Consumer Defaults at Record Lows: Why Does that Matter?

Data released recently by major indices and industry aggregators (S&P / Dow Jones and Experian) indicates that defaults on consumer credit continue to decrease across the country.  See the WSJ’s brief write-up on this data here. Clearly this bodes well for those who currently hold consumer credit in portfolio – it’s a relevant data point for favorable macroeconomic dynamics that set the stage for profitable lending.  That said, the shape of the data isn’t new – charge-off rates of bank credit card receivables are typically in the 3-5% range.  So it also further validates one of the fundamental tenets of direct peer-to-peer lending: the rates charged by brick-and-mortar institutions are reflective of additional costs of lending over and above the risk of the asset.

This is becoming increasingly obvious as the industry trends towards stability and greater critical mass.  The rates charged by banks and credit card companies are high for two reasons: default risk and overhead costs.  Companies like LendingClub and Prosper are reducing the overhead cost of lending by implementing models that are primarily data-based by effectively utilizing modern technology.  With lower overhead costs, a more efficient market is created wherein the primary component to pricing loans is risk.

This is also accomplished by parsing out the lending function from the underwriter.  Since LendingClub and Prosper don’t hold the loans on their own balance sheets, the pricing of the loan isn’t intended to cover operating costs – unlike many brick-and-mortar institutions.  Of course, this brings with it a whole host of other agency issues – e.g., shouldn’t the underwriter’s compensation be tied to the performance of the loan?  Sure – and to the extent that the long-term viability of the peer-to-peer market-maker depends on the skill of the underwriter, this issue is adequately addressed.  That’s another topic for another day, but its implication holds constant – the loans should be priced for risk.

The point is this: direct lending models already make credit markets more efficient by utilizing technology to reduce operating costs.  Then, by delineating the investor from the underwriter, the cost of credit is more accurately dependent only on risk.  With respect to that exposure, we’re learning a lot these days.  Those whom traditional institutions have black-marked as non-creditworthy are actually pretty good at paying back their loans – and that’s good news for those of us who are willing to participate in the market.