“A US FDIC-insured industrial bank with a 59% ROE and a very low risk classification” 

(Source of ROE & Financial health measure)

Banking ROE averages are around 8% (BOfA around 7% and Wells Fargo 14%). Just this past week reported in “Return in Techquity”

“JPMorgan and its competitors seem destined to amble along with returns on equity slightly above or below the 10 percent considered enough to cover a big bank’s cost of capital. Dimon’s outfit, for example, is expected to earn an average of 10.3 percent ROE for each of the next three years, according to Thomson Reuters”

The 59% ROE bank, is not publicly traded and is categorized as a “state industrial bank”. One can buy the holding company, which according to Insider Monkey is slowly but steadily being picked up by hedge funds. Steel Partners (SPLP) is a small cap conglomerate with low volume that may deter you from investing (let alone the market that is acting like a falling knife).

Steel Partners owns WebBank which is based in Utah. In my first research note for the year “Lending marketplaces grow up and get boring”, I introduced WebBank because they are very much involved in underwriting the loans of many US P2P platforms. Lending Club, Prosper and Paypal are major clients of WebBank. When a borrower qualifies on any of these platforms, the loan note is issued from WebBank and the loan proceeds, net of the origination fee, are passed onto the borrower.

It takes about 48hours for the platform to match this loan to investors / lenders that eventually end up funding the borrower. At that point, the platform can buy the loan note from WebBank and the funding is “transferred” to the lenders. Essentially, the regulatory license and the capital of the FDIC insured industrial bank is used for 48hours and then this capital is replenished. The high volume of origination, the high turnover rate, brought $46million in revenues this past year to WebBank. In the WSJ December article “Behind the Boom in Online Lending: A tiny Utah Bank”, it is emphasized that Webbank is a very lean operation of roughly 50 employees and $ 278 million of capital that has been extremely profitable by focusing on this niche. Cross River bank in New Jersey is another FDIC insured institutions that is involved with multiple lending marketplace platforms. Felix Salmon, alludes to these behind the scenes relationships, as triangles or four-sided markets in his year end piece “Financial startups are getting an edge by growing up”

Who are these regulated entities and what is special about them, apart from the fact that they are operating behind the scenes and facilitating the growth of lending marketplaces? Why isn’t everybody else jumping into this business and what is their “raison d’être?”

Looking at a map of US states in which credit card companies are chartered, tells the backbone story. There are roughly half a dozen states that have NO Caps on interest rates charged on loans. Credit card companies have been positioning themselves in such states with no or lax usury laws. That has allowed them to issue credit cards to people in states with strict usury laws without having to comply to the caps in the state that the borrower resides. The roots of the concept of “usury”, dates back to medieval times. It came about to address the prohibition of informal or black market loan-sharking. US States vary in terms of their laws about interest rate caps on loans, amount limits and qualifications of borrowers. Circumventing mechanisms for these cross-state complications, were already in place for P2P and marketplace lending platforms to simply mirror from the credit card industry.

Lending marketplaces have mirrored the incumbent credit card practices, to overcome the cross-state complexities of the US market. Pure Lending marketplaces and Paypal type of businesses, are neither FDIC insured, nor CFPD regulated but have been partnering with banks that provide them both with the necessary regulatory compliance and with cross-state match making ability. They have mirrored the old-fashioned credit card businesses practices, in order to be able to match lenders and investors from any state to a borrower in a state with strict usury laws.

The first hike in US interest rates has already been passed onto to the consumers (borrowers and lenders) on the lending marketplace platforms. Default risk is monitored as the macro economic environment becomes more jittery. However, the creepiest risk for the US lending marketplace businesses, looms in the US courts and state regulators.

The business practices of WebBank have been challenged already and are heading to the US Supreme court (to be decided this Spring). Regulators from the U.S. Treasury and California are looking into whether anyone is cutting corners in the origination business. WebBank, as a chartered bank is allowed to provide financing anywhere so long as it is consistent with its own state laws. However, once the loans are sold to the lending platform, there is a gray area that is on state-lawmakers radar screens. Lending Club, as a public entity, disclosed during last year’s earnings call in August that approximately 12.5% of their consumer loans may exceed state interest rate limits. Lending platforms would have to obtain state licenses to avoid any regulatory issues. As a result customer acquisition costs would rise.

Issues of loans on lending platforms that are exceeding the state usury limits of the borrower, can spill over and “hurt” the development of a secondary market for these loans and the growth of the securitization deals. Ratings agencies would consider pools of such loans of lesser quality in their valuation procedures. These types of regulatory risks are not reflected in the Texas Ratio.

-Efi Pylarinou