Finance

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

Data glitches are bad for any company. But they are especially terrible for online lenders that trumpet having high-quality data as a main selling point.

This was true of LendingClub, which about a year ago disclosed some problems with loans that caused great concern among investors, as demonstrated by the company's plummeting share price. And now comes Prosper Marketplace, which said on Thursday that it told investors their returns were inflated because of a systems error. Annual returns for some investors were cut in half, while others declined by 2 percentage points or less.

Out of Favor
Publicly traded online lenders have lost their shine. The latest to stumble, Prosper Marketplace, is fortunate that it's still closely held.
Source: Bloomberg

The news is a significant blow to Prosper, especially because it follows other concerns about its heavy reliance on a concentrated pool of investors.

It would be overly dramatic (and wrong) to say that Prosper's latest woes signal the imminent demise of the independent online lending industry. But it does highlight how these lenders are slowly losing some of their competitive advantage with respect to big Wall Street banks. While they once had a relatively easy time raising money and were more lightly regulated than the biggest banks, these online lenders are going to have higher financing costs going forward.

For example, take a look at a recent securitization by Avant, the online lender that cut its staff by about 30 percent last year and whose loan default rates had been higher than expected. To attract investors to the nearly $220 million deal, Avant had to materially improve the underlying creditworthiness of loans by reducing their length and the amount financed and increasing their risk-adjusted yield, according to PeerIQ.

This shows investors are pushing back, which will end up squeezing the online lenders that are trying to attract more creditworthy borrowers while still demanding high enough rates to lure investors. Data provider Orchard Platform said the average return on online consumer loans was 3.95 percent last year, which doesn't seem sufficient unless the default rate was extremely low, especially compared with average returns of 6.93 percent in 2015.

Meanwhile, big Wall Street banks are aggressively competing for the better-quality borrowers -- think of Goldman's Marcus and SunTrust's Lighstream -- and are capitalized well enough to offer attractive terms.

And it's not just banks. At the LendIt conference in March, Marlette Funding's Chief Executive Officer and founder Jeffrey Meiler acknowledged that steepening competition for "near prime" borrowers from credit card companies would seriously hurt marketplace lenders. “The best days are over; we are going into an environment where things aren’t going to improve,” he said.

Struggle Street
Personal-focused lenders are facing more headwinds than their rivals. Most of them experienced a decline in loan originations in 2016.
Source: S&P Global Market Intelligence

The answer, as floated by some, is consolidation, although this idea hasn't had as much traction as some thought it would.

Tie-Ups, Not Takeovers
Banks have purchased loans from online lenders, formed partnerships or built competing platforms -- all lower-cost alternatives to acquisitions
Source: On Deck

Meanwhile, time for online companies to fine-tune their business models is running out. The Trump administration is eager to reduce regulations for the biggest banks, which should make it easier for them to compete. And investors are growing increasingly skeptical about startups that relied more on their technology than any history or expertise of actually lending to people.

The U.S. economy will slow at some point, leading to a reduction in loans and higher defaults. And eventually, all lending will be done online. What's unclear is what role the existing independent online lenders will play. It's likely they won't all survive, certainly not as stand-alone companies. The pressure is rising for them to adjust their business models before it's too late.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net