New types of lending are coming of age
The US banking structure is screwed up in many ways, but policy-wise, nothing is more destructive than FDIC insurance for banks that do investment banking and trading as well as commercial lending. The fact that we haven’t split up plain vanilla lending from riskier, more leveraged operations has all sorts of perverse effects, the best known being the too big to fail problem.
But as I’ve been looking into the $1 trillion student loan bubble, I’ve found another perverse effect of our misaligned banking system. One of the reasons that the student loan bubble is so big and loans are so onerous is that any bank that is insured by the FDIC can’t actually price risk in the market effectively. There are base student loan rates, all of which are set by the government. Rules about how depository institutions backed by taxpayer dollars can make loans create a situation in which it is very difficult for such institutions to come come in and give, say, a Stanford MBA graduate that has incredibly high earning potential a better rate than a English major at a lesser institution. (Sorry, Edith Wharton fans.)
Now, on the one hand, this policy has its roots in a fair-minded—it helps prevent discrimination by geography or a host of other factors. But on the other hand, it leads to a system in which we have a one size fits all approach to lending. It doesn’t matter whether the default rate at school A is 1 %, and the default rate at school B is 10 %, students must pay the same rates. The difficulty in effectively pricing risk is a key reason that the government, not the private sector, represents 93 % of lending in the student loan market.
But these inefficiencies have created an interesting opening in the market, from which a new financial model is emerging, one that uses peer to peer lending in a way that evokes the community banking models of old. One of the companies at the forefront of it is SoFi, started a former head of prop trading at Wells Fargo, Mike Cagney. Working in the Bay Area, Cagney wondered why extremely marketable Stanford grads with no money but extremely good future earnings prospects had to pay such a high rate to borrow. (After all, most of them are extremely unlikely to default.) He looked into starting a bank to loan to such customers, but ran into the issues I’ve described above.
So, what he did was go to Stanford grads, people who would actually know the trajectory of Stanford students, and ask them to underwrite loans to students at preferred rates, thereby raising money without having to become an FDIC insured bank. The alumni who have an affinity with the people to whom they are lending absorb the loan risk. “They know their customers, in effect, and have an emotional tie with them,” says Cagney. It’s kind of like a modern version of the “It’s A Wonderful Life” community savings and loan model, where you walk across the street to see the people you are lending to. (“The money’s in Joe’s startup. And in Kennedy’s medical practice. And a hundred others.”)
The project, which has been a success in California, started rolling out nationally in 2012. In each market, Cagney would approach alumnae at various colleges (University of Michigan, Penn State, etc) and get them to make initial investments. He has since been able to raise independent financing. SoFi now has over $400 million of loans outstanding with 4,500 borrowers, and will likely do another $1 billion this year, adding another 10,000 borrowers.
This idea is just one of many alternative lending models that are coming of age. SoFi itself is entering the mortgage market, which is ripe for restructuring. More importantly, it shows how badly our overall financial system needs restructuring. Certainly, there are social questions that the SoFi model raises—should we as a society allow students who graduate from better school and want to work in richer fields to get preferred loan rates? Cagney would argue yes, because he believes that a better market pricing of loans would force universities to price degrees differently, and acknowledge that while an Ivy League degree in a STEM or business oriented field might be worth $50,000 to $60,000 a year, many others are not. If that led to a re-pricing of education itself, it could help deflate the loan bubble and make school more affordable. But we’d have to make sure that it didn’t also result in the degradation of liberal arts education, for example, or unfairly penalize kids who simply can’t afford to go to top schools. One solution might be for the government loan system to play a key role there, or for peer-to-peer lenders to package risk in such a way that some of the benefit of premium loans flows to students from less sought after schools in the form of more liquidity and availability of finance.
What’s clear is that it’s not just student loans, but all sorts of risks that are crudely and wrongly priced due to the way that the banking industry is structured. The result means higher capital charges for all of us, but also potentially smaller profits for banks. (Many people, like FDIC vice chair Thomas Hoenig, believe that banks would be far more profitable than they are now if they were split up along business lines rather than allowed to remain conglomerates.) I think that peer-to-peer lending and other alternative models that are closer to the customer than the traditional banking model are will slowly but surely displace Old Finance. After all, who is better at assessing the risk of a credit—a bank, or someone from the borrower’s own community?