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    Marketplace Lending: Block the Noise

    Carlos Nogueira ,Deputy Portfolio Manager
    February 18, 2016

    Intro: The online lending sector has been the target of a few unfavorable media reports as of late. Our opinion is that some of the headline risks highlighted by the media are overblown and overhyped. We do agree, however, that investors should be vigilant in the current environment, especially regarding economic growth. The potential of a downturn in the U.S. economy offers considerably high risks that warrant caution in many asset classes. It also underscores the importance of identifying alternative sources of return and income. That said, we continue to hold a high level of interest in the marketplace lending sector. For additional thoughts, please read our previous post from January.

    Volatile Markets Bring Hyped Headlines

    There’s no question that this has been a difficult market for most asset classes. Not unexpectedly, media reports predicting Armageddon have become commonplace. Many of them have highlighted valid points to be analyzed but, in many cases, the wild predictions have not panned out and the risks have proven to be exaggerated.

    Recently, questions have been raised about the models used by Lending Club (LC) to measure the risk on its online loans. Some have opined that the LC models are flawed and that the loans are underpriced. We do not agree with this view. LC has since issued a performance update which confirmed that credit performance for most fragments was as expected, as well as provided "the correct interpretation" of its modeling.

    The issue of charge-offs is central to virtually all investors in online loans. Like risk, it fluctuates over time. It's not only natural, but necessary, for platforms to continuously adjust their pricing. Our concern is more macro in nature. After a period of positive economic news that led the U.S. Federal Reserve ("Fed") to raise rates, we may be at an inflection point.

    How Could a Downturn of the Economy Affect Charge-Off Rates?

    Bloomberg Consensus Forecast for U.S. Real GDP calls for 2.4% growth in 2016, but some banks have recently lowered expectations significantly. For example, Standard Chartered lowered its 2016 GDP forecast from 1.6% to 1%, UBS lowered its forecast from 2.8% to 1.5%, and Commerzbank lowered its forecast from 2.5% to 2%. The transmission mechanism is straightforward. Less growth leads to fewer jobs. As borrowers lose jobs, their ability to pay back loans gets compromised. The silver lining here is that the chances of further hikes by the Fed have decreased considerably (which typically helps valuations of fixed income portfolios). As shown in the chart below, charge-off rates increased slightly in October and November 2015. It will be interesting to see if this trend persists or if charge-off rates return to previous levels.

    Chart 1: Monthly Coincidental Charge-Off Rates

    PP - Monthly Coincidental Charge-off Rates
    Source: Orchard.

    Ezubao Casts a Shadow on China's Online Finance Industry

    The arrest of 21 people involved with Chinese peer-to-peer lender Ezubao, which was accused of running a Ponzi scheme, also gained much of attention recently. Many have raised the question as to whether this could happen to a U.S. lending platform. While possible, the chances are considerably smaller in our opinion. Local regulation (on a country-by-country basis) is at very different stages. In China, initial regulatory proposals were issued by the People’s Bank of China only in July 2015 and subsequently by the China Banking Regulatory Commission in December 2015. Last year alone, about 700 online lenders went bust in China (there remain an estimated 2,000 online lenders in the country).

    U.S. online lenders, in contrast, are at a different inflection point. They are currently required to comply with federal consumer financial protection laws and some are subject to securities regulation.1 Many of the largest players (including LC and Prosper) have registered with the U.S. Securities and Exchange Commission (SEC).2 In addition, a recent report by the U.S. Government Accountability Office has explored the potential for additional regulatory oversight by the Consumer Financial Protection Bureau (CFPB) or the Federal Deposit Insurance Corporation (FDIC). On the legal front, the U.S. Supreme Court was asked in November to accept for review the U.S. Court of Appeals for the Second Circuit's opinion in Madden versus Midland. In December, the Supreme Court requested Madden to file a response. A decision regarding whether the petition warrants review by the Court is expected by the end of March.

    Positive Fundamentals for Online Lending Continue

    Despite a few unsavory headlines and turbulence in financial markets, the fundamentals for online lending loans continue to be positive.

    The Orchard US Consumer Marketplace Lending Index3 has shown steady growth with very low volatility since its inception in 2011. While the concern that the asset class has not gone through an economic downturn is valid, the low volatility and steady returns shown over the past five years is certainly worth noting (and watching).

    Chart 2: ORCHLEND Index Shows Steady Growth Since 2011

    PP - Orchard U.S. Consumer Marketplace Lending IndexSource: Orchard Indexes, as of 12/31/15.

    U.S. unemployment continues to decline and is currently below 5%, with the latest JOLTS (Job Openings and Labor Turnover Survey) data showing that job openings have almost tripled since the financial crisis.

    Chart 3: U.S. Job Openings and Employment

    PP - Job Openings Employment
    Source: Bureau of Labor Statistics.
    Note: Shaded area represents recession as determined by the National Bureau of Economic Research (NBER).

    U.S. Economic Data is Key Going Forward

    As is true for any asset class, there are numerous risk factors that can affect investments in marketplace loans: regulation, platform fraud, cyber security, and rate hikes, to name a few. Thus far, fundamentals continue to be strong. Going forward, data indicating where the U.S. economy is heading will be paramount to credit rating and duration choices that optimize the risk/reward ratio in a loan portfolio. We recommend that investors block the noise and stay vigilant for potential investment opportunities.