As Peer-To-Peer Lending Draws Wider Interest, Does Securitization Lie In Its Future?

Primary Credit Analysts: Ildiko Szilank, New York (1) 212-438-2614; ildiko.szilank@standardandpoors.com Robert A Chiriani, New York (1) 212-438-1271; robert.chiriani@standardandpoors.com Secondary Contacts: Cian Chandler, London (44) 20-7176-3752; ChandlerC@standardandpoors.com M. Scott S Sehnert, New York (1) 212-438-2603; m.scott.sehnert@standardandpoors.com Weili Chen, New York (1) 212-438-6587; weili.chen@standardandpoors.com

Table Of Contents
The True Test: Weathering A Full Economic Cycle The New Lending Model Carries Risks P2P Companies Could Face Regulatory Hurdles Potential P2P Securitizations Call For A Multifaceted Approach To Evaluating Risks

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As Peer-To-Peer Lending Draws Wider Interest, Does Securitization Lie In Its Future?
As the peer-to-peer (P2P) lending market evolves, questions have persisted about the future role of securitizations in this sector. However, Standard & Poor's Ratings Services believes there are some hurdles that need to be cleared before we assign ratings to such transactions. Through various lending programs or platforms, P2P companies function as intermediaries, matching borrowers with potential lenders or investors who often have common financial interests or shared goals. They also act as loan arrangers and servicers, and they generate their revenues from these activities. The P2P originator/servicer does not typically use its own capital to fund the loans. The common thread involves a business model where the originator/servicer of the loans obtains funding for the specific loan from investors, typically through an online platform. We've seen that smaller finance companies that are growing, like many P2P firms are, have typically looked to alternative financing options, such as securitizations. Today's crop of P2P lenders cover a broad spectrum of entities with diverse business models, financial capabilities, infrastructures, technologies, experiences, and target demographics of borrowers, lenders, and investors. Standard & Poor's believes the novelty of this sector and its wide range of players presents unique challenges in assessing the overall risks in future P2P loan securitizations. We monitor developments in this nascent sector from a cross-sector vantage point and draw upon our experience in rating various types of consumer, commercial, and structured debt. P2P lending is evolving, and it's still too early to know what the industry will look like in its more mature state. As with any young and untested market, we believe there are issues that need to be addressed before we can assign ratings. Some of these issues are P2P companies' lack of performance histories through full economic cycles, uncertainty about their long-term commitment to the business, and their financial stability, operational risks, servicing quality, and loan credit performance in a downturn. We also consider the unproven ability and capacity to comply with new and ongoing regulatory and legislative requirements. We believe it is important to understand P2P companies' specific strategies and their target demographic of borrowers and investors. Information about the sector is largely fragmented, and there is no industrywide consensus on how big a role P2P lending will play in the credit markets. Platform operators in the P2P lending sector are diverse, targeting different consumer and commercial borrower segments and offering a variety of services. For example, companies such as Prosper and Lending Club extend a range of personal and business loans to borrowers, while Social Finance focuses on student debt consolidation/refinancing and is now starting to offer home loans. Funding Circle USA is a P2P platform that is focused on small business lending. Other entities, such as Kiva, have built global microfinance networks, serving underserved communities and entrepreneurs, mostly in developing countries. As of March 2014, the two main programs in the U.S.--Prosper and Lending Club--have collectively made $5 billion of loans in the past six years. Lending Club's Web site reported that since 2007, the company's total loan volume has

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As Peer-To-Peer Lending Draws Wider Interest, Does Securitization Lie In Its Future?

reached approximately $4 billion. Of this, about 83.0% was for refinancing and credit card payoffs, while borrowers used the remainder for home improvement, business, and other needs. Borrowers tap P2P lending programs as alternative sources of financing from the traditional banking services. Investors and lenders participate in P2P lending for the potential returns they will reap from these transactions, particularly given the relatively low returns available to them elsewhere while interest rates remain persistently low.

The True Test: Weathering A Full Economic Cycle

P2P companies tend to be categorized alongside other nonbank financial and lending institutions making unsecured loans. We believe that the short history pertaining to most P2P programs add a layer of uncertainty compared with the more established unsecured lenders. P2P loans have yet to experience a full business and economic cycle, which makes it difficult to assess underwriting quality and borrower behavior and, in turn, forecast potential loan losses in a downturn. It is also difficult to forecast whether or not P2P companies will have the long-term financial stability and commitment to withstand market downturns, particularly because they earn a significant portion of their revenues upfront at the time the borrowers get the loans. Generating attractive fees based on new loan originations places an incentive for these companies to open up their services to a wider base of borrowers. Managing delinquent or defaulting loans in times of economic stress often requires more intensive effort and resources versus doing so in a benign business and economic cycle, when loans generally perform better. In an economic downturn, escalating costs (associated with servicing a deteriorating loan portfolio), coupled with declining fees (associated with reduced loan originations), could pressure a P2P company to curtail or cease operations.

The New Lending Model Carries Risks

P2P lending transactions are generally conducted fully online over the Internet, where there is a greater potential for fraud. In addition, the platform operator is merely a facilitator and conduit for each transaction, with the outside lenders individually making the actual decision to extend credit. There are ongoing concerns with the quality and consistency of the loan underwriting process as well as with the robustness of the data that these systems collect and maintain. More traditional loans--such as credit cards--are typically originated, managed, and serviced by a single entity, retaining the risks and balancing costs and benefits from longer-term relationships. This helps to promote more consistent underwriting and collateral performance, particularly in stressful economic conditions.

P2P Companies Could Face Regulatory Hurdles

In our view, P2P entities generally lack the same degree of regulatory oversight as banks, and they don't face the same operational, capital, and liquidity requirements. It remains unclear what the regulatory environment will ultimately look like for the P2P industry.

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As Peer-To-Peer Lending Draws Wider Interest, Does Securitization Lie In Its Future?

Although a few P2P companies have been in business for many years, the market has only recently started to gain more attention as traditional financial institutions like banks have scaled back their lending. On the commercial lending side, new laws--such as the Jumpstart Our Business Start-Ups (JOBS) Act, passed in 2012--to encourage investment and promote the growth of U.S. small and start-up businesses might have also contributed to the entry of entrepreneurial players and helped advance the concept of crowd funding and various P2P programs. If the P2P lending sector's presence in the credit markets continues to grow, we believe the industry could be subject to additional regulatory oversight. In the case of P2P lenders, it isn't yet known how local, state, and federal regulations might evolve to monitor such a wide range of players.

Potential P2P Securitizations Call For A Multifaceted Approach To Evaluating Risks

There has been much industrywide discussion about the ongoing role of P2P lending, its place in the credit markets, and the sustainability of securitizations as a source for its funding. We expect interest will continue, especially as existing players grow and newer players emerge. In the near term, we believe P2P lending will continue to occupy a limited segment of the broader credit markets. We expect any preliminary securitization efforts will be slow and measured, likely with an eye toward more opportunistic financing. In general, our analysis of potential securitizations of both new and more traditional asset types includes a review of the loan and borrower characteristics, legal and regulatory risks, cash-flow structure and payment mechanics, and operational, administrative and counterparty risks (see "Principles Of Credit Ratings," Feb. 16, 2011). However, it is also important to note that even though P2P loans exhibit some similar characteristics as other types of securitized debt, we believe the risks associated with this nascent sector are unique and still evolving.

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