05 - 01 - 2016 | |
I’ve been a fan of private credit for a long time. More than eight years ago, I predicted that the private-credit world would explode within a few decades.
Recently, I have once again been exploring the private-credit world, and it seems this market is growing faster than I had thought.
With today’s banking environment and all the perks of private lending, however, it shouldn’t be a surprise.
Capitalizing on Impossible Lending Standards
Much of the growth in private credit is a direct consequence of declining bank lending. Between the financial crisis and new restrictions like Dodd-Frank, banks have had to seriously tighten their lending standards. They’ve had to cut back in ways that don’t make sense.
Meanwhile, not only are banks operating illogically, they are centralizing the illogic. The giant Wall Street banks have been snapping up local and regional banks, thereby eliminating the hands-on, personalized approach to lending.
Most banks are now highly centralized bureaucracies. That’s great if your need is shaped like their cookie cutter. If it isn’t, the big banks can’t help you.
I talk to a lot of small-bank executives and directors. They constantly complain that the regulators are forcing them out of profitable markets and making it impossible for them to do business.
I can’t help but sympathize, because they are right. But this regulatory restriction is creating a huge opportunity for the creation of private lending.
An Alternative Everyone Is Happy With
Fortunately, the economy is still free enough to create alternatives to fill the gaps. Non-bank lenders are leveraging technology to supply credit in the niches banks ignore.
You might have heard of the online peer-to-peer lending platforms like Prosper and Lending Club. They connect people and businesses that need to borrow money with investors who have money to lend. They make a match that can give both sides the terms they want.
Here is an example I ran into last week on Lending Club.
Say you want a $25,000 debt-consolidation loan. Your FICO score is in the “good” range (660–720), and you have annual income over $100,000.
With Lending Club, you can get a five-year loan at 7.89% with a 3% origination fee. That works out to a 9.63% APR, less (and in some cases much less) than most credit cards charge.
Where does this money come from? Investors buy packages of loans that may contain thousands of loans like the one outlined above. Lending Club claims its top three credit groups have delivered historical returns ranging from 5.23% to 8.82% with very modest risk.
Modest risk is not the same as no risk, but we’ve already established that risk-free investing pays you little or nothing.
Banks Can’t Compete Against That
McKinsey did a study on P2P lending last year. They projected that by the end of 2015 P2P platforms would be able to offer loans at 400–500 basis points less than an equivalent bank could.
Private credit firms can do this because they have lower expenses than banks do. They don’t need brick-and-mortar branches all over the place. They don’t have decades-old computer systems and cumbersome, lawyer-driven processes. They don’t have to service checking and savings accounts. They do one thing, and they do it very efficiently.
In many cases, private-credit lenders specialize in a particular industry or market segment. They might be experts in equipment leasing, real estate, education financing, vehicle loans, or countless other niches. This specialization matters because knowing the niche lets them control risk and offer the most competitive terms.
Banks are fully aware of this challenge. They also seem to know how deeply stuck in the mud they are.
Earlier this month, JPMorgan Chase announced a strategic relationship with OnDeck Capital. Together they will offer “small-dollar” loans in an online portal. (A small-dollar loan means less than $250,000.)
I can see the attraction for JPM. They will keep loans above the $250,000 level in-house and have their own employees do the credit analysis and other work on them.
They’ve probably concluded that the small-fry loans aren’t profitable for the bank, but they also don’t want to sacrifice those relationships. Their deal with OnDeck is a compromise toward that end.
Such partnerships may be the legacy bank’s best shot at remaining relevant.. They are getting squeezed from both directions. Regulators have made it harder for them to make money in commercial lending to large businesses.
The low-cost private-credit lenders are locking them out of smaller loans. The walls are closing, so they need to do something.