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The Peer-to-Peer Hunger Games (Deconstruction of a Revolution)

by Peter Renton on May 22, 2012

This is a guest post from Loren Picard, Senior Managing Director with LMA Capital, Inc.  He focuses his efforts in the mortgage and P2P financial solutions arenas.  He can be contacted on LinkedIn here.

A revolution against rent seekers is upon us.  Who are these rent seekers in the financial markets today?  This is not another tirade against rich guys on Wall Street who don’t get it; ranting against the beneficiaries may feel good, but it smacks of envy and does not solve any problems.  Worse, it can lead to an Argentinian style thievery on a truly gargantuan scale—leading us all to doom.

No, these rent seekers are the large institutions, both private and government-owned, along with their regulators, who have built a comfortable symbiotic relationship maintaining the status quo.  The newly formed CFPB is a weak response and will themselves eventually become part of the problem.

The Revolution Has Gone Viral

The revolution is starting out slowly and in the background.  Something recently happened that will be misinterpreted for a while, but will nonetheless be seen as the day the revolution went viral.  The event: John Mack joined the board of Lending Club.  For revolutions to get started, it is the intelligentsia which needs to be made aware of the spark which lights the fuse, not the masses.  The masses will be herded into the square in due time.  In this case, the intelligentsia are the people who work in all manner of the financial services industry—including the reviled rich guys. 

If you have worked in financial services over the last 20 years you have heard of John Mack.  He is the former CEO of Morgan Stanley. Even if you have worked in financial services over the past few years, you can be excused for not knowing about Lending Club.  But with John Mack joining their board the world has now heard of Lending Club and of P2P lending.

His arrival at Lending Club is no more important than the noise it created.  In fact, Lending Club could easily hand him his yearly compensation, a little stock, and wish him a happy 2012.  He has served his purpose.  Of course this is somewhat facetious, but it does emphasize that the biggest benefit of his arrival has already taken place.  The irony being he is one of those rich guys from Wall Street.

An Innovation Revolution in Financial Services

So, now what happens? The innovation revolution in financial services begins!  It will start slowly, then everybody and anybody will be into P2P.  P2P will eventually become dated as an acronym, just like the term dotcom became outdated.  A lot of money will be raised, spent, software developed and thrown out, and finally a handful of companies will get the model right for their particular industry segment (consumer loans or car loans or equipment leasing or insurance) then the consolidation phase will begin (this is the fun phase where the formerly admired rich guys overpay to get into P2P); the best consolidations and most durable business models will be P2P’s consolidating with their peers in a horizontal and vertical manner.  We are way ahead of ourselves here; the consolidation phase will be the subject of future articles, not this one.

When you think of the P2P model there are three important “things” to keep in mind.

  1. With P2P, you can’t separate money from ideas.  In essence, where there is a P2P idea, there will be a flow of funds, which the P2P platform will try to participate in.  P2P is not an eyeballs game or a user game (see Instagram for perfect example).  P2P is about creating rivers of money flowing between parties (I use parties because it is inevitable that the peep-peers will be elbowed out when the serious money arrives).
  2. This is not about business per se; it is about markets.  What eBay did for garage sales, P2P will do for the car in the same driveway.
  3. A P2P approach to finance (or the more generic ‘capital’) is about the federalism of the financial system.  It is about increasing the number of nodes in the financial system while simultaneously reducing systemic risk for the average Joe taxpayer.

Mechanisms will develop in P2P finance incorporating ethical behaviors backed by trust and newly created social norms.  P2P is more descriptively described as primitive or devolved finance (think ‘The Hunger Games’) though it will be sold as the next evolution.  It is very tribal.   Do you trust large banks (assuming no government involvement) more than small banks? No. It is back to the natural level of trust imbued in humans.

If you look at the basic model of peer->platform->peer, there are plenty of precedents already in the market (again, think eBay, or match.com).  For business model purposes there is a continuum.  On the far left is the pure play P2P.  In this model the platform is there as an introduction service.  All negotiations, credit decisions, and payment collections/servicing are done between the peers (Visa would be a close example).  The platform takes a fee for a listing or membership or a matching of the parties.  On the other end of the continuum the platform does everything from creating the lending program, underwriting the borrowers, making the credit decision, and closing and servicing the transaction (Lending Club and Prosper fall on this end).  On this end of the continuum the platform can earn origination and servicing fees.

In this writer’s opinion, the most successful P2Ps (I prefer the IP2IP acronym to acknowledge that the platforms will evolve to be dominated by institutional-peer to institutional-peer relationships) will be those that figure out how not to do all the work of originating, underwriting, and servicing of the loans on the platform.  As competition increases the “full service” model will erode due to the effect competition will have on the fixed percentage fee schedule the platforms operate under—i.e., margins will be crushed.

John Mack’s appointment is seen as sending up the signal that it is safe for people to invest in or through such platforms.  And true, it does do that.  In the long run what it does is send up another more faint signal that the battle has begun.   The takeaway is that if you are an entrenched incumbent in the financial services industry, you focus 100% of your attention on Basel III and Dodd-Frank at your long-term peril (honestly, no Keynes’ joke here).

How these P2P companies get valued, what damage they will do to existing Wall Street and large banking firms, where the rating agencies fit in all this, and what nascent bubbles and systemic risks will be created during the development of the P2P infrastructure are to be determined. Let the games begin.

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{ 3 comments… read them below or add one }

Roy S May 22, 2012 at 3:26 pm

I agree that a large reason for John Mack joining LC (from LC’s perspective) was for advertising and name recognition purposes. The impression that I have been getting from LC is that they are looking to grow their business rapidly in order to remain the dominant player in the p2p industry.

Where I’m not so sure I agree is with Loren’s belief that the full-service model will erode. Not everyone or every institution wants to perform all the negotiations, credit decisions, and payment collections/servicing. In fact, even Prosper and LC outsource the delinquent loans to collection agencies. Other institutions, like BAC and WFC, will act as a loan mortgage servicers.

Making a little stretch here, I would say traditional banks are really the first p2p “platforms.” They pool the money of various lenders and lend the money out to those who wish to purchase a car or a house, etc. Because the banks perform other services, take on the risks, etc. the interest rate the lenders receive are smaller than the interest rate lenders receive when they themselves take on the risk and do without other services, like checking accounts. Prosper and LC just streamlined the process a bit and removed some of the features, and mainly got rid of their risk of borrowers defaulting by allowing the lenders to take on that risk themselves. If they put more of the burden on me to perform all the negotiations, credit decisions, and payment collections/servicing then I would exit the market. If they are able to (and it is profitable for them to) outsource all these other elements, like they do with delinquent loans, then I would agree. But a pure play p2p model would not fit me and my needs, and I would bet the same would be true for most, if not all, of other lenders on both platforms, including the institutional lenders.

The Visa model may serve well in the credit card industry, but I cannot envision it in the p2p lending industry. The way I am envisioning it, it either looks similar to the set-up of the institutional lenders already on the platform (where a bunch of investors hand over the reigns of their money and the institutional lenders decide the risks to take on as well as charging an additional fee) or Prosper and LC act as payment servicers with everything else left up to the individual investors on the platforms. As such, I am fairly certain that I am misinterpreting what your vision of the future of p2p lending looks like, I would be appreciative if you would elaborate a little more. Would Prosper and LC simply be the platforms with everything outsourced to other companies? Or would they remain as the Notes servicers, too? Right now, Prosper and LC seem fairly vertically integrated. I’m not sure that horizontal integration would necessarily suit this industry.

Reply

Loren Picard May 22, 2012 at 9:43 pm

*Response to Ron S from Loren Picard: Ron, you raise some good points and questions. Let me try to respond to what I believe you are saying. I’m not advocating any one model to dominant across all product categories. The current marketplace for products outsources certain functions (i.e., sub-servicing for mortgages) and keeps in-house certain functions depending on industry convention and history. With regards to the fixed fee model where all functions are basically in-house, I believe such companies are subject to competition entering the marketplace with a reduced cost model (lowering servicing fees or origination fees) and thus posing a challenge to incumbents to modify their model or face market share loss. We are really in the early stages of this industry and to date no model has been profitable (maybe Zopa is profitable) and any model that comes along is subject to disruption until standards and conventions set in; at which point cost control become vital. That is my main point on this issue. I tend to agree that the pure play p2p platform wherein the parties do everything after being introduced will be difficult to sustain, let alone lead to a durable business model.

Your point about banks being the original p2p platforms are spot on. Of course, the distinguishing feature of today’s p2p model is the lack of any kind of government insurance/bailout backstop (banks did not always have deposit insurance). My vision is that the p2p models that develop in the future will need to expand into multiple products, with varying maturity profiles of the assets, with non-correlated risks, so that the platforms themselves become valuable in and of themselves as businesses. This is what I mean by horizontal integration. If the economy comes roaring back and banks loosen up their credit standards and credit card and consumer loan rates come down then today’s platforms are at risk. By adding different products then no one asset class can jeopardize the platform as an ongoing business. P2P platforms are nothing more than asset management businesses that manage assets and charge a fee. The big question is whether the platforms can supplant other current models and do it more efficiently while widening the base of potential investors.

Ron, thank you for taking the time to comment.

Reply

Peter Renton May 23, 2012 at 11:50 pm

@Roy, Here is my take. P2P lending is still a manual process on the borrower side. Lending Club and Prosper do manual checking of every borrower which often involves quite a bit of back and forth. This process has the potential to be more automated and with more automation there is the potential for lower origination fees. This is part of the downward price pressure I think Loren was talking about. We are just getting started here and I think the business model at Lending Club and Prosper that will exist in 10 years time will be vastly different to what we see today.

@Loren, Thanks for providing such a detailed response and for the thought provoking article. And yes Zopa in the UK is indeed profitable and Lending Club will be within 12 months. Prosper won’t be far behind.

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