Think Flat

by Balaji Yellavalli

My past couple of blogs on peer-to-peer lending and the innovations driven by that model seemed to have generated some interesting debates; some folks did agree that information is the currency of the new economy with e-bay like models becoming main stream. Another school of thought felt that such business models may not prove to be a significant threat to traditional Financial Services firms.   Let me try to address the latter view here by broadening the landscape a little bit.

With the US mortgage market being what it is now and even unsecured “managed” loan portfolios across various hues of lenders – from Banks to Credit Card Issuers - under pressure, there are clear signs that the sub-prime borrower (borrowers who present higher credit risk) will no longer be courted by large lending institutions.

There are two consequences of this: One, the sub prime or marginal borrowers will still need money (more than 40% of loans disbursed over past one year have been in some kind of sub-prime category) and increasingly they will turn to peer-to-peer lending vehicles. So if I am a lender who has the appetite for risk, I will probably lend at a usurous rate to these marginal borrowers, live with the risk of defaults and may be even make a net recovery, post charge-offs, higher than traditional investment channels. 

And the kicker is that I will pick my data elements, make my own informed decisions, demand more transparency and get it from companies like Prosper! (See previous post on this).  As time progresses, I will settle into an equilibrium and may be even diversify to other channels.  But the point is that I will go with a vehicle that provides me a frictionless, transparent platform to build my own risk-reward model!

The second consequence – having said that sub prime borrowers will be forced out of the organized market, there are still loads and loads of sub prime portfolios, which have been turned into mortgage backed securities by hungry investment backs, to feed an even hungrier beast called the hedge fund industry!

So what will happen to these as defaults start hitting the roof?

We are already seeing a domino effect of investment bankers trying to get these securities off their books or revoking purchase contracts with loan originators. But what if peer-to-peer sites find a way to securitize loans? Leaving aside regulatory implications, what would be the impact on the market? Hordes of “private” or individual investors would probably flock to such a portal to diversify their risks and, as transaction sizes increase, may be even larger hedge funds, who anyway do not want to invest in all that big, hairy IT infrastructure would jump on to the band wagon!

I was hence not surprised when the client CIO in charge of e-Commerce for a large Bank mentioned that peer-to-peer business models are the biggest threat to the traditional, organized financial services industry!

May be the day is not far when we will have Prosper and YouTube tying up to post videos of I-Bankers, Private Equity biggies and Hedge funds, pitching for selling or buying their portfolios – a truly Flat World scenario and what is more -  they will stop circling the Earth in their private jets and may be contribute to a Greener World, not just a Flat World!