This is a guest post from Loren Picard, Senior Managing Director with LMA Capital, Inc. He focuses his efforts in the mortgage and P2P financial solutions arenas. He can be contacted on LinkedIn here.
A revolution against rent seekers is upon us. Who are these rent seekers in the financial markets today? This is not another tirade against rich guys on Wall Street who don’t get it; ranting against the beneficiaries may feel good, but it smacks of envy and does not solve any problems. Worse, it can lead to an Argentinian style thievery on a truly gargantuan scale—leading us all to doom.
No, these rent seekers are the large institutions, both private and government-owned, along with their regulators, who have built a comfortable symbiotic relationship maintaining the status quo. The newly formed CFPB is a weak response and will themselves eventually become part of the problem.
The Revolution Has Gone Viral
The revolution is starting out slowly and in the background. Something recently happened that will be misinterpreted for a while, but will nonetheless be seen as the day the revolution went viral. The event: John Mack joined the board of Lending Club. For revolutions to get started, it is the intelligentsia which needs to be made aware of the spark which lights the fuse, not the masses. The masses will be herded into the square in due time. In this case, the intelligentsia are the people who work in all manner of the financial services industry—including the reviled rich guys.
If you have worked in financial services over the last 20 years you have heard of John Mack. He is the former CEO of Morgan Stanley. Even if you have worked in financial services over the past few years, you can be excused for not knowing about Lending Club. But with John Mack joining their board the world has now heard of Lending Club and of P2P lending.
His arrival at Lending Club is no more important than the noise it created. In fact, Lending Club could easily hand him his yearly compensation, a little stock, and wish him a happy 2012. He has served his purpose. Of course this is somewhat facetious, but it does emphasize that the biggest benefit of his arrival has already taken place. The irony being he is one of those rich guys from Wall Street.
An Innovation Revolution in Financial Services
So, now what happens? The innovation revolution in financial services begins! It will start slowly, then everybody and anybody will be into P2P. P2P will eventually become dated as an acronym, just like the term dotcom became outdated. A lot of money will be raised, spent, software developed and thrown out, and finally a handful of companies will get the model right for their particular industry segment (consumer loans or car loans or equipment leasing or insurance) then the consolidation phase will begin (this is the fun phase where the formerly admired rich guys overpay to get into P2P); the best consolidations and most durable business models will be P2P’s consolidating with their peers in a horizontal and vertical manner. We are way ahead of ourselves here; the consolidation phase will be the subject of future articles, not this one.
When you think of the P2P model there are three important “things” to keep in mind.
- With P2P, you can’t separate money from ideas. In essence, where there is a P2P idea, there will be a flow of funds, which the P2P platform will try to participate in. P2P is not an eyeballs game or a user game (see Instagram for perfect example). P2P is about creating rivers of money flowing between parties (I use parties because it is inevitable that the peep-peers will be elbowed out when the serious money arrives).
- This is not about business per se; it is about markets. What eBay did for garage sales, P2P will do for the car in the same driveway.
- A P2P approach to finance (or the more generic ‘capital’) is about the federalism of the financial system. It is about increasing the number of nodes in the financial system while simultaneously reducing systemic risk for the average Joe taxpayer.
Mechanisms will develop in P2P finance incorporating ethical behaviors backed by trust and newly created social norms. P2P is more descriptively described as primitive or devolved finance (think ‘The Hunger Games’) though it will be sold as the next evolution. It is very tribal. Do you trust large banks (assuming no government involvement) more than small banks? No. It is back to the natural level of trust imbued in humans.
If you look at the basic model of peer->platform->peer, there are plenty of precedents already in the market (again, think eBay, or match.com). For business model purposes there is a continuum. On the far left is the pure play P2P. In this model the platform is there as an introduction service. All negotiations, credit decisions, and payment collections/servicing are done between the peers (Visa would be a close example). The platform takes a fee for a listing or membership or a matching of the parties. On the other end of the continuum the platform does everything from creating the lending program, underwriting the borrowers, making the credit decision, and closing and servicing the transaction (Lending Club and Prosper fall on this end). On this end of the continuum the platform can earn origination and servicing fees.
In this writer’s opinion, the most successful P2Ps (I prefer the IP2IP acronym to acknowledge that the platforms will evolve to be dominated by institutional-peer to institutional-peer relationships) will be those that figure out how not to do all the work of originating, underwriting, and servicing of the loans on the platform. As competition increases the “full service” model will erode due to the effect competition will have on the fixed percentage fee schedule the platforms operate under—i.e., margins will be crushed.
John Mack’s appointment is seen as sending up the signal that it is safe for people to invest in or through such platforms. And true, it does do that. In the long run what it does is send up another more faint signal that the battle has begun. The takeaway is that if you are an entrenched incumbent in the financial services industry, you focus 100% of your attention on Basel III and Dodd-Frank at your long-term peril (honestly, no Keynes’ joke here).
How these P2P companies get valued, what damage they will do to existing Wall Street and large banking firms, where the rating agencies fit in all this, and what nascent bubbles and systemic risks will be created during the development of the P2P infrastructure are to be determined. Let the games begin.