Last September, I wondered whether it was wise to hype the fintech business — the trend of Silicon Valley firms delivering financial services like bank accounts, payment services and loans. I worried that these booming businesses didn’t look much different from traditional banks except for standing outside the regulatory perimeter. I questioned whether fintech companies had the goal of delivering better financial services or relying on a laissez-faire free market.
The LendingClub scandal this week confirmed these fears.
LendingClub is the nation’s top “marketplace lender.” Its website connects borrowers looking for money and investors looking to lend. The beneficiary of glowing profiles about “disrupting” Wall Street and democratizing finance, LendingClub and its CEO, Renaud Laplanche, were the darlings of the fintech movement. Larry Summers jumped onto their board of directors. The future was bright.
And then Monday, Laplanche resigned.
It appears the board of directors forced him out after an internal review revealed two red flags. Both of them have to do with the fact that LendingClub was never the “Uber for loans” it was cracked up to be. Private equity funds, asset managers and investment banks are the majority of the lenders on the other side of the loans. In addition, LendingClub sold loans into the secondary markets, with companies like Morgan Stanley and Goldman Sachs issuing bonds backed by them.
In other words, LendingClub is an originator, funneling loans upstream to Wall Street firms. And in executives’ desire to grow amid demands from shareholders — LendingClub went public in 2014 — they began to exhibit the tendencies of the banks they sought to out-innovate.
First, Laplanche approached the board about investing in Cirrix Capital, an investment fund that actually bought a lot of LendingClub loans. If LendingClub invested in Cirrix, then Cirrix could invest more in LendingClub loans, a bizarrely circuitous bit of logic that nevertheless appealed to the board. They agreed to put $10 million in Cirrix. But Laplanche didn’t tell the board that he already held a large investment in Cirrix at the time. So LendingClub’s money wouldn’t just help out the company, but personally benefit Laplanche.
Amazingly, LendingClub board member John Mack, the former CEO of Morgan Stanley, was also invested in Cirrix. He wasn’t part of the risk committee that approved the Cirrix investment, so he hasn’t resigned. But the whole concept of a marketplace lender owning a stake in the fund buying marketplace loans is ripe for abuse. It could force that fund to swallow dodgier loans to increase market share, or give that fund better loans than competing investors.
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The second red flag is even more dangerous. LendingClub wanted to sell its loans to an investment bank named Jeffries, which would bundle those loans into securities. But Jeffries wanted LendingClub to improve its disclosures to customers, explaining to them that, under the terms of the loan, LendingClub can access customer financial information and even sign the promissory note on their behalf. Only then would Jeffries buy the loans from LendingClub.
After some back and forth, LendingClub agreed to the disclosure fix and sold Jeffries $22 million in loans. But in order to maximize that sale, it changed the dates on many loan applications, making it appear that they came in after the alterations to the disclosures.
That may sound trivial, but as Bloomberg’s Matt Levine explained, it’s precisely analogous to the misconduct that got banks in trouble during and after the financial crisis. Securitizations have precise rules — “a horrible Jenga tower of legalities” as Levine puts it — which, if not followed, blow up the whole process. Borrowers could say they were promised certain disclosures and didn’t get them, voiding the loans. Jeffries could claim LendingClub duped them, demanding repurchases. Misrepresentations and omissions become legal time bombs in the securitized world.
Moreover, LendingClub actively forged legal loan documents. I have written the book — literally — on forged mortgage papers, where companies manipulated dates, notary stamps and corporate officers’ signatures to allow them to foreclose on homeowners. This is remarkably similar conduct, considering how everyone solemnly claims to have heeded the lessons of the financial crisis, and particularly considering how marketplace lenders like LendingClub set themselves apart.
At least LendingClub pushed out its CEO, which is more than any bank did after the crisis. You could argue that the corporate governance system worked. But LendingClub’s problems — which continue, as the Securities and Exchange Commission is investigating and the stock has cratered — will prove to infect the industry as well.
A report this week from the Treasury Department cites numerous deficiencies with marketplace lending, from the lack of a database for their loans to the need for consumer protection regulations to cover their activities to inconsistent transparency and disclosure, one of the problems LendingClub faced. That seems incredibly urgent, given this week’s news highlighting the glaring hole in the regulatory framework.
More important, institutional investors are heading for the exits. Even before the Laplanche scandal, funding plummeted in the first quarter of 2016. A self-interested JPMorgan Chase CEO Jamie Dimon (he has his own fintech operation) stuck the knife in further Wednesday, saying (probably correctly) that private market money would flee marketplace lending in a crisis. Now the LendingClub scandal will sap market confidence even further. And that creates the kind of pressure for funding that leads to LendingClub forging dates to get loans into the hands of an investment bank. The next fintech board may not be as forthcoming as LendingClub after the fact.
LendingClub is really the model of a fintech firm, and Laplanche its public face. The whole industry is tainted by their loss of internal control. That’s why other fintech leaders are scrambling to provide reassurances. But they cannot put back the curtain now that the dodgy nature of marketplace lending to the public has been revealed.
If this the future, why does it look so much like the past?