As marketplace lending continues its dramatic growth and regulators consider how best to protect consumers without limiting financial innovation, the U.S. Treasury has openly expressed an interest in whether marketplace lenders should be subject to some form of "risk retention." Under new regulations that go into effect later this month, most issuers of asset-backed securities (ABS) will be required to retain a percentage economic interest in the collateral they securitize.
Some believe that applying similar rules to marketplace lenders would ensure that lenders originate high-quality loans, but marketplace lenders uniformly disagree, arguing they are sufficiently motivated to implement stringent underwriting standards and that such rules would hinder innovation. Regardless of the arguments on either side, with the recent election of Donald J. Trump as the next president of the United States and his promise to curtail government regulations, it is possible marketplace lenders will continue to operate without the need to retain any so-called "skin in the game."
Risk Retention Rules
Risk retention is a direct response by regulators to the subprime mortgage meltdown, which some believe was caused in part by an active securitization market that enabled originators to transfer the risk of loss, thereby loosening underwriting standards. Under the relevant rules, which go into effect on December 24, 2016 as part of the implementation of the Dodd-Frank Act, issuers of ABS are required to retain an economic interest equal to at least 5 percent of the credit risk of the assets they securitize. By requiring issuers to retain some skin in the game, regulators believe issuers will be motivated to monitor and ensure the quality of assets underlying a securitization.
Applicability of the Risk Retention Rules to Marketplace
Although the new risk retention rules likely apply to marketplace lenders that securitize loans and act as a sponsor, it remains unsettled whether similar rules should apply to marketplace lenders in the non-securitization context. Some believe they should.
Many marketplace lenders do not hold the loans they originate and therefore do not retain the risk of non-payment. The risk instead is borne by investors that fund the loans and in return receive "payment dependent notes" whose payments are tied directly to loan performance, and by whole loan purchasers that retain the loans or securitize them. Commentators have expressed concern that without a direct economic interest in the loans they originate, coupled with a desire to originate loans to satisfy investor demand, marketplace lenders may lack the incentive to implement strict underwriting standards.
Marketplace lenders, in contrast, oppose the application of risk retention rules in the non-securitization context. They believe they are motivated to originate high-quality loans because their ability to attract investment hinges on loan performance, and therefore risk retention rules are unnecessary. As one online lender put it, marketplace lenders "still live and die by the quality of their loans." Some lenders also argue that they already retain an economic interest since they service the loans they originate and servicing fees are tied to loan performance. In addition, requiring lenders to retain credit risk could result in higher interest rates to offset the costs associated with raising capital. Greater capital requirements, in turn, could create a barrier to entry and less innovation. Moreover, online lenders contend that risk retention rules are unnecessary since most investors in marketplace loans are institutional and therefore have the ability to protect themselves through due diligence and representations and warranties.
Although these arguments against risk retention have some appeal, there is some skepticism given that many of the same factors would have equally applied to subprime mortgage originators that fed the residential mortgage-backed securities (RMBS) market prior to the financial crisis. Similar to marketplace lenders, many of the now defunct subprime mortgage originators funded their loans through third-party financing arrangements (typically warehouse lines of credit), sold the loans they originated shortly after origination and generally did not hold loans on their balance sheet. Thus, as with many marketplace lenders, their success depended primarily on the quality of the mortgages they originated and the ability to attract purchasers and investors. Nevertheless, although loan quality was critical to success, many believe the ability to transfer risk caused subprime originators to loosen their underwriting standards. Accordingly, without some economic skin in the game, the potential for reputational harm alone may be insufficient to motivate marketplace lenders to originate high-quality loans.
The subprime mortgage crisis, however, does not necessarily demonstrate the need for risk retention in marketplace lending. Experts have cited evidence that the widespread borrower defaults seen at the height of the financial crisis did not result from lax underwriting standards, but instead from the crash of the housing market, which left financially distressed borrowers unable to sell their homes or refinance their mortgages to lower monthly payments. Accordingly, a comparison to subprime mortgage originators may be inappropriate, especially since marketplace lenders generally issue unsecured loans or secured loans backed by collateral that is expected to depreciate in value (e.g., cars).
The Uncertainty of Regulations Under a Trump
Given federal regulators' increasing interest in financial technology companies generally, greater regulatory oversight of marketplace lenders seems all but inevitable, and industry participants are bracing themselves for potential changes in the way they do business. The election of Donald J. Trump as the next president of the United States, however, has made the regulatory landscape more uncertain. Throughout his campaign, Mr. Trump repeatedly promised to dismantle Dodd-Frank, and he appeared poised to live up to that promise in a recent YouTube video in which he stated that, as president, he would formulate a rule under which for every new regulation, two old regulations must be eliminated.
As to Dodd-Frank's risk retention requirements specifically, it has been reported that Mr. Trump may seek to ease its impact on ABS issuers, which could include marketplace lenders that securitize loans they originate. Mr. Trump could endorse legislation proposed by Representative Jeb Hensarling, the Republican chair of the U.S. House Financial Services Committee, known as the Financial CHOICE Act. The act is being proposed as an alternative to Dodd-Frank and, in relevant part, would repeal the risk retention rules for most ABS issuers. In the event this or any similar legislation is passed, it is unlikely that any separate risk retention rules applicable to marketplace lenders would be enacted.
The goals of risk retention, including encouraging sound underwriting practices, would seem to have relevance in the marketplace lending context where a lender does not retain the risk of non-payment. However, if President-elect Trump can be taken at his word, the current risk retention rules will be repealed, along with Dodd-Frank, leaving the marketplace lending industry unaffected and reducing the likelihood of any separate risk retention rules for online lenders.
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