The NY Times had a report this week that Goldman Sachs (GS) is exploring an entrance into the consumer lending market. Comparisons have been made between what Goldman has in mind for consumer lending and the company Lending Club (LC) that went public last year.
To understand Lending Club and Goldman's vision of consumer lending we need to discussion traditional lending first.
Traditional Lending
In a traditional banking model, a bank funds a loan through customer deposits. A bank's source of funding is their customer's deposits. Traditionally banks pay a small amount on deposits to compensate depositors for access to their money. Deposit funding costs are low. In the first quarter of 2015 banks paid an average of .44% in funding costs.
A bank makes money on the spread between the interest received on the loan and the interest paid on their funding (deposits). If a bank makes a mortgage loan to a borrower at 4% and pays .5% in funding costs they earn a 3.5% net interest margin. Operating costs to service the loan as well as providing the infrastructure to take in deposits and make loans is subtracted from that 3.5% spread as well as taxes and the resulting value is a bank's net income.
Banks can make money by lending to consumers then keeping the loan on their books and earning the spread. Banks engage in all types of lending, consumer, credit card, auto, residential, and commercial. Of those types residential lending is viewed as the safest and rates are the lowest as a result. Moving up the ladder commercial loans are viewed as risker followed by auto, consumer loans and finally credit cards.
The truth is it's really a toss-up in terms of risk, sometimes commercial loans are much safer than residential loans, and residential loans aren't always safe. On average banks are usually good at assessing risk. A loan to IBM might carry a 1% rate, whereas a loan for a sub-prime auto might carry a 15% or 20% rate. IBM is a good credit and it's almost assured they will pay back their notes. A troubled car borrower is dicier. Compound that with little residual value for the auto itself and it's easy to see why rates are so high for poor credits.
Banks usually like to diversify their lending mix. This is in an effort to both manage risk, exposure, and increase their net interest margin.
The New Model
Lending Club is not a traditional bank as most consumers think of banks. They own a small bank, Webbank located in Utah, but they are not a traditional lender. The company is not funded via customer deposits, and they aren't focused on earning a spread via the bank. There bank holds certain types of loans on their books and for the most part are just an intermediary for the rest of the Lending Club system.
Lending Club makes money by originating loans and selling those loans to investors. The company takes a 5% origination cut off the top of the loan and then receive 1% of interest for each loan. As an example if a borrower were to take out a $10,000 loan at 9% Lending Club would receive 1% in interest and investors would receive 8% for backing this loan. Loans are funded by selling notes to investors.
From a borrowers perspective Lending Club is no different than a traditional bank. A consumer requests a loan, the company conducts a credit check and if they deem them worthy they'll extend credit. The borrower then pays back their loan with monthly payments. Lending Club takes a portion of the payments and passes the rest onto investors in their notes.
If any investor were to read the Lending Club website it would appear that investors fund specific loans and receive payments from said loans. But that's only partially true. The Lending Club notes are simply derivative securities, the note itself is to Lending Club corporate, and the company then promises to forward on payments from borrowers to the investor minus service fees.
Lending Club makes money on the initial origination as well as service fees and the 1% of the interest rate paid by borrowers.
The actual notes are fairly complex. A prospectus is available on the SEC website and contains general details of how the mechanics of the investing and loan funding process work. Investors are buying Lending Club notes, and then Lending Club pays investors based on what notes the investor has selected via the website. If a borrower defaults the investor has zero recourse, they don't have an actual claim on the loan like a bank would. If Lending Club were to declare bankruptcy the investors don't have a claim on Lending Club, the claim directs to the interest in the underlying note.
Lending Club's costs are much higher than a traditional bank's costs. Any student of the capital markets knows that equity financing carries the highest cost of all types of financing. But for Lending Club the equity financing isn't borne by them, it's someone else's money.
Can it work?
The Lending Club model is different from a traditional banking model. Lending Club needs to keep their origination volume strong and growing if they want to increase their revenue stream. They aren't making much money on each loan so they can't just originate loans then sit and collect interest for years like a bank can.
This creates a unique incentive, the incentive is for Lending Club to drive loan volume regardless of credit quality. If borrowers default Lending Club itself doesn't recognize a loan loss, they simply lose their 1% ongoing interest stream. The company makes the bulk of their money upfront.
The company claims on their website that they have a premier platform and can conduct this type of lending profitably because of a low cost IT platform. Supposedly banks with their high cost personnel and traditional infrastructure are outdated compared to this new IT paradigm.
The problem is the company's financial statements don't match up with what they're saying publicly. In the most recent quarter they generated $81m from originations and service fees and had $86m in expenses. Expenses broke down as following, $35m in sales and marketing (to keep the origination machine running), $12m in origination costs, $12m in engineering and development and $27m in "other". The company reported a GAAP loss, but if investors pretend that stock compensation isn't a true expense then the company was profitable on an adjusted-EBITDA basis.
Lending Club has originated over $9b in loans since they started. For comparisons sake let's look at them compared to a bank with $9b in loans. I ran a search on CompleteBankData.com and came up with Apple Bank for Savings located in NY. They had slightly over $9b worth of loans in the first quarter of 2015. As a comparison it only took Apple Bank for Savings $29m ($16m in salaries, $13m in premise, data etc) to manage this amount of money. Apple Bank for Savings earned $10.2m for the quarter, a far cry from Lending Club's loss of $6m.
Of course this isn't a perfect comparison. Apple Bank for Savings specializes in mostly residential and commercial lending. And they are funded by deposits. But the comparison shows that there is a lot of value in being able to keep lower interest but profitable loans on the balance sheet and earning a spread.
Lending Club is a fundamentally different model compared to traditional banking. Lending Club's model is driven by originations and fees on their loans, not the rates charged to consumers.
The attraction to this model for Goldman Sachs should be obvious. Lending Club is raising funding capital from ordinary investors for their derivative notes whereas Goldman Sachs has a pipeline to institutional capital. Goldman Sachs are experts at raising funds for special purpose entities that are eventually repackaged and then sold again to other (or the same) investors.
Lending Club is raising money at the retail level, $25 at a time. Goldman Sachs can come into the market as a whale given their connections to capital and experience securitizing loans.
If I were to wager I'd say that Goldman Sachs will create a newly named consumer loan unit without the Goldman name on the letter head. This newly created entity will begin to spam American mailboxes offering loans at 15-25% rates. Goldman will then package these loans and sell them back into the market pushing the risk of a default onto investors, the same way Lending Club does.
The risk to this business model is it requires a steady stream of new originations. If loan origination volume doesn't stay steady or grow the company could have issues coving their costs. Lending Club hopes to eventually make money on their origination and service fees. I'd imagine Goldman Sachs has the same idea, although I'm sure they'll make a little extra on the back end of the deal as well when they resell their packaged securities. This is where Goldman has an edge. They can make money up front and make money on the back trading these securities between clients.
Risk will appear when the "good" (good in a relative sense, not many truly good credits are borrowing at high rates) credit dries up and the company continues to make loans to poor quality borrowers in order to hit their origination metrics.
The real risk will be borne by the investors in these notes. Whereas Lending Club investors can select the types of loans they'd like to be exposed to it's likely Goldman will do the selecting themselves and offer their clients pre-packaged securities. We've seen what can happen to pre-packaged securitizations of low quality credits in the past, let's hope history doesn't repeat.
Just to offer a little different perspective on LC's profitability, isn't the comparison between them and a traditional bank a little short term? They're putting quite a bit toward marketing and presumably development costs as a percentage of revenue will taper off as the platform becomes more mature. Tying into your point on their incentive to drive volume, once LC's volume reaches a certain point their model is profitable and additional loans just add to their bottom line. Whether those loans are sound for LC's lenders remains to be seen.
ReplyDeleteExcellent article as always.
The quarterly profit comparison on a bank that has 9Bn of outstanding loans is not fair:
ReplyDelete1) Firstly, Apple Bank with 9Bn of outstanding loans, may have a quarterly net income of 10.2M v. LC -6M loss, but how many of those 9Bn are new loans? i.e. next quarter even if Apple Bank does not grow its loan book, it will receive 10.2M. Whereas the -6M of LC, they make the bulk of their money (5%) on origination. So the only fair way to compare them is on the incremental Return on Capital, i.e. if apple bank grew their loan book by 1Bn in the next quarter to 10Bn, how much more/less profit comes to the bottom line and the equivalent for LC.
This is why I used $9b, that's how much LC has originated since they started, not just this past quarter. They originated $1.6b in the past quarter.
DeleteAnd yes, Apple bank doesn't need to do anything, that was exactly my point. The business models are drastically different.
Aren't you overlooking a small detail? LC usually loans out money for a limited period of maximum 5 years, while a bank usually loans out for much longer periods. Some of those lenders might return after that and take out another loan.
ReplyDeleteAside from that, LC is targeting the "small" fish that aren't worth the attention of the big banks. The big banks have to spend as much time (= money) on 100k loans as on 1 - 10 mln loans, so the smaller companies get turned down a lot, because the banks prefer to spend their money efficiently. I know that's the case in Europe, but not sure if that's the same in the USA. It seems there are way more small banks in the USA than in Europe.