and credit ratings agencies’ failure to evaluate risk in these portfolios was in part to blame for the financial crisis.


One of the factors helping online lenders the most is how much time Americans spend using devices

source
Keefe, Bruyette & Woods report: FinTech Revolution: When the Wind of Change Blows, Some Build Walls and Others Build Windmills

More Americans are using the web more of the day, a big advantage to online lenders. And that could turn into a big advantage for the startups as well as hedge funds looking to back consumer loans over the next few years, while the industry expands.