The newest bubble: peer-to-peer lending?
Is there a bubble boosting the market? Wall Street money manager Doug Dachille, who appeared in our Making Sense segment on the stock market last week (above), thinks so. He points to one existing bubble — albeit still small — that has a lot in common with the recent housing bubble and could be a sign of bigger things to come.
Paul Solman: On Friday’s NewsHour, we looked at the stock market in light of the Dow-Jones Industrial Average ending the week atop 16,000, a new record. (Watch the segment above). Our main protagonist was Wall Street money manager Doug Dachille, who has appeared on this page numerous times, at greatest length when he explained why the much-hyped LIBOR “scandal” was not as big a deal as some had made it out to be.
Doug, trained as a medical doctor, switched to finance and eventually ran proprietary trading for JP Morgan before starting his own firm, First Principles Capital Management, in 2003. It now manages more than $9 billion. And the CEO is nothing if not outspoken. During the course of our interview, he questioned the Fed’s role in inflating the stock market and, as evidence of asset inflation far and wide, pointed to the advent of peer-to-peer lending over the Internet. I asked him to expand for our readers.
Doug Dachille: What history has demonstrated is that while the name of the financial instruments responsible for financial crises always seem to change, the root causes are the same: poor credit underwriting standards, the excessive use of leverage, classic agency problems (lack of economic skin in the game) and the power of group thinking pushing the belief that this time, things will be different and financial alchemy has somehow produced real instead of fool’s gold.
If you reflect on some of the causes of the recent financial crisis, the parallels to peer-to-peer lending are striking. During the recent crisis, lenders extended credit with limited or no documentation. Loan originators and underwriters had far too little economic skin in the game. Investors relied far too much on the risk analysis coming from elsewhere in the investment decision process — mainly bond credit ratings. Diversification was just an illusion — unfortunately it is hard to diversify rampant fraud risk linked to loan originators and borrowers. Remarkably, peer-to-peer lending has all of those key ingredients.
So, how is it possible that history can repeat so soon? As I like to say, history repeats itself when all those who can recall history are history. Yet peer-to-peer lending adds a twist to this phenomenon by simply bypassing the lenders who recently experienced history and instead going to those who have not.
In peer-to-peer lending, lenders are provided limited financial documentation about the borrower. The lending clubs laud the benefits of diversification, and the clubs provide the equivalent of credit ratings for each borrower to aid the lender in determining the appropriate loan rate to compensate for “risk”. Do the founders and the board members of these lending clubs have any economic skin in each of the loans that are posted on the websites? Doesn’t this sound all too familiar?
The recent financial crisis should have taught investors not to be over-reliant on third-party credit ratings when making investment decisions. There is no substitute for independent credit analysis. Yet in the case of peer-to-peer lending, lenders are dependent on the credit ratings from the lending club’s proprietary models to decide to extend a loan and the rate to accept. There is no way for a lender to independently evaluate the plausibility of the proprietary borrower’s credit rating posted on the website.
Instead, lenders rely on blind faith and past credit performance history. Of course, given the short history of borrower performance on peer-to-peer loans, it would be impossible to determine with any statistical reliability that the credit rating categories are strongly correlated to the credit performance of the respectively rated loans. But consistent with the group thinking encountered in the past, no one is challenging their reliability.
If professional credit officers and investment managers were duped in the previous financial crisis into making loans to borrowers that were supposedly “AAA”, when in reality it was all junk, what chance does a retiree with no credit analysis experience have of avoiding the pitfalls of lending? Now a retiree is empowered by these peer-to-peer lending sites to become a senior lending officer, making loans with his retirement savings to borrowers he has never met, relying on an unproven credit rating metric and comforted by thinking that diversification will neutralize the impact of all his lending errors. He is also comforted by the thought that many of his other retired friends have also made loans to the same borrowers.
General experience with email has proven that folks are willing to say things in electronic form that they would never consider saying in a face-to-face interaction. So, would it be a stretch of the imagination to consider that borrowers may approach loan repayment differently when they’ve gotten those loans over the Internet from nameless and faceless investors? And what lessons did investors learn about the benefits of diversification when every individual security in a “diversified” portfolio of sub-prime mortgage securities was valued at cents on the dollar?
So, what is the major financial innovation of peer-to-peer lending given its remarkable similarity to the foolish lending practices of the recent crisis? The innovation is not the loan product itself. Instead, the key innovation of peer-to-peer lending rests with finding a new set of lenders. And given the current lack of income generated by traditional fixed income investments, there are a lot of investors looking for alternatives that offer a higher rate of return.
First, it is important to remember that finding borrowers is never the hard part of the loan origination business, especially one geared toward making loans to people with poor credit histories; they’re always in bountiful supply. The critical ingredient to growing a lending business is to expand the universe of parties willing to make loans to the weakest credits based upon the most liberal credit standards. This was the key element that drove the growth of sub-prime lending leading to the financial crisis. And this is the key innovation behind the growth of peer-to-peer lending.
The lender in a peer-to-peer loan is not an experienced bank credit officer who’s learned from years of making bad loans. Those experiences reduce the likelihood that he will make similar errors in the future.
Nor is the lender a professional investment manager with credit analysis experience gained the hard way. Over-relying on credit ratings and believing that diversification mitigated risk when making non-traditional loans would have taught him a lesson. Unfortunately, it was a lesson learned on his investors’ dime. Yet he is unlikely to commit those same errors in the future. In short, the recent experiences among these traditional lenders have likely resulted in appropriately more stringent credit standards for loans to unproven borrowers, limiting growth of the lending business.
So where do you turn to grow a lending business when there is plenty of demand for loans by credit-impaired borrowers yet the supply of capital to make such loans by traditional lenders is prudently limited?
Empower inexperienced lenders to make these loans. These new folks likely have not yet learned the mistakes you can make in the lending business. And the websites make it seem so easy to make a loan and to construct a diversified portfolio of investments offering an attractive rate of interest in a world that has become income deprived.
Another unintended, or perhaps intended, consequence of monetary policy!
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions