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Investors Beware: Summers praised Marketplace Lending

If Larry Summers speaks about marketplace lending, it is advisable to listen. Not because he used to be the president of Harvard, the head of Treasury, and an economic advisor to Barack Obama, but because of his outstanding ability to predict the opposite of what is going to happen.

Most people working in finance know one colleague with an outstanding sense for being wrong. It is the person who always buys at the peak and sells at the trough; he is the one you ask for investment advice and then do exactly the opposite of what he advised you to do. In the political sphere of Washington, this person is Larry Summers.

Larry's Take on Marketplace Lending…

When Larry pushed for deregulation because he believed it made financial markets more stable and efficient, you should have become worried: The financial crisis of 2007-08 was just around the corner. When he pursued a complicated investment strategy based on interest rate swaps, you should have taken the exact opposite side and made one billion dollar. When he praised the CEO of a company such as Enron, you should have immediately shorted the stock and made the trade of your life.

Another “Larry-moment” occurred just a couple of weeks ago. Larry spoke about marketplace lending at the LendIt conference in New York, the get-together of this rapidly growing industry. The important part of his keynote speech was his argument that marketplace lending would make our financial system more stable:

“Platform lending doesn’t have the central connection to leverage that traditional banking does. There is no entity that carries a balance sheet with leverage. There’s nothing there that is too big to fail. There is nothing there that requires deposit insurance. There is nothing there that is implicitly subsidized, and there is, therefore, a greater contribution to stability, to the kind of stability that we seek to achieve.”

… and He is Wrong, again

Each and every one of these statements is 180 degrees wrong. Again, Larry’s unique ability draws our attention towards pressing issues, this time to the digital frontier of finance. Changing his sentences to the complete opposite, we get:

“Leveraged entities and too-big-to-fail institutions become the dominant players in the marketplace lending industry. Funding that is covered by deposit insurance is directed into marketplace loans and institutions enjoying implicit subsidies through government guarantees are squeezing out other investors. Financial stability is at great risk.”

Miraculous! Larry is as reliable as a compass that mixes up North with South. Let us explain why.

From P2P to Marketplace Lending

Not until long ago, marketplace lending was actually called peer-to-peer lending. It was about connecting ultimate borrowers and investors directly; information technology was used to match their differing needs. Investors could split up their savings into $25 chunks to diversify risks, and the platform operator would use automated and sophisticated scoring algorithms to handle credit risk.

Today, peer-to-peer lending is dead.

Institutional investors such as hedge funds, banks and asset management firms have taken over the investor side of marketplace lending. All these types of institutions are highly leveraged.

At the same conference Larry gave his speech, Lending Club – the company that hired him as a board member – announced a partnership with Citigroup, one of those financial institutions that received a massive government bailout in 2008. Citi provides a $150 million credit facility to a hedge fund called Varadero capital that uses the facility to invest in marketplace loans.

Or, using Larry’s words: a leveraged too-big-to-fail institution, which both enjoys deposit insurance and an implicit funding subsidy, lends money to a leveraged hedge-fund that in turn engages in marketplace lending.

The partnership between Lending Club and Citi is not an isolated instance where leverage enters marketplace lending. Backed by federal deposit insurance, smaller banks have directly invested into marketplace loans for quite some time now.

Shadow Banking 2.0

It is not only old fashioned banking that is hijacking the supply side of marketplace lending. The big investment banks discovered marketplace loans as viable raw material for their securitization machines. And the same rating agencies that awarded AAA-labels to fraudulent financial products – those that fueled the financial crisis of 2007-08 – now gladly provide high ratings to securities backed by marketplace loans.

Hedge funds or investment banks can buy these asset backed securities (ABS) and use them as collateral for borrowing money on the money market – that is, borrowing money from banks enjoying deposit insurance or from money market mutual funds that enjoy implicit government guarantees. This type of financial chain is known under the term shadow banking and its destructive potential has been demonstrated during the financial crisis of 2007-08.

It is only a matter of time until a systemically relevant institution will have the brilliant idea to insure the repackaged marketplace loans, that is, to sell credit default swaps (CDS) on ABS using marketplace loans as an underlying. Surely, Larry would welcome this development. CDS are the same type of product he pushed so hard to deregulate 15 years ago. AIG was very grateful for his efforts; it faced less of those annoying regulatory obstacles when it went on a $500 billion selling frenzy with CDS, which eventually ended up in a huge government bailout.

Leverage and systemic risks creep into marketplace lending from every angle, and too-big-to-fail institutions are capturing it to satisfy their insatiable risk appetite. They flood the industry with money that is subsidized by government guarantees. Marketplace lending has morphed into shadow banking.

Larry Could Have Been Right

While Larry's argument about marketplace lending is fundamentally wrong, it would be perfectly valid for peer-to-peer lending. If borrowers and lenders interact directly without all this leveraged institutions shoved in between, actual “peer-to-peer” lending would neither be as vulnerable to nor trigger systemic instability. The initial concept of peer-to-peer lending is ingenious.

So why did peer-to-peer lending transform into shadow banking, as we have described above?

It is the latest chapter of a sad story that started in the 1970s when information technologies entered the stage. Unfortunately, the new technologies were not used to support the real economy with better financial services. The rocket scientists from Wall Street had something else in mind.

They spent their time devising financial “products” with questionable economic value. What is not questionable is that the alphabet soup of structured finance – all those ABS, MBS, ABCPs, CDOs, or CDS – was used to circumvent financial regulation. This enabled an unsustainable boom that ultimately ended in tears: the financial crisis of 2007-08.

With the transformation of peer-to-peer lending into marketplace lending, history is repeating itself. Instead of working hard to establish liquid and transparent secondary markets, the industry is going to great lengths to make marketplace lending as opaque and complicated as possible. Instead of striving to maximize the convenience and minimize the costs for retail investors to invest in a loan portfolio that matches their financial needs, they are shutting them out.

A dark force is at work that turns useful financial innovation into destabilizing financial engineering. This pattern has been so pervasive in the past that Paul Volcker, a former chairman of the Federal Reserve, even remarked that the ATM was so far the only useful banking innovation. It is hard to imagine that marketplace lending will change his mind.

We have used Larry Summer as the common thread for this article. Fairness commands the remark that not many regulators or academics have recognized the devastating impact of the digital revolution within the current regulatory framework. This is why we decided to start a blog and write a book. We are convinced that a simple change in corporate law can enable a decentralized and stable financial system; a financial system in which market forces are unleashed such that good innovations are spurred. Rest assured: If Larry knew about our ideas, he would urge you to ignore them.

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Tags

financial innovation financial regulation Fintech Larry Summers marketplace lending peer-to-peer lending securitization shadow banking too-big-to-fail
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Comments:

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[…] The End Of Banking opined in 2015 […]

TechHub, 2017-08-21 20:24:21

Its a good article and to some point I agree with it. The only data point used here is Larry Summers which lacks the support. I doubt if the same person will repeat the mistake again and again. At some point he/she will make the right decision. In this case, its Larry Summers. Its not a pure P2P lending which I understand and the risk involved when the institution backed investing goes to the lending marketplace. Still the current lending marketplace has not reached anywhere when you compare it with CDO’s or Credit Default Swaps. It is still in the initial stage and lot of room to grow.

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