Perry Rahbar
From my desk at Bear Stearns, where I’d traded mortgage-backed securities for years, I watched as the financial and housing markets crashed in 2008. A few months later, there was no Bear, and my new desk was at J.P. Morgan.
It’s easy to think the crisis was a result of “Wall Street got drunk,” as George W. Bush admitted. But I saw a different cause: the financial sector’s failure to keep up with innovation.
What really happened in 2008?
In short, innovation without checks and balances.
If you’ve seen The Big Short, you know some of what led to the collapse was the rise of mortgage-backed securities (MBS). But the real problem wasn’t that those securities existed. MBS was an innovation in its own right, after all, created by the financial industry as a way to modernize mortgage lending and allow investors to lend directly to homeowners. On its face, it was a positive change.
The problem was the industry didn’t keep up. As new offerings like MBS hit the market, the tools and processes investors used to make decisions didn’t change. The result? Investors didn’t always know what they were buying. When it’s too hard to run the numbers, you start believing the guy on the phone, the news cycle, the hype. And then everything crashes.
Financial collapse led to more innovation
By the time I left J.P. Morgan in 2013, peer-to-peer (P2P) lending had erupted. Companies like Lending Club, Prosper and SoFi were originating loans in greater numbers, using proprietary risk-analysis tools and distributing smaller, niche loan amounts. Consumers saw P2P lenders as a more transparent and modern option compared to the traditional banks they blamed for the 2008 mess. P2P lenders, in turn, created attractive websites and apps that made getting a loan from your bed as easy as selecting a playlist on Spotify.
As P2P lending grew, so did its investor base. With high demand for loans, P2P lenders turned to the institutional investors, hedge funds and financial institutions they once replaced. And as the business model evolved, so did the name. “P2P” became “online marketplace.”
While marketplace lending is still a small component of the market, it’s growing rapidly. A white paper recently issued by the Treasury Department projected marketplace lending will eventually be worth $1 trillion, and estimated that loan origination volumes would reach $90 billion by 2020. That means more involvement by the capital markets, both in financing and purchasing assets.
So the question becomes: Has innovation for consumers been matched by innovation for investors?
Finance requires responsible innovation
While innovation for consumers has evolved, the back end of lending and investing is just as opaque now as it was prior to 2008.
Worse yet, investing in marketplace assets is even more complex than traditional loans. With less regulation than banks and no consistent reporting practices across lenders, it’s extremely difficult for investors to figure out what they’re buying and how it’s performing.
It gets even more complicated when you think about marketplace securitization, which is essentially marketplace loans bundled into bonds. Sound familiar?
Despite a lack of new tools, securitizations are occurring with greater frequency. According to the Treasury, marketplace securitization has reached more than $7 billion in volume since the first transaction in 2013, with more than 40 deals in just three years.
So what should be done to ensure the newest wave of innovation is safe? We need a system of checks and balances that ensures responsible lending by originators and responsible investing by capital markets. A focus on data versus profits is key, as is the goal of providing impartial data to all stakeholders.
It starts with surfacing previously inaccessible data and sharing it with everyone involved in a deal. By making the truth too obvious to ignore, we increase smart decision-making and decrease the possibility that our newest innovations will lead to the next financial collapse.
Transparency — not just a buzzword
Post-collapse, perhaps the strongest criticism leveled at Wall Street was its lack of transparency. Unless we innovate quickly, we risk this again — this time as it relates to marketplace lending.
Two of the Treasury’s key recommendations for marketplace lending focus on increasing transparency. The Treasury suggests consistent reporting standards for loan-origination data and portfolio performance, and transparency into the loans included in securitizations.
Both recommendations can be addressed with the right technology. Current market trends have created the right environment to bet big on transparency and third-party software and services. Today’s “do more with less” mantra means Wall Street is much more open to non-proprietary solutions than ever before. And while marketplace lending isn’t going away, neither is capital market involvement.
Without innovative solutions to new problems, we risk reverting to 2008 decision-making. Or, worse, we risk creating an investor pool bearish on investing in marketplace assets, which will kill liquidity and raise rates for the rest of us.
So let’s support innovation. But let’s also do our part to innovate responsibly.
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