His questions: “What do you think about the impact of rising rates on credit margins? Is margin compression a likely result? Or could they hold and if so, why will the investor side change behaviour? Or will a steepening yield curve mean that banks will be willing to take the maturity mismatch and in doing so undercut the level at which p2p can sustainably operate without sacrificing their credit standards?”
Rather than answer directly via my first post, I think Brad’s questions deserve their own forum, hence this post sequel.
Impact of rising rates on credit margins: As my partner Jim Rothberg at R66 states bluntly “Margins should narrow if rates rise.” Providers of capital will require a higher compensation for their efforts, i.e. higher yields, because their own cost of capital will also rise – most are floating rates for sure. The cost of capital rise will not be compensated fully by increased rates to borrowers as these rates are already relatively high and there is in some cases little room for increases – remember that yield has attracted hot money to the sector in the first place – so we should expect to see credit margin compression with marketplaces and on balance sheet lenders.
Impact of rising rates on investor behaviors: “Hot” liquidity and capital providers seek risk until they find it. As interest rates rise, the risk of certain asset classes which Alt Lenders focus on will rise too, probably at a faster pace than safer assets. This will change investors behaviors for sure, and a flight to safety, on average, cannot be ruled out. The more Alt Lenders have moved closer to subprime targets, the more the risk of investor behavior changes.
Will Banks be more competitive: Banks will absolutely be more competitive. Banks marginal cost nears zero due to the inherent magical properties of retail checking accounts. It is not so much a case of “will banks be more competitive” but a case of “will Banks want to lend more”. If we assume they do want to lend more for various reasons, then they will be formidable competitors, or formidable acquirers of the best Alt Lenders. Alt Lenders that remain independent (especially those that are publicly traded…) will be forced to alter their behaviors to sustain growth. This will mean relaxing underwriting standards to produce more paper – and this will prove problematic for some as I would be very surprised if Alt Lenders’ capital providers have not inserted protective provisions controlling underwriting and credit scoring standards.
The above analysis leads me to the conclusion that a rapprochement between Alt Lenders and Banks is a natural evolutionary step, especially as interest rates rise. Alt Lenders benefitted from Bank retrenchment and a low interest rate environment plus the ability to deploy new technology and consider different data sources. Take away Bank retrenchment and the low interest rate environment and add renewed appetite from Banks to deploy their lending wings and you are left with Alt Lenders as natural partners from a distribution channel point of view – lower cost of acquisition, faster origination and underwriting…
Should we expect more Banks entering into partnerships with Alt Lenders, making investments or acquisitions? Should we expect Alt Lenders (the marketplaces maybe, rather than the on balance sheet lenders) tweaking their business models to focus on processing and servicing?
One thing is certain, interoperability between Alt Lenders and the only source of stable capital around is going to be a hot topic.