An alternative way to look at the target market for non-bank online/ digital lending could be to segment the purpose of loans into ‘Refinance’ and ‘Purchase’ and cross-tab with Credit Risk into a ‘mutually exclusive and cumulatively exhaustive’ segmentation plan as below:
| Segments | Refinance | Purchase |
| Above Prime | 1 | 2 |
| Sub Prime | 3 | 4 |
Non-bank marketplace lenders (primarily Lending Club, SoFi, Prosper, OnDeck and Avant) originated approximately $20 Billion in combined new origination in 2015. Interestingly, about 70% of this origination was concentrated in Segment 1, which is primarily Above Prime-Refinance:
| 2015 Origination | Refinance | Purchase |
| Above Prime | ~$14BN | ~$4BN |
| Sub Prime | ~$1BN | ~$1BN |
To make things a bit more granular, the loan purposes in each one of these segments can be further broken out into the following mutually exclusive sub-segments:
| Purpose | Refinance | Purchase | |
| Above Prime | Student Loans | Small Biz Loans | Elective Medical |
| Debt Consolidation | Home Improvement | Other Purpose | |
| Sub Prime | Debt Consolidation | Home Improvement | Emergency Cash |
| Auto Loans | |||
It may not come as a surprise that Banks have had less of an incentive to extend credit in most of the above segments and online lenders have not had much success in the ‘Purchase Other Purpose’ segment, which is the mainstay of Banks and Credit Card companies. For Refinance, banks would be cannibalizing their own book of existing and profitable loans and they do so once in a while through offering Balance Transfers – but this is for capturing market/ increasing top-line. For the Purchase segments, Banks have curtailed lending in these very segments given the high credit risk (and capital reserve requirements) especially post the 2008 credit meltdown. Nevertheless, we are beginning to see an increase home equity loans, given home price appreciation and more recently Banks venturing back into the small business lending space.
Niche Markets
Building further on this ‘credit-purpose’ segmentation plan, it is interesting to note that the leading online lenders have found their respective market niches as below:
| Purpose | Refinance | Purchase | |
| Above Prime | So-Fi Student Loans | OnDeck – LC Small Biz Loans | LC – Prosper Elective Medical |
| Lending Club Debt Consolidation | LC – Prosper Home Improvement | LC – Prosper Other Purpose | |
| Sub Prime | Avant Debt Consolidation & Auto Refinance | Avant Home Improvement | Avant Emergency Cash |
Evaluating some additional aspects such as Acquisition Marketing, Credit Risk, Funding and Revenue models by sub-segment further strengthens the ‘idiosyncrasies’ of each segment.
For instance, the largest/ fastest growing sub-segment in terms of recent and current origination volumes is Above Prime–Refinance–Debt Consolidation. Online lenders have accelerated growth of this segment primarily through the use of Direct Mail. This channel allows upfront screening for credit risk and has consequently become a fast and effective way for increasing origination in a ‘responsible and disciplined’ manner. Above Prime–Refinance–Student Loans segment leader So-Fi on the other hand has expanded through a B2B driven acquisition marketing plan of affiliations and partnerships with corporations. In the Above Prime–Purchase–Elective Medical Lending, distribution is through a Sales network with Doctor’s Offices.
From a Credit risk/ modeling perspective, credit scoring in Above Prime segments is more correlated to FICO and driven by regression models, while Sub-Prime lending is apparently more complex and ‘machine learning’ based, which also creates barriers to entry for traditional lenders.
Funding and Revenue Models
This brings us to a critical component that is becoming increasingly important for building a sustainable online lending business model; Funding and Revenue:
| Purpose | Refinance | Purchase | |
| Above Prime | Student Loans @Cost of Equity+ 3-5% | Small Biz Loans @5.4% | Elective Medical @0.06% |
| Debt Consolidation @7.4% | Home Improvement @7.4% | Other Purpose @7.4% | |
| Sub Prime | Debt Consolidation @Cost of Equity+ 3-5% | Home Improvement @Cost of Equity+ 3-5% | Emergency Cash @Cost of Equity+ 3-5% |
For segments that are primarily driven by ‘investor’ funding, the cost of funds is directly linked to the promise of returns to investors. Above Prime-Refinance-Debt Consolidation segment leader, Lending Club (with Prosper close on its heels) has built a brand promise of 7+ % annual return and established ‘consumer lending’ as a new asset class for their target investment community, that now includes over 30 Hedge Funds. Since there are additional costs associated with originating loans and ultimately charge-offs, for investors to get their expected returns, Lending Club has to charge an origination fee and interest rates that are much higher than 7% on an average. This has forced lenders in this segment to target borrowers with relatively riskier (near prime) profiles.
Paradoxically, over the last few years, average interest rates at Lending Club have been declining (keeping average loan terms relatively constant) and were at 12.25% in Q4-2015 for average 695 FICO loans. But lately, investors who have been seeking 7+% returns have demanded higher rates as an uptick in loss rates is beginning to eat into their expected returns. Is consumer credit facing some credit headwinds, or have lenders in this segment been under-pricing credit risk to accelerate top-line growth?
Balance Sheet Funding
Only as a comparison, per its Q1, 2016 earnings release, Discover Financial personal loans funded $3BN in new personal loans in 2015, at an average interest rate of 12.26% (for a slightly longer duration vs LC). Cost of funds was at 1.86% with average FICO at 755. Also the thumb rule is losses double for every 20 points drop in FICO?
For online lending segments that are funded through a combination of balance sheet and consequent investor funding, the cost of funds are lower and the dynamics quite different. For instance Above Prime-Refinance-Student Loans at So-Fi and Sub-Prime Loans at AVANT are initially funded through a mix of Equity and Warehouse lines and consequently packaged into ABS and sold to investors to free up the credit facility for re-use. For these segments – there is no external pressure on charging high rates and fees to customers. Revenue is earned from Net Interest Margin for the initial months and through coupons on small portfolio tranches that can be retained by the lenders, which also helps to establish ‘skin in the game’ and ‘true lender’ status. Both these segments do not charge any origination fees to their customers and rates are often lower than those charged by traditional lenders or not applicable if Banks do not participate in those segments.
To sum up, for success in the long run, online ‘lenders’ must establish ‘lending economics’ that are more similar to traditional lenders. Borrowing money at relatively high costs and lending at rates that don’t cover their expenses and charge-offs is not sustainable. At Lending Club, tightening credit now and increasing rates may result in a decline in conversion rates, increase in per unit marketing costs, slow down growth and additionally increase the risk of adverse selection? Conversely, reducing the promise of yield to investors may shrink funding sources and again limit growth? This not very different from the balancing act that traditional lenders have to manage to along with keeping in mind the cyclical nature of credit risk.
The bottom line is, online lending is fundamentally a ‘lending’ business and non-bank online lenders must not only find their niche ‘under-served, loan purposes’, but also have a sustainable ‘banking model’ to cater to the same.
Disclaimer: The views and opinions expressed in this article are solely those of the author. Examples of analysis performed within this article are only examples. They should not be utilized in real-world analytic products as they are based only on very limited and dated open source information.
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