Are LendingClub's Troubles Bigger Than Just One Company?

The spin factory is working extra shifts these days.

No, I’m not talking about the upcoming presidential election. Rather, I’m referring to the surprisingly quick and robust efforts on the part of financial services industry advocates to regain control of the narrative following a so-called FinTech (financial technology) poster child’s fall from grace.

LendingClub Corporation was the first peer-to-peer finance company to have an initial public offering. Given the breathtaking $8.5 billion valuation it garnered at the time of its 2014 debut on the New York Stock Exchange, it’s clear that expectations for the company, and the edgy sector of financial services it represents, were high.

Although the firms that share space in FinTech vary in their approaches to the consumer and small-business demographics they target, the two things they have in common are super-fast online processing (thanks to algorithmically based credit underwriting) and limited regulatory oversight because none are depository institutions—no savings and checking account balances are at risk. At least not yet.

Lately, these two commonalities have begun to attract negative attention for reasons I’ll discuss in a moment. At first blush though, it appears as if the LendingClub scandal involves an isolated instance of alleged impropriety on the part of some members of senior management.

Until you take a closer look.

LendingClub’s CEO Renaud Laplanche resigned after the company disclosed that it had misrepresented key characteristics of the loans that were sold to an institutional purchaser. Bulk-loan purchase agreements are specific about what constitutes a so-called eligible contract — such things as bona fide, legally enforceable documentation and the timely receipt of installment payments to the point of sale.

So the $22 million question (the value of the subject transaction) is: Why would a company the size of LendingClub allegedly jeopardize the reputation it has with customer-borrowers, institutional and retail investors that trade in its stock, and the sources on which it depends to fund the loans it originates, all for a deal that represents less than 1% of the loan volume the company booked in just the first quarter of 2016?

The answer could be the canary in the FinTech coal mine.

Are There Problems With the Credit Underwriting Process?

I learned three important lessons the hard (costly) way during the slow-motion train wreck of the Great Recession: Sell when the company builds a corporate Taj Mahal, when the CEO leaves for any reason other than dropping dead at his desk, or when senior management speaks nihilistically about “new economy-related paradigm shifts.”

FinTech companies — along with the private equity firms and venture capitalists that have pumped billions of dollars into their operations — seem to believe they are the future of low-dollar-value lending. Thanks to the advent of big data-driven algorithms, what once took a ridiculous number of weeks, if not months, for institutional lenders to complete is now accomplished within hours online. That the activities of these nonbank institutions aren’t subject to the same regulations as are their traditional banking counterparts doesn’t hurt either.

I believe this is the real story behind the news story.

The credit underwriting process isn’t singular — science vs. art — it’s binary, particularly in regard to transactions that involve borrowers who are unbanked (no institutional relationships and/or credit history) or under-banked (limited relationships and/or tarnished credit), both of which constitute FinTech’s demographic mainstays. That’s why any lender that believes it’s developed a magical mathematical mechanism (i.e., algorithm) to take all this into account but neglects to test its hypothesis by re-processing a statistically significant sample of credit failures that occurred at various points during an end-to-end business cycle (boom to bust to boom) is, in my opinion, kidding itself. Why go through all that trouble for a comparable result — or worse?

Considering that so many FinTech lenders didn’t appear on the scene until after the last meltdown, coupled with the fact that the historical credit-performance data they’d need to test their prospective underwriting methodologies reside within the very institutions they propose to supplant, one can’t help but wonder if the next credit cycle — which would be the companies’ first — may well be their last.

And then there’s the structure of these loan products.

Small-dollar, short-term lending is a tough business. There simply isn’t enough profit in a $1,000 loan that’ll be on the books for only a month or two. Not without automating the process, hyping the hell out of the rates of return (i.e., APRs, which mathematically combine interest rates and fees), setting up shop in accommodating jurisdictions (there’s a reason why many credit card companies call South Dakota home) and devising products that encourage repeat use (payday and merchant advance loans are good examples).

The Need for a Watchdog

That leads me to the second problem facing FinTech companies: The growing call for regulatory oversight at the federal level to override individual states.

So whichever comes first — an economic downturn or amped-up regulations — you can probably look forward to a frenzy of mergers and acquisitions to follow. My guess is that the old-economy banks will take the lead because they’d stand to pick up loan portfolios and tech platforms all on the cheap.

The question is, how will consumers and small business fare if this happens?

They’ll do well if the banks successfully translate what they learn from their nonbank counterparts into an ability and willingness to lend to the under-represented demographics upon which FinTech currently relies.

They’ll also do well if the surviving FinTech firms combine new- and old-school approaches for underwriting credits as they transform their existing loan products into ones that are more reasonably structured and priced.

Don’t hold your breath though. If history teaches us anything, it’s that the more likely outcome will be yet another credit crunch for small-time borrowers. That is, until the banks realize they need more business or a fresh crop of entrepreneurs come up with something new. Again.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.