More and more, the financial industry is changing. Tuesday, January 7, the Wall Street Journal published a front-page article on what many are calling Merchant Funding. If I can attribute one thing to the rapid expansion of this group of lenders…it is information technology.
The article "Alternative Lenders Peddle Pricey Commercial Loans," lays out in sketchy detail the essence of this corner of the Shadow Banking world. Let me just say that these merchant funders are filling in a "missing market" and they are doing it in a way that can only grow and become more and more important in the financial landscape.
This movement is not that different from other innovative financing vehicles, like those new organizations that inhabit the world of crowd funding, that make primary use of the Internet.
Earlier this year I wrote several posts on the peer-to-peer funding market. This market vehicle seems to be taking on a life of its own and rightly so.
Merchant funders make loans. They make loans to people and businesses that are too small, want loans that are too small, have not-the-best credit, or, are just starting out. In other words, these people and businesses have do not fit into the "box" that commercial bankers want to place them in and consequently can't get served by the commercial banks.
Merchant funders are stepping up to the plate. First of all, the loans are cash flow based loans. That is, they pay back the loans out of their cash flows. Payments will be collected daily or weekly, on a real time basis, and often directly from the borrowers bank account.
Second the loans are generally very small loans. They can be as small as a couple of hundred dollars, and they generally do not get up to a six-figure amount.
Third, the loans are very short-term; say in the six- to nine-month range.
Fourth, the loans require no collateral…a fact that will often disqualify the borrowers from a commercial bank loan right up front.
Fifth, many sources of information on the potential borrower are used. The usual credit rating scores will be used, but, in this day and age, there are many other sources of information that are available that these merchant funders will tap.
The Wall Street Journal has provided us with another current article on this practice: "Borrowers Hit Social Hurdles." These merchant funders will go to Facebook (FB), LinkedIn (LNKD), Yelp (YELP), Twitter (TWTR), and other social networking sources of information to verify work history, customer satisfaction, and other background information on the potential borrower, sources that traditional banking organizations do not access. That is, the whole information base on potential borrowers is available at low cost and in real time to learn more and more about whom these organizations might be lending to.
The key to this funding is…funding is available to those need it…and, have not had access to in the past.
It is expensive…yes, but if the money is needed, the cost is less of an issue.
The cost…think of the interest expense of credit cards.
Yes, the merchant funders all adhere to the usury laws and most of these lenders operate in all fifty states in the United States so that they have to meet the requirements in each and every state. So, they can charge rates that approximate credit card rates and given that the terms of the loans are in the six- to nine-month maturity range, the annualized interest rates charged could seem quite high.
But, I have talked with quite a few of the borrowers on these terms and they seem to have no problem with the terms.
Responses are like these: well, I couldn't get a loan before so I couldn't even start the business; I may be paying a 30 percent annualized rate on my loan, but I am earning a 40 percent return on my business so the loan is cheap; having these loans allowed me to build up a credit record so that I have other sources available to me; and, I needed loans to get started but my cash flow is such right now that I don't need debt at all anymore.
The confirming thing to me is that you visit these merchant funders and you see that the business is all electronic…at least the ones that I have visited.
The rooms that these organizations make loans from include dozens of young lenders. They are all attached to "wires" and have cubbyholes where their computers are kept. Most of the individuals are walking around…talking. It reminds me of some of the trading rooms of investment banks I used to visit…Solomon Brothers, the biggest, only on a much smaller scale in the case of these merchant funders.
Two other things are remarkable about these organizations. First, their use of data is incredible. They have built major databases…and they know how to use them. This helps to lessen the problem of knowing whom they are dealing with and what these people or businesses are like.
Second, these merchant funders are going the route of the investment banks, hedge funds and other "quants." As the first Wall Street Journal notes, at New York-based OnDeck Capital Inc., you will find that "fifty-six of its 225 employees have backgrounds in math, statistics, computer science, or engineering and work on data analysis, credit modeling, and technology infrastructure."
And, they don't take deposits...and, they don't have branches. Yet, as mentioned, many of them lend in all fifty states.
Although this part of the industry is small now, it is growing dramatically. The first Wall Street Journal article quotes that "about two dozen such nonbank lenders lent about $3 billion collectively last year, double the 2012 total…" It is my estimate that this total will double again in 2014.
These are not the only financial innovations I have found in the "shadow banking" world, or, as stated in more polite company, the world of "alternative financial organizations. I am very interested in this space and will be writing about these as often as I can. I would be interested in what sources you readers have about the organizations that are growing up in this area. I have founded a new company, "New Finance, LLC" to work in this space and to contribute to the development of the financial industry in the twenty-first century. I think it is going to be an exciting space to be in.