New Age Lending and the Evolution of Credit

We're beginning to see a shift in how money moves. Similar to the very efficient corporate markets like bond trading and commercial paper, money is beginning to move to consumers too.
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I originally founded LendingTree out of my frustration getting a loan from a bank. The process was cumbersome and time-consuming, and it didn't make sense to me why there wasn't a transparent marketplace for the cost of money, similar to marketplaces for the cost of other goods and services. At the same time I was getting that loan, I was working in the energy sector watching people trade commodities contracts like they were just that -- commodities.

What struck me was that money is the most basic and fungible commodity in our economy -- why would you have to "extract" it from a lender like you have to extract oil from the ground? Particularly when the money you're extracting from the bank is actually lent to it by someone else -- the Federal Reserve, a bondholder, or a regular consumer who deposits money into the bank. Money should move freely across states, across nations, and certainly find its way to whoever will pay the most for it (on a risk-adjusted basis of course).

Unfortunately, that wasn't the case. To get money (a loan), regardless of the loan type, you had to jump through all kinds of hoops. It didn't matter whether you were a small business or a consumer, whether you were looking for a credit card, a mortgage, a personal loan, or an auto loan. There were multiple intermediaries, a lot of paperwork and confused consumers. The money didn't "flow" like it should.

That is now starting to change. I believe we're beginning to see a shift in how money moves. Similar to the very efficient corporate markets like bond trading and commercial paper, money is beginning to move to consumers too. It's happening because institutions like money managers and hedge funds, as well as consumers who don't want to simply deposit money at the bank, are taking matters into their own hands. These institutions are using new platforms to lend money directly, quickly, and in an incredibly efficient manner in several different areas:

Small Businesses: We're seeing new platforms like OnDeck Capital lend money directly to small businesses. Their money comes from institutional investors and they use risk-based scoring models to lend money in real time. Additionally, following the Jobs Act of 2012, the government has made it easier for individuals to invest in the equity of small businesses. Basically, non-accredited investors can invest in equity directly and small businesses can get equity from customers, other businesses, or people they don't even know. Small business was the most un-banked population of the business world. Extracting a small business loan from a bank was in many cases terrible, until the business was big enough to matter. Now, money is flowing from people or companies looking for a return and businesses looking to borrow it and give the investors a return.

Personal Loans: These loans used to be given out by "finance companies." Remember the companies in strip malls around the country? Now, they're being given directly over the Internet by companies like Prosper and LendingClub. Just like the small business examples, these companies get the money that they lend from institutions and individuals looking for a return and cutting out the "middleman" of the bank. These companies are using sophisticated risk-based scoring models to make sure that the return reflects the risk. Consumers get access to money instantly and at rates that are based on their specific risk profiles. Again, money is flowing.

Mortgages: Even though the government has put in significant regulations to impose more liability on loans made to consumers outside of very strict underwriting standards, we're seeing the beginnings of institutional capital coming back into so-called non-conforming mortgages. Angel Oak Funding is one example. They believe that they can profitably take institutional capital and get it in the hands of consumers outside of the bureaucracy of Fannie, Freddie, FHFA, and the other governmental agencies. Additionally, many of the "peer-to-peer" companies have also said they want to move into home-lending as well.

Auto Loans: Historically, consumers would go to their bank for a direct auto loan or directly to the dealer for their finance offerings, without context as to whether or not the loan or the car's purchase price was a "good deal." Additionally, if they opted to use dealer financing, they would often spend hours at the dealership while the F&I office shopped their loan, possibly adding basis points to increase margin dollars to the dealer's bottom line. Now customers can compare prices through companies like TrueCar and CarGurus, compare auto loan rates at LendingTree, Credit Karma, and, and secure financing through traditional lenders, dealers, or peer to peer sites like Lending Club and Prosper.

Student Loans: Private student loan companies like SoFi and Common Bond are following the same model -- making loans to students that the government won't do at slightly higher rates. Interestingly, the collateral here isn't a car, house, or inventory -- it's the future earnings potential of a student. Again, money is flowing like it should.

Think about it -- when our parents grew up, if you wanted to start a business, you might ask a family member for a thousand dollars, or a neighbor, or maybe a friend. You'd do the same thing for a car, college tuition, or even filling the tank up with gas for a road trip. These companies are simply institutionalizing that practice -- getting money from people who have it to those who need it.

So, what is the role of banks in this new world? Until deposits go away and banks can no longer borrow money from the Fed at obscenely low rates, they will be massively important and have the lowest cost of capital. However, banks need to increasingly focus on the "unlendable" market and do so in an automated way, like the companies mentioned above. It's one thing to have an underwriter analyze the financials of a billion dollar bond issue -- that makes sense. But, for a restaurant looking to borrow against receivables or inventory, that can be automated. It needs to be.

Banks also need to implement risk-based pricing. Consumers or businesses with less than perfect credit shouldn't need to go to another institution -- banks should charge higher rates. When you go buy your car insurance (for example), if you have three speeding tickets and an accident on your record, you pay more than your grandmother who rarely drives. But, that can all be handled by one insurance company. In the corporate bond market, companies with bad credit ratings can still find access to credit, they just pay more.

What I find really interesting is where all this could be headed. We could be headed for a future where money flows freely, based solely on the risk of who's borrowing it. The beauty of this is that even today, real people who "lend" their money to banks in the form of deposits will get higher yields by using these new platforms. And borrowers who need access to credit will not only have access to it, but will pay lower rates. With this model, there will be more accountability. Consumers would likely default less for two reasons: 1) the loan is from a real person, not a faceless institution, and 2) your risk profile will follow you. This won't be your "credit score" from today -- it will be almost like your Yelp reviews as a small business owner. People will hold each other accountable, the market will be transparent, and yes, money will flow as it should. I for one am very excited to be part of it.

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