What Bubble? Wall Street To Turn P2P Loans Into CDOs

So far this year, around $38 billion in auto loan-backed ABS issuance has hit the market, around a quarter of which is backed by subprime loans. Meanwhile, America’s $1.3 trillion pile of student debt is likewise being sliced, packaged, and sold even as real delinquency rates (i.e. the rate for students in repayment and stripping out those borrowers in IBR payment plans whose calculated payments are zero) are probably at least 40% if not far higher. All told, around $76 billion in ABS deals went off in Q1 and for 2015, the total should come in at around $200 billion. While that’s a far cry from the $750 billion or so that came to market in 2006, it’s still on par with last year, which saw the highest total since the crisis.

As far as the collateral pools backing the deals, there’s cause for concern. For instance, Moody’s recently warned that some $3 billion in student-loan backed paper was in danger of default, while Skopos Financial (to whom we introduced readers last week), brought a $150 deal to market backed by loans to borrowers whose FICO scores ranged from just 350 to 500. Now, it appears Wall Street is set to feed its securitization machine with a new kind of debt: peer-to-peer loans. You read that correctly. Soon enough, the pool of micro loans that are facilitated by sites like LendingClub will be used to create CDOs. 

Via Bloomberg:

Barely a decade old, “P2P” has gone mainstream and is now being co-opted by some of the big financial players it was supposed to bypass.

 

Investment funds can’t get enough of this business, which involves lending to people over the Internet and hoping they pay you back. Investors are snapping up the loans directly, while the banks are bundling them into securities, much as they did with subprime mortgages.

 

Now peer-to-peer lending and its Internet enablers like LendingClub Corp., the industry leader, are being pulled into the high-octane world of derivatives. While many hail Wall Street’s growing involvement, others warn investors could get carried away, as they did during the dot-com era and again during the mortgage mania. The new derivatives could help people hedge their risks, but they could also lure speculators into the market.

 

“It feels like the year 2000 again,” said Frank Rotman, a partner at QED Investors, an Alexandria, Virginia-based venture-capital firm that has invested in Prosper Marketplace Inc., Social Finance Inc. and 13 other P2P lending platforms. “Everyone is chasing ’it,’ but they don’t know what ’it’ is, and that is kind of scary.”

 

Of course voracious demand is a direct product of central bank policies that have sent investors searching far and wide for yield and they’ve apparently become so desperate they’re now willing to gamble on the payment streams generated by loans made on peer-to-peer platforms.

It’s easy to see why investors are so enthusiastic. In today’s low-interest-rate world, high-quality P2P loans yield about 7.6 percent. Two-year U.S. Treasuries, by comparison, were yielding a mere 0.6 percent on Friday.

 

And the same dynamic that drove the housing market off a cliff (and that very soon will do the same for the subprime auto market) is at play with peer-to-peer loans.

But P2P’s rapid growth also raises questions about the potential risks, including whether the firms involved might lower their standards to stay competitive. During the mortgage boom, Wall Street’s securitization machine fueled questionable lending practices. Derivatives tied to the debt were blamed for spreading their risks around the globe, and then amplifying investors’ losses when the housing market crashed.

But don’t worry says Mike Edman (who readers will recall knows a thing or two about derivatives), everything will be fine as long as you embed a credit default swap thus allowing investors to bet against the loans by buying protection — this would ‘balance things out’.

Edman, who runs New York-based Synthetic Lending Marketplace, or SLMX, has some high-profile experience. In the early 2000s, he helped invent a kind of credit-default swap that enabled some Wall Street firms to bet against U.S. subprime mortgage bonds.

 

But Edman sees little resemblance between the boom-era mortgage market of and the current peer-to-peer market. He said his derivatives will help investors hedge their bets and also improve the pricing of the underlying loans.

 

Indeed, Edman said the ability to short the loans could curb some of the enthusiasm for this asset class before any of the debt sours.

This sets up a scenario wherein sophisticated investors could theoretically choose the credits they want to bet against and, with the help of Wall Street, structure a synthetic deal which would then be sold to clueless investors on the premise that a 5% yield is hard to come by these days (so the investor who structured the deal would be buying protection on the tranches while everyone else would be selling protection and picking up the CDS premium, while the bank plays the middle collecting hefty fees).

We wonder what role LendingClub and other peer-to-peer sites will end up playing in this process and whether the online component and relatively small amounts being lent have the potential to turn the whole thing into an underwriting standard nightmare once these tech startups realize they can get paid for providing securitizable assets.