Posted by Patrick Gannon :: August 18, 2007 @ 7:17 amBy now, most people have noticed that something is going on in the financial markets. For those of us who follow the equity and debt markets as closely as I do, it has been a gut-wrenching few weeks. What exactly is going on? The financial press is calling it the Subprime Meltdown. We think the situation is serious, and we want to let you know how we think it impacts you and Lending Club.
What is subprime? Subprime, short for subprime debt, is credit that has been extended to riskier borrowers. In credit score terms, most lenders consider borrowers subprime when they have FICO scores below 620 – there is no fixed definition. For individuals, subprime loans were made by mortgage companies and, to a lesser extent, by banks to people who were not creditworthy by traditional standards. Basically, these institutions were lending too much money to people who could not afford the houses they were purchasing. For the markets, subprime investments were debt instruments comprised of thousands and thousands of loans, including some percentage of subprime loans.
What happened in the markets? Mortgage lenders securitize their loan portfolios periodically to raise money for new mortgages. These portfolios are sold in the market through collateralized debt obligations (CDOs) that are split into risk tranches so that investors (including hedge funds, financial institutions, investment banking companies, trusts, mutual funds, and individuals) can invest in the higher-yielding risky portions (the subprime pieces) or the lower-yielding, less-risky portion of the portfolios. This approach creates liquidity in the economy by allowing financial institutions to lend to more borrowers, which is generally a good idea.
However, one of the key triggers for the subprime meltdown was that CDOs were often rated AAA because the higher-risk tranches of the CDOs were set up to take all losses first, hopefully leaving the lower-risk AAA pieces of the CDOs unaffected by losses. These high credit ratings led to hedge funds and other investors investing in debt that looked less risky than it really was. Adding to the risk, many investors buying the securitized mortgages were highly leveraged in an attempt to maximize their returns. Based on market conditions, the lenders to these investors called for payment of these loans that had allowed them to leverage their investments. The credit markets froze and values of good investments plunged as the borrowers sold their good investments to generate cash.
We believe that the entire mess was originally caused by aggressive lending practices – loans and mortgages given to people whose likelihood to pay the loan back was low. Additionally, the practice of piggyback lending – offering additional loans on top of mortgages – contributed to the practice. Why did mortgage brokers and financial institutions do this? They could maximize profits by originating as many loans as possible and then selling off the resulting loan portfolios to the market. This approach took advantage of people with weak credit who are now facing serious financial problems.
We understand that many lenders are worried about potential losses, and that many borrowers are concerned that they will not be able to qualify for or afford new credit. What is the impact of subprime on Lending Club and its members?
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• First of all, the impact on our members will be limited. As the Fed continues to make moves to settle the markets and to increase liquidity, we think there is a high probability of the fed funds rate being reduced following the 50 basis point reduction in the discount rate. Since our loans are fixed rate loans, current borrowers and lenders will see no changes in their payments
• Second, we think that borrowers will see us as a great alternative to banks. There are a growing number of banks that have had to raise their credit standards because they have not been able to sell their loan portfolios on the open market very easily, leaving them with less capital to lend to new customers. Our credit policy and risk management practices are conservative, but we are not planning on drastically changing our underwriting practices in response to the market situation – we believe that we have been originating loans correctly since we got started
• Third, we think that lenders will see us as a safe haven from the fixed income market. Our borrowers’ strong credit (640+ FICO score and non-mortgage debt-to-income ratio no higher than 20%), our members’ shared affiliations, and our portfolio-based diversification make lending money at Lending Club attractive. We offer good returns and relatively low risk, making lending a good strategy for many people over the long term
Please watch our video interview that discusses the subprime situation on YouTube: http://www.youtube.com/watch?v=HClLkBM4obc
We welcome your comments.
4 Comments
To me the market is adjusting to overpriced consumer items and over spending by businesses who invest into ventures that are off the scale risky. Plus since this all is based on what our government is going to do to back this up the rest of the world sits back and again starts bashing Americans as being fat cats and work on keeping a negative trade deficit... The US economy and market needs adjusting...for example, there are hundreds of thousands of houses here for sale . Then there are places around the country where they need housing due to their aging infrastructure but due to the rising interest on loans are not going to be able to spec out homes. So the economy and market needs to adjust to where the infrastructures has been paid for my municipals bonds until it gets back to balance...
As a CDO analyst currently with Bank of New York (formerly in a group under JPMorgan), I am in the middle of all of this mess with a front row seat to watch how this movie was made, distributed and bombed.
For the last couple of years investors' appetite was through the roof for these kind of instrument backed by securitized pool of these mortgage loans both high grade and sub prime. I analyze these multi million and billion (deals of less than 500MM was considered below average size-wise) dollar deals on a daily basis and wonder if investors really know what they are investing in. Granted, the risks are supposed to be spread thinner by the entire pool of collateral so if one defaulted, it has minimal effect on the entire structure.
Bear Stearns and other Investment Banks underwrote these deals like a auto assembly line. You can't blame them because it is easy money for them. Demand was high and defaults were relatively minimal. The rating agencies, tempted by high fees, also approved them with high regularity.
I often see some of these CDO deals that hold lower quality assets squeezing every little bit of "juice" to pass coverage tests. It doesn't take a genius to know that one little hiccup will cause the lower tranches of these borderline deals to trigger a default event. The current sub-prime woes are just elements of a perfect storm that will have lasting effect on these investment vehicles.
Lending Club should be in a good position to capitalize on the sub-prime misfortune. As money move out of those investments, investment alternatives like Lending Club should benefit from the exodus of money of some of these high net worth investors. One man's pain is another man's gain
Scot, thanks for the comment. There are a lot of people that think the market and the economy were getting overheated. Now that the market hit the down 10% level (intraday last week), the big question is: where do we go from here? It is quite likely that there will be an ongoing period of credit crunch news, and it is possible that some of the lenders who are facing liquidity crises will be facing an uncertain future.
At Lending Club, we think that the good news is that most borrowers will not be directly affected (especially if they avoid looking at their IRA statements this month!), and we are glad to continue to make loans available to borrowers who meet our strict credit criteria. We hope to be a source of liquidity for borrowers, and a place for lenders to make good returns with reasonable risk.
Patrick from Lending Club
Jimmy, thanks for your insights on this. The CDO market is very complex, and it is no wonder that things got a little carried away. Just because everyone was doing it didn't make it right... That being said, with the market hopefully learning from this credit crunch, I wonder if we will see higher quality CDO offerings that will not suffer from stretched creditworthiness and over-leverage.
Lending Club is very excited about the value we bring to borrowers and to lenders - we think that there is a very big opportunity here that we are helping to bring to the market.
Thanks again,
Patrick from Lending Club
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