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Dec 16 2016 | 4:44pm ET
Editor’s note: Marketplace lending activity has ballooned in recent years as investors have sought solutions to a perennially low-yield environment, traditional sources of financing have gradually evaporated due to regulatory and capital constraints, and technology has enabled platform-based loan origination and investment. However, as Mark Parsells of Global Debt Registry writes in this contributed article, increased confidence in underwriting, risk management, verification and validation is increasingly necessary for this new asset class to continue its rapid growth.
Investor and Warehouse Lender Confidence is Key to Fueling Growth in Marketplace Lending
By Mark Parsells
The marketplace lending industry has been in the hot seat recently as investors, warehouse lenders and regulators scrutinize the assumptions that have been driving this young industry’s rapid growth. Marketplace lenders (MPLs) have an opportunity to address these concerns head-on to increase confidence that the MPL approach to lending provides investors a safe and sound investment vehicle.
Investors and warehouse lenders in MPL loans to-date have been concerned about credit losses and performance of MPL underwriting models in a market downturn. These concerns certainly will continue until performance can be demonstrated over multiple market conditions. The new questions on the top of investors’ minds address more fundamental concerns about the asset class and the unique funding and management of these assets.
For most investors, representations and warranties by an MPL, all of which have very short operating histories, are not sufficient to address the risk that the underlying assets may not be exactly as presented. Even more directly, without a mechanism to test the loan level data in a timely manner against trusted third party data sources, there is no effective way to determine if a representation or warranty has been violated. While investors receive an unprecedented amount of loan level transparency, these files are anonymized since investors and warehouse lenders are not set up to handle personally identifiable information (PII) and do not want the regulatory and legal risk of receiving PII on the loans. Without PII, investors are receiving elaborate spreadsheets of data but have no mechanism to confirm that the underlying data is valid against trusted third party data sources.
This dilemma creates a significant challenge for MPLs and the original creditors that initially underwrite the loans. The MPL needs to protect the PII, yet it needs to assure investors that the reported data is beyond reproach. If we look at the changes in the mortgage industry since the crisis, we see an enormous emphasis on loan level validation, particularly by Fannie Mae and Freddie Mac. This level of scrutiny has historically not been feasible with lower balance loans such as MPL consumer loans.
The Path Forward
In order to increase – and in some scenarios gain back – investors’ and warehouse lenders’ trust in marketplace lending, the industry should recognize the benefit of pro-actively raising the bar as it relates to data integrity. This can be achieved by embracing independent validation to deliver confidence to investors and lenders. A trusted independent source of validation with expertise in handling PII - and separate from the servicing platform - can reduce risk for MPLs by providing a PII clearing house, using PII to independently validate information for investors and lenders. Investors and lenders have the benefit of independent loan-level validation using the actual loan level PII without the risk of ever having to handle this highly regulated information themselves. The validation identifies inconsistencies between the reported data and the investor’s or lender’s requirements, thus enabling a method to enforce representations and warranties much earlier in the life cycle of the loan.
Independent validation is important at several points in the life cycle of a loan. Certainly at the point of initial purchase or assignment as collateral, the investor wants to ensure the integrity of the asset. It is equally important that loan information is validated prior to securitization or sale of a loan. In these cases, the seller or sponsor can reduce its risk of having to take back loans by only including assets that have been independently validated to meet the representations and warranties of the transaction. This approach should lower risk and with that, lower transaction costs.
The Industry Benefits of Real Loan Validation
As the MPL industry matures, asset classes will expand into deeper risk pools, new asset types and variable terms. Overtime, a secondary market is likely to emerge to add liquidity and targeted investment durations. Lenders and investors will consolidate or liquidate and debt buyers will play a more active role as the asset base grows and loan losses increase. This type of market evolution will require clear evidence of the chain of title, validated data and associated documentation to ensure downstream collectability.
The challenges of loan level data integrity have been a significant source of compliance and legal costs in markets such as the credit card market, due to a lack of supporting documentation or chain of ownership information. The MPL industry is well positioned to avoid a similar fate by embracing changes now that can ensure the transportability and ultimately the collectability and enforceability of ownership rights well into the future, when this will be much more difficult and costly to address.
The Next Evolutionary Phase for MPL
Additional validation of credit data, income or education may be added as needed. With a repository of loan data, investors and warehouse lenders can also ensure loan ownership and collateral obligations are tracked to avoid inadvertent mis-assignment or double pledging of assets. Investors are looking for an independent chain of title system which allows for proper tracking of loan ownership as well as collateral tracking registry to protect warehouse lenders against the possibility of double pledging of collateral. These types of independent risk infrastructure initiatives will allow them to gain confidence in the infrastructure behind this market.
Increased investor and lender confidence will attract new investors to help keep borrowing costs lower for MPLs and ultimately increase interest from new borrowers looking to obtain a loan. The benefits of this new approach abound – for investors, lending platforms, warehouse lenders, and even borrowers.
The MPL asset class needs to build risk control infrastructure for its next evolutionary phase - one where investor confidence is top of mind and new data validation standards nurture safe growth.
As more and more regulators and lending industry associations look closely at the risk infrastructure in the MPL space, now is the time for all industry players to set the new standards of what they need to remain confident in the space. 2017 could indeed be a great year of growth for the industry as long as investor confidence and business risk are top of mind for all market participants.