The Hourglass Effect - A Decade of Displacement

It’s amazing what can be accomplished in ten years. In just ten years,
an idea can start out as a few scribbles on a napkin and grow into a
business that threatens an entire industry. In just ten years a market
leader can gradually lose ground and one day wake up to find
themselves an essentially irrelevant player in a space they once
dominated. Ten years is a long time when measured in business years
(or an eon when measured in internet years).
While it’s often the case that new market leaders are crowned when the
incumbents are asleep at the wheel or become too bureaucratic to
innovate, there are also times when new business models thrive
because the stars align in just the right way. External forces can cause
existing market players to act in a particular manner while these same
forces might affect new players very differently and even act as a
tailwind. And if you add talent and capital to the right business model at
the right time when the forces are aligned properly, a dominant model
can emerge very quickly. In many ways the story of the personal loans
players in the last ten years in the US is just this, a perfect storm from a
business perspective. The hourglass was turned over ten years ago and
ever since assets have been descending from the Banks’ balance
sheets to the open arms of the next generation players.
So why look back ten years? The answer is simple --- in January 2005 I
had just switched jobs within Capital One to take over the personal
loans business. Ten years is a look back to a period that I know and
remember well. The business was throwing off decent bottom line profit
numbers but it was struggling to grow. And at a company like Capital
One, growth is life. If the business couldn’t grow, and quickly, then it
didn’t have a home under the Capital One umbrella. The business was
fundamentally in need of an overhaul. One year later the business was
originating hundred of millions in new assets a month and generating
solid returns for the company. Mission accomplished.
A few years later and a failed startup in the middle, I found myself joining
back up with two former early renegades from my Capital One days.
Nigel Morris was the co-founder, President and COO of Capital One (my
THE HOURGLASS EFFECT: A DECADE OF DISPLACEMENT 2

personal mentor), and Caribou Honig had joined Capital One a few
years after I did and spent the better part of a decade tackling difficult
corporate challenges. The three of us naively formed QED Investors
and put our own money to work as a “boutique” venture capital firm.
Since then we’ve stumbled our way into building a portfolio of some
pretty exciting financial services companies that includes Credit Karma,
SoFi, Avant Credit, Braintree, LendUp, GreenSky, Remitly, and
PeerTransfer. As crazy as it sounds, in our portfolio we now have more
than 15 companies that originate or facilitate the origination of
consumer and small business lending assets. And guess which
company was the first? Prosper.
Hopefully this paper will be a helpful perspective for those who have
arrived at the party recently and want to know more about the
partygoers who have been around a while and where they’re likely
heading. The stakes are great, with Goldman Sachs estimating in a
recent report that over $200B in assets are at risk of leaving the Banks
in the Personal Loans vertical along with $4.6B in profit (source: GS
Report - The Future of Finance Part 1 - The rise of the new Shadow
Bank). And if I’m lucky, maybe a few of my predictions at the end of the
paper will even prove out to come true.
Let the story begin.


The Boom Era


External Forces

Jack didn’t star in any movies in 2005 nor did the Lakers win the NBA
title, but as far as the economy was concerned, 2005 was a very good
year. 2 million new jobs were created and unemployment rates fell from
5.4% to 4.9%. 2006 continued this trend with another 1.8 million new
jobs created and the jobless rate fell to a very low 4.5%. The average
household had been growing its net worth rapidly over the past few
years, almost entirely due to a very significant run-up in the value of their
homes. The Case-Shiller Index was up over 50% since 2000 so most
homeowners were feeling good about their financial situations.
And like many periods of optimism, consumers spent like it was going to
last forever. The average household spent 6.9% more in 2005 than they
did in 2004 when they spent 6.3% more than in 2003. Credit card
balances were on the rise and the personal savings rate was on the
decline, hitting a decade plus low of negative 1.4% in the fourth quarter
of 2006.


Source: US Bureau of Economic Analysis
With all this newly found wealth trapped in the average consumer’s
home, the banking industry found a way to give consumers a way to
access their equity through HELOCs and cash out refinance. Many
consumers were refinancing their homes and banks were aggressively
bundling HELOC products as part of the package. A checkbook or card
was put in their hands that turned their house into an ATM. And guess
what happened? The consumer started to withdraw money quickly.
HELOC balances more than doubled between 2003 and 2006 with
consumers taking an additional $350B of home equity and converting it
to cash. Let the good times roll.

Source: Federal Reserve Bank of New York

Source: Federal Reserve Bank of St. Louis
Large Banks’ Personal Loans Departments

While each and every Bank has its own strategy for success, their
general plans look very much alike - bake buffers into the loss forecasts
for every decision that extends credit. But even the most conservative
of organizations valued growth and it was the job of the P&L owners to
deliver. A good friend of mine that works at one of the top 5 Banks in the
country told me that during this era the mantra of the Executives was
“Earn your bonus one year at a time”. The Powers-That-Be told them to
chase asset growth so that’s what they did.
The issue with growing an unsecured
Personal Loans business during this
period was that the product itself was
potentially inherently inferior to the
other choices that consumers had at
their fingertips. When I took charge of Capital One’s Personal Loans
business in 2005 this was very true, and “fixing” it required a complete
re-engineering of the product.
The first question every Bank should have asked their Personal Loans
business unit was: “If given perfect information about their choices,
would a rational consumer pick our product?” The answer for most
Banks at the time was a resounding “no”. The typical product in the
market was neither twixt nor tween and didn’t seem to have a place in
the consumer’s eyes. HELOCs were the financial product of choice for
large purchases as well as for consumers who wanted to consolidate
their debt. House prices were consistently rising, the interest rates on

HELOCs were low and all the interest was tax deductible. What’s not to
like?
And to make matters worse, the credit card industry was aggressively
trying to capture consumer spend through massively incentivized
balance transfer offers and aggressive credit limit increases. Significant
incremental buying power was put in the hands of the average
consumer in an easy-to-use vehicle that accompanied them
everywhere they went.

Source: QED Analysis, Federal Reserve Bank of New York

So where did the Personal Loan fit into the mix? This was a real
challenge. Finding customers for whom it was a rational choice to pick a
Personal Loan over their other choices wasn’t easy, but the market was
big and the segments did exist when one looked hard enough.


Capital One was one of many Banks that re-imagined the business and
found segments hungry for Personal Loans. The typical product in the
market had no origination fee, credit availability up to $25,000, variable
rates in the 5.9%-6.9% range, and in many cases terms as long as 6
years. 85% of the customers used the product for debt consolidation
and the remainder funded large life-events such as vacations and
weddings. At Capital One, growth went from very modest levels to
hundreds of millions of dollars a month in new originations by the end of
2005. And the growth continued after I left. By the end of 2006 the
portfolio had grown into the double digit billions and was rumored to be
throwing off 2.5% unlevered returns with ROEs well in excess of 20%.
The economics were compelling.
Many other Banks had similar products to Capital One’s in the
marketplace, but Bank of America took an even more aggressive tack.
They rolled out a revolving line of credit under an assumption that they
had more pricing flexibility given it was open-ended vs. closed-ended
credit. Re-pricing rule breakers in open-ended credit products was the
norm, so the Bank of America team decided they could “book it now and
fix it later”. The pedal went to the metal and by the end of 2006, it was
rumored in the industry that they had amassed greater than a $25B
book of business. There was an obvious 800 pound gorilla in the
industry and its name was Bank of America.

Prosper and Lending Club

Founded by Chris Larsen after his successful exit of E-Loan (he was its
co-Founder), Prosper was the original peer-to-peer lending institution in
the US and made its first loan in February of 2006. The idea was simple
yet profound. Create a marketplace where individuals could fund
fractional pieces of other individuals’ loan requests. This model would
theoretically bring borrowers great rates and would allow lenders to
earn a return in excess of their other market options. Anti-Bank
positioning. Seamless internet application process. Jack meet Jill. The
common man wins. The phrase “peer-to-peer lending” was coined and
the market has never looked back since.
But with any new idea comes growing pains, and in the case of Prosper,
the early model wasn’t quite right. Prosper initial launched as an eBay
style auction marketplace where loan rates were determined by the
participants using a Dutch auction system. The responsibility for
setting price was squarely placed on the shoulders of the lenders which
was problematic because the lenders were individuals with very little
understanding of credit risk or yield management.

It was also unclear as to which regulatory body had responsibility for
overseeing Prosper’s business. Was Prosper a Bank/Financial
Institution? Was Prosper selling Securities? Was Prosper merely an
unregulated marketplace? This uncertainty made many investors
skeptical of the model and was compounded by significant negative
feedback about how uninformed lenders were driving down the rates to
levels that no traditional lender would touch. And this feedback was
spot on. The loans made in this era proved to be quite poor and many
lenders ended up with negative returns as a result. In fact, one online
analytic website estimates that the net return from all loans from this
early Prosper period was negative 4.67%.
Source: (http://www.nickelsteamroller.com/#!/page/prosper_1_0)

Source: LendAcademy


The Bust Era


External Forces

What goes up must come down, and in the case of the US economy it
came down hard in a few short years. The unemployment rate started
to creep upward in 2007 to 5.0% but rocketed to 7.2% by the end of 2008
with no end in sight. Even with massive Federal intervention, the
unemployment rate hit 10.2% in October of 2009, the highest rate it had
been in a quarter of a century.
While jobless rates were increasing, it had also become clear by
mid-2007 that a substantial percentage of homeowners were struggling
to make payments on their mortgages. Delinquency rates were on the
rise and consumers started to realize that the net worth gains they had
experienced over the past decade weren’t real. Nearly $500B of
“subprime” mortgage securities were devalued significantly and the
equity markets were in turmoil.
Because the problems were so severe and so many “average
Americans” were affected by the economic crisis, it’s not a surprise that
the natural reaction of politicians and journalists was to try to find the
culprit. Fingers were pointed and the Banking system as a whole was
under siege. Lehman Brothers declared bankruptcy, the biggest filing in
history, and the collapse and sale of Bear Stearns to JP Morgan was a
prelude to the global financial crisis.

Source: Federal Reserve Bank of St. Louis (FRED database)

But the problems of Lehman Brothers and Bear Stearns were merely
the tip of the iceberg. The Government seized control of Fannie Mae
and Freddie Mac and then stepped in with the American Recovery and
Reinvestment Act of 2009 in an attempt to get the economy back on
solid footing, but the extreme nature of the crisis caused Regulators and
Politicians to examine the “sins of the Banking world” and craft what
they believed would be more permanent fixes.
The CARD act presented issuers with a final “bite at the apple” and
many chose to reprice the accounts of their existing customer base –
regardless of the underlying credit quality. Even superprime borrowers
saw their average credit card APR increase almost 300 basis points in
an overall low interest rate environment.

Source: CFPB’s Credit Card Database sourced via CARD act study, September 2013

In fact the crisis was so severe that a Congress deeply divided along
partisan lines came together to enact the most sweeping piece of
financial legislation since the Great Depression – The Dodd-Frank Act
(DFA), so named after its two main congressional sponsors, Senator
Chris Dodd and Representative Barney Frank. While the legislation
touched essentially every corner of the American financial system, three
main changes are worth noting that each had an impact on the lending
industry.
First, one of the key tenets of DFA was to establish the Financial Stability
Oversight Counsel (FSOC) to preside over firms that were deemed “too
big to fail”. The FSOC was established to prevent situations like the AIG
meltdown because of how intertwined the entire system was with risks
that no one seemed to think much about until a crisis was at hand.
Second, another key and highly contentious aspect of the law was the
establishment of the Consumer Financial Protection Bureau (CFPB) to
house consumer facing banking regulation for both Banks and
non-Banks under one roof. This had traditionally been the domain of
regulators like the OCC and the OTS but now fell under a new, very
active organization. The first two years of the CFPB were focused on
writing the wholesale changes to the mortgage rules but one only needs
to look at the credit card industry to see the CFPB’s impact via the
hundreds of millions of dollars in restitution and fines levied against
issuers for their sale of add-on products through 3rd
party outsourcing.
Lastly, the DFA touched on capital reform. In conjunction with the
implementation of Basel III rules, the capital required to be held by
Banking institutions had a severe impact on their return hurdles as well
as their internal transfer rates of funding.

The net result was to force the Banking system into a defensive mode
with many Executives in the largest Banking organizations spending the
majority of their days with Regulators. In 2013, Reuters reported that
JPMorgan Chase was planning to spend over $4 billion and focus 5,000
FTE on risk and compliance issues. The Banks were effectively put on
notice and they had no choice but to listen.
The significant reduction in home values caused Banks to re-assess the
outstanding credit that had been extended to homeowners in the form
of HELOCs. Most unused lines were frozen and by late 2008 most
consumers were put into “paydown” mode. The net result was a
reduction in HELOC balances of nearly $50B by the end of 2010 and
almost four times that by the end of 2013.

Source: Federal Reserve bank of New York

Having been responsible for the loss forecasting team at a large
Banking institution, I can personally say that it might be one of the most
difficult and most thankless jobs on the face of the planet. Business
units are more than happy to take credit for any improvements to the
credit loss numbers but will act very defensively (and sometimes with
anger) when the projections show major increases. The reason for this

goes beyond the immediate P&L impact and beyond worrying about
one’s annual bonus.
It stems from the fact that any new assumptions in the forward looking
credit loss forecast don’t take long before they’re baked into the loss
curves that drive marketing and booking decisions. Significant negative
changes could actually cause one’s entire “raison d’etre” to be
challenged. If a business slowed down or stopped booking new
customers it wasn’t long before Executives were fired, staff reallocated
and the existing portfolio ultimately absorbed by a still-functioning unit.
And in 2007 and 2008, the loan loss forecasts of the personal loans
businesses at most major institutions were being revised upwards
monotonically every single month. It was only a matter of time before
the loss forecast teams decided to make a large adjustment to the
forecast instead of ratcheting it upwards a little every month. And when
it happened, it was an extinction event.
The personal loans product has a distinct disadvantage over many
other financial products in that it has no future utility. You live in your
house. You drive your car to work. You can use a credit card for new
consumption and delayed payment. This means that in a Maslovian
sense the personal loans product is not in a privileged place in the
payments hierarchy. In fact, it was at the bottom.
So when the loss curves were finally adjusted upwards to what was
being seen in the market, the net result was 2-3X the losses that were
originally projected when the loans were booked. One large institution
with a $10B portfolio was looking at a $300MM net loss. Bank of
America was the biggest player at the time due to their aggressive
booking into their line of credit product, and rumors circulated that the
loss rate on this portfolio was projected to peak in the “mid-teens”,
creating a multi-billion dollar projected loss for the firm. GE Capital had
looked to sell its personal loans business in 2007 for “strategic fit”
reasons and these plans had to be shelved given the market conditions.


Source: Discover Financial Services SEC filings

With the exception of Discover, practically overnight the personal loans
business units at most major Banks were shuttered. Discover’s portfolio
was very small to begin with so it was just as easy to keep it alive as it
was to shut it down. But at just about every other entity, the personal
loans product was stripped from their web sites and collateral material
was pulled from the branches. Since very little can be done to a
closed-end loan product from an account management perspective the
teams were deployed elsewhere. And Bank of America’s strategy of
“book now and fix it later” didn’t work. The Regulators took a very strict
and conservative view towards the actions that they would allow and as
a result the re-pricing power that Bank of America thought they had
didn’t materialize. The comet hit the Earth and the dinosaurs were now
extinct.

The question I ask to this day is “What would have happened if Prosper
and Lending Club didn’t raise large rounds when they did in 2007?” The
timing of their raises is incredibly fortuitous because it gave them
enough capital to survive an environment filled with turmoil. Prosper
raised $12.5MM of venture capital in 2006 and an additional $20MM in
June 2007. Lending Club raised a $2MM Angel round in May of 2007
and an additional $10.3MM that August.
If the same capital raises had been needed in 2008 they might not have
happened. Any credible venture firm would have researched the
landscape and seen that the Banks were busy shutting down their
personal loans businesses and would have questioned the ability to
attract lenders to the platforms at the peak of the crisis. The increases
to these companies’ loan loss reserves were very public and scary, and
there was no credible argument that could be made that these
platforms could “outperform” the giants from a risk modeling
standpoint.
And while it was very painful to the platforms and the Venture Investors
backing the platforms, the timing of the SEC’s intervention couldn’t have
been better. There was a debate throughout 2007 and 2008 regarding
which agency was going to govern these new “Peer-to-peer”
marketplaces and the ultimate answer was the SEC. Lending Club
adopted their oversight much earlier than Prosper did, with Lending
Club entering a quiet period from April of 2008 and resumed originations
activities that October.

Prosper challenged the SEC for most of 2008 and was ultimately forced
to change in November of 2008 when the SEC issued a Cease and
Desist order against the company due to their supposed violation of the
Securities Act of 1933. Prosper adjusted its business practices
accordingly and in July of 2009 reopened its website for lending once
again.
Source:
www.sfgate.com/business/article/Prosper-back-to-making-loans-still-battles-SEC-3262142.php
The reason why the timing of the SEC actions is important is subtle but
profound. While both companies were busy spending money adapting
to the SEC mandated business practices, the economy was going
through its own changes. It was much easier to see where the economy
was heading and where the trouble spots were by mid-2009 than it was
in early 2008. Credit models could take this into account and Prosper
and Lending Club could focus on the prospects in the marketplace that
weren’t under severe stress. Customers were underwriting themselves
everyday through continuing to pay or not being able to/strategically
choosing not to pay their bills, and as a result it became very easy to
avoid the worst of the applicants. An artifact of this issue is that the
performance of the small tranche of customers booked by Lending Club
in 2008 is quite poor but by 2009, origination vintages improved
dramatically. And, Prosper made the important decision to wind-down
its Dutch auction process and play the critical role of setting rates and
credit policy on behalf of its lenders. It shouldn’t be a surprise that since
then the performance of lenders on the platform has improved
dramatically.

Source: Prosper Marketplace 10-Q, Q3 2014

Source: Lending Club 2014 form 10-K

Source: https://www.lendingclub.com/info/demand-and-credit-profile.action

While personal loans were a well-known and understood product
category, the way Prosper and Lending Club were originating loans and
their respective track records had yet to be proven. There needed to be
a Promethean leap of faith by lenders that the “revised” risk adjusted
returns represented by Prosper and Lending Club would come to be.
Some early investors jumped on the band wagon, mostly hedge funds,
and it was common for these investors to want the higher priced assets.
Hedge Funds looking for yield saw the Prosper and Lending Club
platforms as places to put money to work, especially in light of a
sustained low interest rate environment.
But an obvious issue emerged due to the fact that the core product
offered by Prosper and Lending Club was a debt consolidation product.
More than 75% of the borrowers wanted to pay off higher priced debt,

much of which was recently repriced in the credit card space in
advance of the CARD Act going into effect in early 2010. For a debt
consolidation loan to be successfully marketed and closed, the pricing
needed to be low, resulting in lower monthly payments for consumers.
There were struggles on the funding side of the equation as well since
return expectations of the hedge funds were in the low to mid-teens.
Thus the platforms had a structural disconnect. Prosper felt this
profoundly with many of the low risk loans on the platform not clearing.
Lending Club had similar problems but not as pronounced. It was fairly
typical during this period for Prosper or Lending Club to offer additional
incentives to their lenders in an attempt to entice them to purchase
certain securities. The platforms would continue to have problems on
many fronts if they couldn’t solve the market imbalance issue. The
marketing efficiency was low, volume was low, platform revenue was
low, and profitability was nowhere in sight.
But with time came results. Prosper and Lending Club’s credit policy,
pricing and marketing skills continued to improve. They were able to
start sharing the early investor return results and they looked very
promising. By the end of 2010 there was mounting interest in the
category by some of the early
institutional capital adopters but
neither platform had yet to achieve
enough scale to attract the deeper
and lower cost pockets of capital.
Both businesses were burning cash at a fairly alarming rate relative to
their results. Exiting 2010 Lending Club was originating $35.7 million of
quarterly volume and Prosper $8.4 million. But the Venture Capital
community continued to write checks and Lending Club was able to
raise another $40MM in 2009 and 2010 and Prosper nearly $18MM over
the same period. A lot of money had gone into these businesses and
there were many believers with skin in the game that believed the
Prosper and Lending Club models were destined to succeed.


The Recovery Era


External Forces

Slow and steady wins the race, and in the case of the US economy, by the
end of 2014 the economy had bounced back to a pre-recession level of
health.  Unemployment rates slowly came down to near pre-recession
levels.  GDP recovered and stabilized at a steady 4% rate.  The average US
consumer’s personal balance sheet started to improve with much credit
owed to their pay-down and refinancing of existing debt.

Source: US Bureau of Economic Analysis


Home values also started to recover as the economy improved and the
backlog of foreclosures started to work their way through the system.
By no means was the mortgage crisis forgiven or forgotten, but the
increase in home prices was a boost to general morale and a signal to
the average consumer that the recovery was actually happening.

During this period of economic recovery the typical consumer behaved
very rationally. It took years to clear out the sins of the mortgage
industry, but it was clear that the “bad mortgages” were working their
way through the system. Strategic defaults on houses with underwater
equity positions were still fairly common and for the first time, auto loans
swapped positions in the payment hierarchy with mortgages.
Consumers realized they could live in their car but they couldn’t drive
their house to work.
Percent of Balance 90+ Days Delinquent by Loan Type


And with the backdrop of a low and still falling interest rate
environment, consumers started looking for ways to refinance their
debt. A period of significant deleveraging began and by the beginning
of 2013 the typical consumer had given themselves an effective raise
by lowering the cost of their existing debt.

Source: http://www.federalreserve.gov/releases/housedebt/


The old saying “everything that goes up must come down” proved to
once again be true. With a reduction in unemployment rates and a
de-levering of the average American’s personal balance sheet, losses
started to decline in every major loan product in every major Bank.
Deep analysis was done within the Banks on the damage done by the
Great Recession and where the various portfolios performed better and
worse. The conclusions of these studies were quite interesting and
shaped the strategies of the major players to this day.
The first insight was very specific to the personal loans product line, and
although the magnitude of this finding was different by institution the
conclusion were the same. Basically, when looked at through a
rear-view mirror, the personal loans businesses were shut down when
the forward looking loss forecast hit its peak. The actual losses incurred
on the various portfolios were lower than forecasted by a very large
margin. For instance, the $300MM projected net loss on one Bank’s
portfolio ended up being very close to $0. The portfolio performed at a
break-even level instead of delivering the forecasted drag that caused a
panic at the time.
The second insight applied to unsecured personal credit products and
was most pronounced within the Big Banks’ credit card portfolios. The

insight was that customers with lower DTI ratios performed much better
in the recession than those with higher DTIs. Many of these customers
were traditional transactors on credit cards and weren’t the debt-laden
revolvers that the card companies chased after aggressively in the
1990s and 2000s. This might sound like a “no duh” conclusion, but it has
profound implications. It means that the Regulators may have been
right in their conclusion that underwriting at the Big Banks had gotten
sloppy and that specific calculations that ensured borrowers had the
Ability to Repay were needed. When some of the large players sought
growth in the 2005/2006 timeframe, it came at the expense of good,
solid underwriting. Almost all of the marginal growth proved to be toxic
while the clean, high credit quality, low DTI populations did just fine.
So the obvious question is “Why not restart the business given these
conclusions?” The answer is one that only those of us who have lived in
a Bank can understand. The answer has many parts that include
brilliant truths such as: “Banks have long organizational memories”,
“Who’s crazy enough to be a champion?”, and “Accumulated
technology dust.”
First, big corporations really do have very long organizational memories
especially when it comes to failures. Everybody remembers how much
money Joe or Mary wasted trying to get a new product into the
marketplace. Failures are held against Executives for a long time and
can cause them to re-badge with another company. As a result,
working at any big company has and always will be an exercise in
building up favors and calling them in later. If an Executive can build a
track record of success, he or she can take a little more risk and try
something that may fail. So the formula for career progression is to fail
on small projects and succeed on big ones. And for any individual in an
organization the definition of a big project is one that your boss’s boss is
holding your boss accountable for. Or it’s one that requires a large
budget or many scarce resources. Or it’s one that requires restarting
something that was painfully shut down and written off.
So what executive in his or her right
mind would take the risk to start back
up a business line that was shuttered
due to large write downs on paper? It
would have to be someone who has
built up massive trust within the organization and who was able to make
the case that the re-start was more important to the organization than
other “mission critical” projects. And to re-start a business line that had
been completely turned off for a number of years would require a
dusting off of old technology (much of which would require the signing of
new 3rd
party contracts), a complete overhaul of the loan docs and
underwriting policies in order to be compliant with the new regulations,

and a commandeering of critical staff and budget to get the first tests
out the door.
I know executives at two Big Banks who tried. Not a surprise, they both
failed. Not because the Banks couldn’t compete against Prosper and
Lending Club if they wanted to, but rather because they didn’t see the
point. The Banks had already dramatically shifted their spend and
product mix to attract more transactors into their Credit Card divisions
and all discussions of trying to increase concentration with customers
who actually carried balances was deemed “crazy talk”. One or two
very small attempts were made to re-launch the product at these
institutions but each time the resources were pulled when needed
elsewhere and/or the budget was never made available to take the
challenge seriously.
Face it, what’s a few Billion dollars of loan balances to a top ten Bank?
Rounding error. And that’s what Prosper and Lending Club were seen
as throughout this era. Even at a combined $5.1B of originations
volume in 2014 they were seen as irrelevant.

While Prosper and Lending Club had very similar models at their core,
the go-to-market strategy was very different between the companies.
And while both ended up finding their way to a very healthy place in
today’s landscape, Prosper’s path was much rockier along the journey.
Both firms realized that while the peer-to-peer concept was a very pure
and noble design, the reality was that institutional funds were needed to
scale the business. And back in 2011, with respect to the battle of
attracting institutional investors Lending Club was winning.
Lending Club’s Executives and Board members made the bold call to
form a subsidiary of Lending Club called LC Advisors, an SEC registered
investment advisor that also acted as the general partner to two private
investment funds. This vehicle was run by Lending Club and effectively
became a bucket of funds that could be deployed to clear loans from
their platform that otherwise might not get purchased. Many of Lending
Club’s investors put money directly into the fund and by April of 2012 it
had over $100MM under management.
Meanwhile, Prosper was fighting hand-to-hand combat trying to get
institutional investors to commit funds to the platform. One fund did
commit $150MM to the platform in June of 2011 but this lender wasn’t
interested in buying the low risk paper and controlled how and when the
funds were deployed. This created incredible leverage over Prosper
and didn’t solve their core issue of needing an investor who wanted the

low risk paper that was at the core of a healthy debt consolidation
business.
The two platforms quickly started to diverge in originations volume and
by late 2012 it was clear that Prosper was in a distant 2nd
position. If
something didn’t change the marketplace was going to have a single
winner. Changes were made through a very drastic re-capitalization of
the company that was also accompanied by new management. It
didn’t take long for them to right the ship and very quickly Prosper was
back in the game.
While both companies were busy trying to figure out how to attract
lender capital and prove that their models actually worked, the
opportunity for their product and fit in the marketplace increased
dramatically due to the actions of the Banks. Sometimes it’s better to
be lucky than good.
First, even though the equity in consumers’ homes was starting to
bounce back the Banks were still allergic to lending against it. In this
environment, asking your Bank for a HELOC was futile even if you
owned 30%, 40%, even 50% of your house. When they did say yes it was
after an application process that felt like a proctology exam that ended
with a fraction of the access that one originally wanted.

Source: Oliver Wyman/Experian Market Intelligence Data sourced from CFPB CARD Act report

Second, every major credit card issuer slipped in one last change in
terms before the CARD Act went into effect. Goldman Sachs estimates
that $186B of balances were repriced which effectively made the
Prosper and Lending Club products that much more relevant to these
customers. Finding them online was easy through growing franchises

like Credit Karma. Pre-screened direct mail was another obvious
channel that helped increase loan volume and was very scalable. And
since Prosper and Lending Club could truly save customers a significant
amount of money, the platforms migrated the originations fees upward
and customers didn’t complain.
The combination of new and efficient channels, improved targeting
capabilities, increased consumer appetite due to lack of options and
increased fee income in the system “unlocked” the business. The
platforms could originate a customer for 1.5%-2.0% of the face value of
the loan and turn around and charge the customer a 4.5% origination
fee. They then turned these loans over to investors looking for 6%-10%
unlevered yields and captured a 1% servicing fee that was slightly
profitable. The businesses entered a “just add water” phase where all
that was needed was capital for marketing and loan purchasers on the
back end who wanted the paper.

Source: CFPB’s Credit Card Database sourced via CARD act study, September 2013

And then came 2013 and 2014, the years that Prosper and Lending
Club truly accelerated. Because the yield on Prosper and Lending Club
loans had been stable and strong for years, many large sources of
capital started contacting the platforms to see if they could gain access
to their originations volume. Public announcements about new
strategic relationships seemed to be coming out frequently and those
close to the platforms knew that there were dozens of sources of

funding waiting in the wings that were disappointed they weren’t being
given access to forward flow originations volume.
Equity capital followed to fuel the originations appetite and the market
cooperated --- Prosper and Lending Club were able to originate $2.3B in
2013 and $5.1B in 2014 combined. Some of the big announcements
included:
● March 2013 – Santander entered into a receivables purchase
agreement with Lending Club that allowed them to purchase up
to 25% of their originations for the next three years
● May 2013 – Google Capital backs the majority of a $125MM
equity round in Lending Club
● June 2013 – Titan Bank makes its first loan on the Lending Club
Platform
● September 2013 – Prosper raises $25MM in equity and added
BlackRock as a backer
● May 2014 – Francisco Partners led a $70MM equity round into
Prosper
● May 2014 – Lending Club formed a Strategic Alliance with Union
Bank to both buy loans from the Lending Club platforms and to
offer new products to the Union Bank customer base
And it wasn’t all about big Banks and Private Equity backing the
platforms. The early institutional lenders on the platform also wanted
originations volume and were willing to reduce their unlevered yield
expectations to do such. To combat the lower yield they sought
leverage from big Banks like Capital One and because the category had
“arrived”, the leverage did as well. 2:1 and 3:1 leverage ratios became
available for hedge funds as did securitization of their portfolios which
pushed their yields back into the teens. As a result, investment
management firms like Eaglewood Capital Management, Colchis
Capital, Ranger Capital Group and Prime Meridian Capital Management
became steady buyers on the platforms.
By the end of 2014 it was clear that the smaller Banks saw Prosper and
Lending Club as valuable partners rather than competitors. A few
months into 2015 solidified this perspective with big announcements
made by both platforms regarding relationships with consortiums of
hundreds of Banks. Only the biggest Banks weren’t playing ball, and
with over $200B of assets in the marketplace at risk of displacement
from the Banks to Prosper and Lending Club (according to Goldman
Sachs Global Investment Research estimates), the hourglass was at no
risk of being turned back over. Lending Club started trading on the New
York Stock Exchange on December 11, 2014 and was so well received
that their shares ended the day up 56% from its initial offering price. The
platforms had arrived and were here to stay.

My name isn’t Zoltar and therefore I’m not very good at predicting the future. I could speculate
about the interest rate environment or when the economy was going to turn and how these
changes would have an impact on the players named in this paper. But, the usefulness of this
exercise is questionable. Instead, I’ve decided to take a stab at answering the questions “What
would it take for the Banks to fight back?” and “What would it take for the new Platforms to
sustain their emerging leadership positions?” By no means am I suggesting that any of the
scenarios I’m about to outline are in the works today, but rather that these are methods for the
Banks and/or the Platforms to productively move forward from here.

Scenario #1: The Emergence of the SBU

It’s becoming increasingly clear that many smaller banks and credit unions have embraced
Prosper and Lending Club (and other specialty originations platforms) as their preferred method
of originating yield producing lending assets. Most of these smaller organizations have
internalized that the skills and systems needed to efficiently originate high quality lending assets
are now beyond them and that the best way to build a solid portfolio is to partner with one of the
new platforms to do it for them. Direct mail is a scale game that requires the hiring of analytic and
creative marketing talent. Credit policy and product design are complex tasks that could crush a
portfolio’s profitability if done incorrectly. And the billing and collections efforts associated with a
portfolio are true scale tasks. It was really a question of Partner or Die and they’ve smartly
decided to Partner.
But, every skill needed to run a high quality, high growth personal loans business exists within the
larger Banks. And while in an earlier section I discussed why most of the large Banks haven’t
re-started their personal loans businesses, there is a future that can be designed that has the
Banks back on top. The cost of funds advantage they have over the new originations platforms is
significant, but the corporate costs and decision making processes are drowning them.
The steps to turn this possibility into a reality are quite clear, so the question is “will they head
down this path?” One simple articulation of the necessary steps:
1) Separate the personal loans business from the other lending businesses and run it as an
SBU
2) Staff the SBU with dedicated talent in each of the major functional areas (credit,
marketing, IT, compliance, finance, etc.) to simplify cost allocation and prioritization
3) As much as is possible, the systems being used to serve the SBU should be dedicated
systems to simplify cost allocation and prioritization
4) Stop the transfer pricing madness that Banks typically thrust upon smaller business
units and instead allocate corporate costs on an as-used basis
5) The personal loans SBU should be the profit center, not the Treasury department, so the
cost of funds given to the SBU should reflect this
While each and every step seems simple on the surface, it ends up that they’re quite complex to
execute in the real world because Banks don’t think this way. The ripple effect of having the
personal loans business carved off would send shock waves through the larger organization and
hence, it’s more likely to be squashed than to succeed.
ODDS OF THIS SCENARIO OCCURRING: LOW

Scenario #2: One Bank Wakes Up

A beautiful thing about a marketplace with a handful of well capitalized players is that it only
takes one deep pocketed player to rock the ecosystem. Imagine if one of the major Banks were
to wake up and decide that they wanted to own the personal loans marketplace. And instead of
building it from within with all the complexities I’ve outlined in Scenario #1, they decided to acquire
their way to the leadership position.
The benefits of a major Bank buying one of the existing platforms is that they could naturally keep
it separate from their core lending businesses. Instead of taking on the self-inflicted pain
associated with the steps outlined in Scenario #1, a Bank could get to the same destination
through an acquisition as long as they “do no harm” to the business. If the acquired platform
were left alone except for those functions that BENEFIT the platform, the resulting business would
be a force to be reckoned with. An articulation of this scenario:
1) A major Banking institution acquires a major personal loans originations platform
2) The acquired company is left alone with the exception of the capital markets/treasury,
compliance and the finance functions
3) Up to the risk level the Bank wants, shut down all lenders on the platform and fund the
assets using the already existing deposit base
The Bank would have to hold reserves against the assets but even with reserves in place the
profitability and resulting ROE would be fantastic due to their extremely low cost of funds and
high leverage ratios.
The challenges will be in justifying the acquisition cost of one of the big platforms as well as
having the discipline to keep the acquired company as separate from the Bank as possible.
ODDS OF THIS SCENARIO OCCURRING: LOW TO MODERATE
Scenario #3: Status Quo

Newton’s first law of motion is typically stated as: “An object at rest stays at rest and an object in
motion stays in motion with the same speed and in the same direction unless acted upon by an
unbalanced force.” Inertia is a law of the Universe and happens to be one of the strongest forces
in the business world as well. So a likely scenario worth discussing is that the Banks will continue
to act the way they do today.
For the new Originations platforms to continue on their growth trajectory and solidify their place in
the future as well managed, sustainable, safe and profitable businesses, there are a few steps
that should be taken. There are no burning problems that the platforms need to address

immediately, but over time it will become more and more necessary to address some critical gaps
in the business models. A few of these gaps are:
1) The correlation coefficient of the lender capital on the platforms is strikingly close to 1.
Diversification of lender capital is important because the platforms live and die based on
the appetite of their lenders and if they all react identically to various future scenarios
then the platform is at risk. Adding international Banks and more retail deposits to the
mix are examples of steps that can be taken to diversify the lender base.
2) Diversification of asset classes is critical because the core debt consolidation product
offering won’t behave like it does forever.
3) Regulation is going to come and the Platforms will need to adjust accordingly. Nobody
knows what the future holds with regards to the Regulation of Specialty Originators, but
what is certain is that any new rules issued (if any) will have to be absorbed.
4) The credit policies of the platforms will have to adjust if and when consumers start to
re-lever their personal balance sheets and the economy starts to turn. The recent
performance results have been delivered with the backdrop of a very favorable set of
economic conditions which have very little room to get better but a lot of room to get
worse. In a recession, customers with high debt service burden ratios will perform worse
than those with stable professions and moderate debt levels so the platforms will need
to build the organizational muscle to infuse these insights into their policies.
If this scenario were to come true, the platforms would have near unlimited runway to steal
existing mis-priced assets from the Banks and originate new consumption loans that otherwise
would have been originated within the traditional Banking system. The platforms could march
product category by product category as long as there were lenders looking for the returns that
the products would throw off. Five or ten percent of a big number is still a big number which
suggests there’s room for a few giant winners to emerge while the Banks continue to do what
they’re comfortable doing today.
ODDS OF THIS SCENARIO OCCURRING: MODERATE
Scenario #4: Knife Fight

Everyone loves a good knife fight unless you’re in the knife fight of course. And those of us who
have operated businesses in hyper-competitive environments know that the chore of delivering
profitable growth can feel like hand-to-hand combat at its worst.
In the case of the personal loans ecosystem, the makings of a major brawl are on the horizon.
Venture Capital is (unfortunately) all about pattern recognition and nothing attracts capital faster
than the success of multiple players in a gigantic sector. The multi-billion dollar market caps of
Prosper and Lending Club have inspired many management teams to come together and the
capital is flowing their way. Companies like Payoff, Marlette Funding, Upstart, Pave, Earnest,
SoFi, Kabbage and Avant Credit are all originating Personal Loans, and although they have
slightly different strategies and target customers there’s enough overlap to worry about what

happens next. What is clear is that without change the winners aren’t the asset origination
platforms but rather the owners of the channels that provide access to prospective customers.
The Post Office wins because every asset originator eventually figures out that targetable direct
mail is an efficient and scalable channel. But response rates will drop as more mail shows up in
credit worthy consumers’ mailboxes so the originations companies lose.
Google wins because every asset originator eventually figures out that a well optimized keyword
strategy has a meaningful place in their marketing plans. But with more competition comes a
higher cost-per-click price which is fantastic for Google but very bad for the community of
originators.
And Affiliate Partners like Credit Karma and Bankrate Monitor win because they own the eyeballs
of, make recommendations to, and drive clicks from contextually relevant loan applicants. With
more and more asset originators vying for real-estate on their sites the bounties for successful
delivery of new customers should rise.
So while all these channel partners will do quite well in a hyper-competitive environment, the big
question is what the asset originators can do to execute their very aggressive growth plans while
keeping acquisition costs under control. A few answers come to mind:
1) Develop products that stand out in a competitive set of offers. “Me too” plays won’t work
well in crowded channels so differentiation will be a critical component of success.
2) Lock down unique sources of applicant volume. I can’t overstate how important this will
be to the long term success of the next-generation originations players. Privileged
access to channels chock full of relevant high quality customers is a sustainable and
winning strategy and one that will quickly turn into a “land grab”.
3) Remove every source of inefficiency. Low cost players will have an unfair advantage
over the newer, less efficient players and this advantage can be given back to the end
consumer through price reductions. Price reductions almost always drive positive
selection so becoming efficient is the same as boosting response and reducing losses.
The best of the next generation originations platforms will understand and deliver on the above as
well as on all the issues outlined in the Status Quo scenario.
ODDS OF THIS SCENARIO OCCURRING: MODERATE TO HIGH

Scenario #5: Lending as a Service (LaaS)

It seems like every few years a new “fill in the blank” as a service model emerges. Everyone is now
familiar with Software as a Service (SaaS) and Platform as a Service (PaaS) business models.
A few businesses already exist in the lending ecosystem that scratch the surface of what LaaS
could eventually become. LendKey is currently helping hundreds of Community Banks and Credit
Unions create and manage online lending programs. Insikt is hanging its shingle directly in this
space and has declared on its website that “Inskit was born out of our realization that banks will
not be the lenders of tomorrow - brands will. We’ve launched LaaS to power this transformation.”
Lending Club recently formed a partnership with a national consortium of 200 Community Banks
to enable co-branded offerings and various services through their platform. And only a few weeks
after Lending Club’s announcement, Prosper made their own announcement about forming a
similar partnership with a consortium of 160 Community Banks.
The reason why this is a major development is that it could end up being the glue that
permanently binds the emerging originations platforms to the established Banking ecosystem.
Platforms like Prosper and Lending Club will soon be recognized as foundational businesses (like
the credit bureaus, Fair Isaac, ratings agencies, etc) that have the competencies and capabilities
to enable the smaller Banks to compete with the larger Banks. And the number of entities that
need these services is large. VERY large.
In the US alone, there are 13,000+ smaller Banks that are having difficulty generating high quality
loan portfolios because today’s table stakes to play in the lending space are higher than ever
before. The smaller Banks are great deposit gathering machines, but the skills required to gather
deposits (i.e. - locating and managing 30X30 boxes on street corners that consumers walk into to
hand you their money) are very different from those required to manage a lending business.
These entities need world class capabilities in scoring, pricing, servicing, technology, compliance
and capital markets. They also need a deep understanding of marketing and how to best reach
their own customers with compelling and targeted offers. Lending as a Service providers can

reinforce the Banks’ foundations by helping them build and manage lending portfolios for a
modest fee rather than asking them to build business muscles that they don’t have.
And, there are many other benefits and services that are likely to emerge as the LaaS Platforms
evolve such as:
● Banks will be able to market products into their existing customer base but retain only
the assets they want. If they want to keep “A” and “B” credit loans, the LaaS platforms
will be more than willing to clear the other loans with their deep base of institutional and
retail investors.
● Non-Banks will be able to create loan products that serve their customers without
needing to invest in the systems and personnel historically needed to power these
programs. And, if these entities want to participate in the loan economics or subsidize
their program in any way, the LaaS platforms will make this simple.
● Banks will be able to start/re-start their personal loans businesses using the experience
and performance history of the LaaS platform they decide to partner with. The LaaS
platforms will likely offer “generic” and “custom” risk solutions to their partners as well as
the reporting and monitoring needed to maintain a healthy portfolio. Having access to
years of performance data is invaluable and almost a reason in-and-of-itself for
partnering with one of the more established platforms in the space.
● The LaaS platforms will be able to hire talent and invest in innovation at a pace far in
excess of the traditional Banks. It’s not unlikely that in a few years the resulting user
experience and suite of tools will put users of the LaaS platforms at a competitive
advantage over the Bank incumbents. In online and mobile channels and across every
application and servicing process, consumers will show preference to the LaaS
platforms’ offerings because of their focus on meeting the needs of their customers.
Complete fragmentation and re-assembly of the lending value chain will be possible using a LaaS
platform. Banks will be able to pick and choose which functions they want to manage internally
and which ones they want to outsource. If they want to control marketing, great. if they want to
use their own Bank Charter and product configuration, great. If they want to service their loan
portfolio, great. But if they want a “lending in a box” solution this will also be available. Complete
customization will be the new norm.
ODDS OF THIS SCENARIO OCCURRING: CERTAIN!

THE SANDS CONTINUE TO FALL

Change. It always comes down to change. Businesses either change or die and the Banks are
being asked this question as we speak. Can they change how they operate or will they wake up
one day and wonder why they’re no longer on top? Billions of dollars of assets have shifted hands
from the incumbents to the new kids on the block and billions more are at risk of doing the same.
And while outsiders regularly ask if today’s originations volumes might be nearing their apex, all it
takes is a little peeling of the onion to realize that there are hundreds of billions of dollars still in
play and likely heading down through the hourglass.
Some observers wonder if the new players are here to stay or if they’re merely the most recent
fashion trend that will cycle through its popularity and eventually disappear. I believe they’re here
to stay but only time will tell. The new players have invested in the technology and the core
competencies needed to compete directly with the Banks. Their product offerings are really good
and getting better as the sources of capital on the platforms diversify. And the portfolios they’re
generating are much more resilient than those assembled by the Banks in the mid 2000s. Quite a
few unknowns still exist and these businesses have yet to weather a real storm, but on the
surface they’re positioning themselves well to be permanent fixtures in the Banking sector.
And while there are more than a few armchair Nostradamuses that are predicting some pretty
dramatic outcomes for the Future of Banking (myself included), there are equally bold claims in
every sector. I’ve heard a prediction that blindness will be wiped out in the next ten years. Some
say that very soon we’ll be printing our own shoes and clothing at home. And many experts
predict that we’ll be traveling in autonomous cars by the turn of the next decade. So what does
the next ten years hold for the Lending sector? Who knows? See you in ten to find out!


The Hourglass Effect - A Decade of Displacement

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