Recently I wrote two articles on Lending Club (NYSE:LC). This article seeks to open up the lens and look at the broader picture of online lending. The first part looks through the eyes of the U.S. Treasury Department. The second part, opening the lens still more, takes a look at a far broader picture of the impact of new technologies on financial services through the eyes of Jo Ann Barefoot, one of the best students of the field, who has a new website.
The Treasury Department has conducted a review of the online lending marketplace and has released a report Opportunities and Challenges in Online Marketplace Lending dated May 10, 2016. The report is thoughtful and touches all the relevant bases. I am going to be a little bit unfair to the authors of the report by focusing on some issues and not others, but they are issues that I think need airing.
The role of credit in promoting growth and innovation
The Report begins with the following general statement:
"Access to credit is the lifeblood of business and economic growth. From Main Street storefronts to high tech startups, American small businesses have been responsible for creating two out of every three net new jobs over the last two decades. The ability for individuals to pursue an idea, to start a company, and to grow a business is the foundation of the U.S. economy. As the Obama Administration seeks to ensure the benefits of our continuing economic recovery reach all Americans, it is important that consumers and small businesses have broad access to safe and affordable credit. Without credit, entrepreneurs cannot put innovative ideas into action. Without credit, Americans cannot grow their businesses to create new jobs and opportunities for the next generation."
This is a peculiar statement to make in an era when many economists believe that too much debt is holding back growth both in the U.S. and globally. There are dozens of books and articles that make this point. Two interesting books are The Age of Stagnation by Satyajit Das and Fault Lines by Raghuram G. Rajan, now the Governor of the central bank of India. That promoting credit is the path to renewed economic growth is the U.S. Treasury's lead sentence in a report about credit tells us they (and quite possibly the Obama Administration as a whole) simply reject the thesis that too much credit can hold back economic growth.
In the eras of greatest economic growth and technological innovation in America, which were before 1970, credit was not at all abundant. (See Robert J. Gordon's massive The Rise and Fall of American Growth-I confess I have not quite finished the book yet, so maybe you want to read Neil Irwin's interesting précis in the May 15 New York Times.) In most places, ordinary folks could not borrow, except to buy or repair a house. Commercial banks were for businesses and savings and loans were for housing loans. Innovation and growth happened anyway, in part because Americans were becoming better educated and in part because innovation was more widely prized in America than in other parts of the world.
The paragraph also seems to me to misunderstand how businesses start. New businesses cannot borrow. An individual starting a new business may borrow on her own credit, but the business is not creditworthy. Most new businesses start with someone investing equity capital. And pretty much all early stage venture capital investments come in the form of equity. Later on, many businesses become creditworthy and can borrow to support their operations, but that is not how they start.
The problem of credit for the less affluent
The emphasis on the desirability of ubiquitous credit is related, I believe, to one of the Report's biggest concerns: " this white paper intends to encourage positive innovation in an industry that has potential to broaden access to affordable credit for underserved consumers and businesses." It seems to be an article of faith among progressive Democrats that the poor (a category that includes many people of color) are cheated of credit because lenders discriminate against them. (This goes back to the "redlining" charges that probably were true in the 1950s but that probably were not true by the time the Community Reinvestment Act was passed in 1977.) With that assumption, the Administration seeks to expand access to credit for the "underserved".
The desire to expand credit for the underserved is fine, standing by itself. The problem is that in trying to enforce that desire as a matter of law, the government has twisted the credit granting process in knots. "Disparate impact" prevents credit grantors from doing what rational credit grantors do. Instead of paying strict attention to creditworthiness, they have to worry about whether their standards of creditworthiness cause them not make loans to underserved populations. Everyone involved in the credit process-including borrowers-pays for this, though how much is a moot point. It is a stealth tax.
Community Development Financial Institutions
The Report encourages online lenders to participate with CDFIs. Probably most readers do not recognize that acronym. It stands for Community Development Financial Institution, which can be any type of financial intermediary. The key to the definition is that it receives funding from the Community Development Financial Institution Fund administered by the Treasury under a 1994 enabling law. There are about a thousand CDFIs that operate in poor areas of many U.S. cities. Many CDFIs do good work in their communities, funding projects that are not creditworthy to private sector lenders but that, with government support, can pay for themselves over time. For more on CDFIs, see here.
The Report encourages partnerships between online lenders and CDFIs, which would, in effect, allow both to leverage the U.S. government funding. I am no expert on CDFIs, but it does seem that if the government is going to fund projects in low-income areas (which probably it should do), the CDFI mechanism is a good one. And it is far better than the type of regulation that ties lenders in knots. It is on-budget, transparent, and targeted at things that need to be done.
How to do low-income lending?
I see lending to low-income people as a specialty. It is a difficult business that requires a special expertise and, perhaps, a special approach. Vouch is a company that has a special approach. It seeks to build on the type of relationship lending that immigrant populations have used. It is the brainchild of Yee Lee. One Financial Holdings, a sort of financial think tank run by Vinay Patel, is another company that is searching for better ways to serve less affluent communities. Yee and Vinay are brilliant people who use all the modern technologies. It is people like them who may be able to figure out how to create a better credit platform for less affluent communities.
Small businesses and online lending
The Treasury Report also emphasizes the possible benefits to small business borrowers. However, small business borrowers have not been very satisfied with their online experiences (a satisfaction score of 15% as opposed to 70% at community banks), Treasury finds, and Treasury thinks they need more legal protections. But Treasury would like to see online lenders doing more for small businesses.
The most promising aspect of online small business lending that I saw in the report was the use of real-time sales, inventory and collections data that could allow revolving business credit based on a real-time data formula and enforced without human intervention. That sort of monitoring could lower the cost of borrowing and make it available to additional businesses, so long as they were profitable.
Lending Club and Prosper-Underappreciated Innovators
The Report fails, it seems to me, to appreciate the great service that Lending Club and Prosper are providing to the economy. It sort of critically notes that a large majority of their borrowers are "prime" as defined by credit scores and that 68.5% of Lending Club loans are for the purpose of paying off credit card or other high-interest-rate debt.
If I had written the Report, it would be applauding because all these people who reduce their interest rates, substitute a level payment program for revolving debt, and commit to try to get themselves out of debt within three to five years are getting a marvelous hand up that many of them in fact utilize to get out of debt. Some incurred the debt for good reasons, such as medical bills or fixing a house, some for so-so reasons such as paying for a wedding, and some for bad reasons, such as current enjoyment. But all were, before refinancing, paying high interest rates that bled their ability to get out of debt, reduced their current lifestyles, and prevented them from saving for retirement. Getting their payments reduced and getting them out of debt benefits the economy and the nation's future as well as the individuals involved. The Treasury Department should be celebrating such achievements.
But see Jonathan Ford's very good article in the May 16 FT on how much Lending Club has deviated from its original mission.
I am a Democrat who believes in markets
The Report concludes by saying,
"It will be critical to monitor how online marketplace lenders test and adapt models if and when credit conditions become weaker. Will new credit scoring models prove robust as the credit cycle turns? Will higher overall interest rates change the competitiveness of online marketplace lenders or dampen appetite from their investors? Will this maturing industry successfully navigate cyber security challenges, and adapt to appropriately heightened regulatory expectations?"
"On a system-wide level, the impact of increasingly sophisticated models on overall credit access and outcomes for disadvantaged groups merits careful monitoring."
The market created the online lending market. The market will monitor its success or failure. If some companies fail in lean times or some loans go bad and investors lose money, the market will adjust. Public policy need not worry about those things. Similarly, excess emphasis on protecting "disadvantaged" groups almost certainly will detract from the ability of online lenders to serve all communities as efficiently as they might be able to. Low costs for borrowers and high income for investors is what the financial markets need. Not many innovations bear promise to accomplish both.
I admit that I am a member of the relatively privileged classes. But my experience suggests that borrowing more than one comfortably can service, borrowing at a high rate, or borrowing for other than acquiring long-lived assets is counterproductive for an individual and bad for the economy.
Jo Ann Barefoot's image of the future
I would contrast the Treasury's somewhat fearful view of online lending with Jo Ann Barefoot's vision of a changing world and the good things that those changes can bring. In the linked article, Jo Ann discusses Big Data, Artificial Intelligence, Natural Voice Technology, Digital Currency and Blockchain, and Online and Mobile platforms. Jo Ann sees great progress for humans deriving from these sources. And she has a vision of how technology and regulation can adapt to each other. I am not as confident about technology and regulation learning to understand each other. But for sure, that will be needed in order for Americans to derive many of the potential benefits.
I see Jo Ann's five categories of technology fitting together very readily. "Big Data" is a term I don't like because it seeks to make something mysterious which is not. The term describes the exploding world of data, how the exploding world of artificial intelligence-the ability of a machine to learn-can arrange the data and reach conclusions. The conclusions may be right or they may be wrong. At this time in the history of the world, humans then need to figure out how to test the conclusions, presumably using tools similar to those that created the conclusions in the first place. But this combination of computing power can change the way we see the world.
Digital currency and blockchain are facilitated by the same computer revolution. It is but one manifestation, but it is a manifestation that has great promise to change the way that records are kept and accessed, with great benefits in terms of cost and time.
Our platforms-the computers, phones, watches, whatever, that we use to link us with the big data, artificial intelligence and digital currency that we do not and need not understand-are still fairly clunky. Jo Ann shows how voice technology is changing that and will continue to do so. That was my biggest takeaway from the linked article. We not only will not know or need to know how the darn thing works any more than we need to know how a modern automobile works. We can just get in and drive our platforms, whatever they are, by talking-and, the harder part, by listening as well.
An investment thesis
There have to be great investments for people who can see where all this technology is leading. And probably there are great small companies that will be the best investments. But I do not know which ones they are. (Although I am a fan of the company, I am not ready to invest in Lending Club common stock, as I explained in a previous article.) However, I do know there are a number of companies that have a boatload of smart people looking at the same issue: How do we benefit financially from these ineluctable trends?
Goldman Sachs (NYSE:GS), JPMorgan (NYSE:JPM), Apple (OTC:APPL), Alphabet (NASDAQ:GOOG) are among those companies. In an article on blockchain, Kurt Dew suggested that IBM (NYSE:IBM) might be a good bet in this area, and he does not think Goldman and JPM will benefit. The banks will lose payments system revenue. I think, however, that some of them will figure out how to replace that revenue by being part of the disruption. Whichever investments you choose, these big companies are not going to make you rich by investing in them to take advantage of the profits that will come from Jo Ann's five categories of technological change; a smaller company might do that, if you picked right. But the companies I mentioned are profitable, have great businesses, and also have the money and the brainpower to be or to back winners. Although the technologies may be disruptive, that sort of disruption is anticipated and has been anticipated for some years. Therefore the bigger smart companies are likely to take advantage of the change rather than being victims of it.
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