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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2018

Online Lending Comes of Age

What originators need to know about a growing sector of the mortgage industry

 

Key Points

The alternative-lending landscape

  • Underwriting algorithms go beyond credit scores.
  • Loan decisions are often made faster, compared with traditional lenders.
  • Borrowers can apply for loans from home or after work hours.
  • Much of the industry is untested by a downturn.
  • Cybercrime poses concerns for the future.
  • Regulators are just beginning to shape oversight.

No longer the new kid on the block, the alternative-lending industry has transitioned from the days of innovators testing the waters with new online underwriting algorithms into a maturing industry accepted by Main Street borrowers and Wall Street institutional investors alike.

From real estate crowdfunding to peer-to-peer marketplace lenders, the online lending sector — more broadly referred to as the alternative-lending sector — ballooned in size in the United States from 2010 to 2015 before growth began to taper off a bit. With a variety of players, there isn’t a simple description of what encompasses the alternative-lending industry. A major component of it is defined as companies doing business via online lending platforms beyond that of traditional brick-and-mortar lenders.

Without a doubt, the sector has faced a bumpy ride at times. The United States has seen alternative lenders successfully raise millions of dollars, merge or be acquired, and go public. It also has witnessed some valuations plummet and companies go out of business.

Mortgage originators will want to be well-informed about the maturing and evolving alternative-lending sector and all that it offers. That includes comprehending the challenges and opportunities that exist in the sector in order to best serve present and future borrowers.

Rapid rise

Advances in technology have altered the way individuals and businesses access capital, and alternative lenders have been at the forefront of that change, bringing forth innovation that has shifted how Americans borrow and invest.

Alternative lending via online platforms in the United States began, in a limited form, in 2005 and 2006 with companies such as Prosper.com and Lending Club. The sector expanded rapidly after the subprime mortgage crisis and the larger financial collapse it sparked some 10 years ago, which led to tightened credit conditions after traditional banks and nonbank mortgage lenders became embroiled in the mortgage meltdown.

In fact, it could be argued that tighter credit still persists today in some fashion as a consequence of the financial crisis. This provided an opportunity for alternative-lending innovators to form and act as financial-industry disruptors.

U.S. online lenders more than tripled their lending volume between 2014 and 2015, from $11.7 billion to more than $36 billion, according to an April 2016 study by the University of Cambridge’s Centre for Alternative Finance and the University of Chicago’s Polsky Center for Entrepreneurship and Innovation. Online marketplace lenders are poised to reach $90 billion in originations in the U.S. by 2020, notes a 2016 U.S. Department of Treasury report.

The growth in real estate crowdfunding, another subsector of alternative lending that has been around less than a decade, has quickly grown into a billion-dollar industry, and several real estate crowdfunding platforms have reached significant size in terms of revenue, deal flow and participation from borrowers and investors. Institutional investors also have raised their equity commitment in real estate crowdfunding’s profile.

In July 2017, a joint study by the Federal Reserve Banks of Chicago and Philadelphia concluded that online lending platforms offer access to credit at fair prices to otherwise underserved, but still creditworthy borrowers. The companies’ “technology platforms and their ability to use nontraditional alternative information sources to collect soft information about creditworthiness may provide significant value to consumers and small-business owners, especially for those with little or no credit history,” the joint report stated.

“In addition, as more millennials make up the pool of small-business owners and the consumer population, they are more comfortable with technology and, therefore, may be more comfortable dealing with an online lender than in dealing with a traditional bank,” the report continued. The two Federal Reserve Banks used data from Lending Club and stress tests to inform the report.

Unique advantages

While alternative lending is often touted for its technological advances, mortgage originators should be wary of overemphasizing technology to the detriment of personal interactions. Mortgage originators who prefer to work directly with a lender rather than through an online interface still have opportunities to assist their clients in the alternative-lending space.

Certainly, some online portals may not staff their origination teams with sufficient manpower to provide high levels of customer service. But some alternative lenders do provide “high-touch” service and make it easy for mortgage originators to reach a real person to get questions answered quickly and efficiently.

The advantages of alternative-lending platforms can be multifold. Underwriting algorithms may go beyond the traditional FICO credit scores or they may not rely as heavily on FICO scores as do traditional lenders. Alternative-lender SoFi briefly announced a FICO-free lending product in 2016, but then later reincorporated the scoring system along with its own underwriting algorithm.

As the alternative-lending industry grows in size, interest from regulators also is increasing.

The benefit of going beyond FICO is that borrowers with a limited credit history, a ding to their credit or an error on their credit report may be turned down by a more traditional lender but could still be approved for a loan from an alternative lender who is looking at asset value and other credit information beyond the credit score. Another advantage is it’s common for online alternative lenders to provide potential borrowers with a lending decision within minutes, hours or just a day or two, and usually much faster than a traditional lender. These fast decisions are a significant benefit to borrowers and are made possible by robust underwriting technology.

While not all alternative-lending platforms are created equal, many do a good job of explaining a loan’s terms, rates and fees. Borrowers and investors alike will need to make their own judgment calls as to whether they have all the information they need at their fingertips to apply for a loan or to make an investment decision with an alternative lender.

In addition, consumers might assume going into a brick-and-mortar bank or mortgage office would provide them with superior customer service, but that isn’t necessarily the case. Applying for a mortgage can certainly be a lesson in patience. Alternative lenders shine in this area because they make the process more user-friendly with online applications and electronic connections to the IRS and bank accounts. Borrowers and investors alike can use the platform during times that work best for them, which might be after dinner or late at night after the kids are in bed.

Challenges ahead

Many alternative lenders are still new. They are evolving as they grow and mature to incorporate best practices. The older ones have less than 10 years of experience and the newer ones may only have a handful of years of operating history. Most haven’t been tested during recessionary times, so it’s unknown how they might perform in a severe economic downturn.

Among the other challenges the industry will face as it matures is cybersecurity. This must be top of mind for all alternative lenders who operate entirely online. As criminals become more sophisticated, so too must the lenders — to avoid a wide variety of cyber crimes that have hit the financial industry, including ransomware attacks targeted against community banks. Ransomware attacks, which often required payments in Bitcoin to regain access and prevent permanent data destruction, are growing at a yearly rate of 350 percent, according to the Cisco 2017 Annual Cybersecurity Report.

As the alternative-lending industry grows in size, interest from regulators also is increasing. There is no one regulatory body assigned to oversee alternative lending, so keeping track of the many regulatory agencies potentially involved can be time-consuming and complicated. To date, there has been regulation or oversight powers exerted by a variety of different entities, including the U.S. Securities and Exchange Commission, the Consumer Financial Protection Bureau and the U.S. Office of the Comptroller of the Currency.

Congress has dozens of bills currently pending that could affect financial technology sector, several of which could impact alternative lending such as legislation to expand and improve mobile-device banking, the use of alternative data to expand access to credit, and a bill to require the IRS to automate certain data. Certainly, it remains to be seen what will happen in the halls of Congress, but there appears to be a significant amount of bipartisan interest in this area, with the goal of ensuring the sector works efficiently while still offering consumer protections.

•  •  •

The alternative-lending industry is still young and will continue to evolve as it matures. Mortgage originators will want to keep track of the latest news in the industry to see if new entrants, new products and new services could benefit their clients.


 


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