[Editor’s note: This is a guest post from Michael and Connie Erlanger, co-founders of Marketcore.com. For the full byline see the end of this article.]
Reports of potential systemic vulnerabilities in loan markets are appearing with increasing frequency in both the mainstream and the trade press. These reports do not bode well for the lending industry (or the financial sector) in general. At the same time, speakers at marketplace lending (MPL) industry events have discussed the need for an expanded spectrum of services and an associated increased volume of borrowers and investors. In particular, at every conference we’ve attended, numerous participants have cited the need for a viable secondary market to provide the liquidity of the underlying assets that will power continued growth in MPL.
Sustainable liquidity is a fundamental and complex issue for any marketplace, most particularly a new one. Exit strategies for investors are as critical for continued market growth as are both efficient pricing and execution. The absence of a functioning secondary market directly, and adversely impacts originations.
We have all seen the devastating results of illiquidity in loan markets before. In the 1990’s there was tremendous product demand in the mortgage market but, because of inconsistent process and workflow standards across loan originators, transactions in the secondary market had an extraordinarily high rate of “failure-to-close,” especially in the secondary market for whole loans (as high as 85%).
When principals to transactions did not want to share their underwriting standards or make warranted risk-detailing disclosures, market makers responded by creating novel and often opaque products, such as increasingly complex securitizations, derivatives, alternative loan structures and tools with which lenders and investors could purportedly “bucketize” and/or hedge their risks. However, simply pooling risks (viz. subprime mortgage securitizations) proved faulty, as became apparent with the failure of critical market sectors. The resulting viral loss of confidence led to the ensuing global credit crisis.
Over the past several years the MPL community has grown into a significant alternative to conventional commercial banking and finance. The technological innovations that have enabled MPL and the resulting efficiencies in loan origination solve many of the significant issues that still plague conventional lenders. Why, then, does the issue of asset illiquidity exist in MPL?
We believe that the reasons for this persistent problem are the twin issues of reduced confidence in the market(s), and illiquidity. Based on our experience in institutional whole loan brokerage, and from our history in tracking markets in a broad range of more than 60 different types of instruments, we believe that it is possible to resolve both uncertainty/lack of confidence, and illiquidity through (1) use of tools for clear, ongoing standards of valuation, within the context of the most viable risk-matching universe; and (2) the creation of a robust secondary market for whole loans that establishes value across the full life cycle of any instrument, and in which investors can readily price and sell their loans.
Today’s borrowers and investors continue to feel the impact of the global financial crisis that began in 2007/08. As a result, they are often much more cautious and more debt-averse than in previous times. Uncertainty is the order of the day and it increasingly drives down asset values – just at a time when relative risk prediction is increasingly possible, as proven by emerging technology. In order to achieve the long-term viability of MPL, it is essential to build borrower, lender, and investor confidence in the broad marketplace by actually lowering uncertainty risk in contracts. Reducing uncertainty actually raises asset values. Such an ability – to increase financial asset values through the origination process and in the aftermarket – is a transformative development.
A robust secondary market primes liquidity and enables the continued growth and development of marketplace lending. It is possible to create such a vibrant secondary market today using innovative tools for standardization, that reduce fragmentation and friction, providing real price discovery, and that is open to all investors.
The face of MPL is changing rapidly (as is currently illustrated by the number of participants and the market complexity depicted in Orchard Platform’s “Lendscape”). As increasingly sophisticated investors enter the MPL universe, and as the lending environment changes, they will require a viable secondary market. There is a clear place for it and now is the time for its development.
The authors, Michael and Connie Erlanger, are co-founders of Marketcore.com, Inc. From 1993-2000 through their own broker dealer they executed secondary market placements of $1.8 billion in residential market whole loans between institutions. Marketcore was founded to implement this proprietary technology to build borrower, lender and investor confidence in primary and secondary financial markets. Their work has been commercially licensed in complex risk markets, such as insurance/reinsurance and climate change and sustainability finance. It has received extensive independent review by: national and international private sector risk managers, as well as trade and mainstream press; in academic and regulatory studies; and, an unusual mention in a Library of Congress Congressional Research Service “CRS Report to Congress.” Contact: www.marketcore.com or merlanger@marketcore.com.
