Alternative lending has been a saving grace for many borrowers that had nowhere else to turn when the credit market dried up in the wake of the 2008 housing bubble collapse. For borrowers, alternative finance became the only option when banks tightened lending standards. But have alternatives simply moved subprime risk to a new conduit? Let’s dig into the question.
Subprime loans and risky borrowers: A recipe for disaster
During the housing bubble, the number of subprime mortgage loans being originated in the U.S. exploded. Many loans were made to risky borrowers with FICO scores below 620, while “Alt-A” loans -- those made to borrowers with good credit scores but poor employment history -- also ballooned. Often, these loans had unfavorable terms, like 2/28 hybrid mortgages, which have low fixed interest rates for two years before costs increase dramatically. The stats are staggering. The subprime mortgage loan market grew from $65 billion in 1995 to $625 billion by 2005. As of March 2008, the subprime market was estimated to be 11.8% of the total mortgage loan market -- a recipe for disaster.
The bubble had to burst
When the mortgage bubble burst, many of the world’s largest lenders found themselves fighting to survive at all costs. Between 2007 and 2009, real estate values in the U.S. dropped by $6 trillion. The world’s 100 biggest financial institutions wrote off over $370 billion in subprime-related losses. Part of this struggle to remain solvent included a drastic reduction in lending. Not only could subprime borrowers no longer get loans, many borrowers with solid credit were left out in the cold as well.
The alternative finance revolution: A better way?
In the aftermath, alternative lenders like LendingClub and Prosper recognized the huge opportunity the crisis created and quickly established a sizable new market. LendingClub alone reports it has now issued over $13.4 billion in alternative loans. Notably, leading alternative lenders are taking steps to make sure their platforms avoid the dangers of pre-crisis subprime lenders faced. Many members of the industry have higher lending standards than subprime mortgage lenders did before the housing bubble. LendingClub, for example, requires a minimum FICO score of 660 for its borrowers and Prosper requires a FICO score of at least 640 -- both fall above the 620 threshold that classifies a borrower as subprime. This duo also doesn’t issue deceptive or irresponsible terms seen in subprime mortgages, such as the aforementioned 2/28 hybrids; all of LendingClub’s and Prosper’s personal loans have fixed rates and equal payments over time. Of note, Avant does have less stringent credit requirements than other players in the space. The startup offers what it calls near-prime loans to borrowers not quite prime, but not as risky as their subprime peers. Understanding borrower risk and assigning appropriate interest rates isn’t the only advantage alternative lenders have in their corner, though: They’re also using more advanced underwriting models than those used by traditional banks. Upstart, which advertises “data-driven” personal loans, is just one example of a company using an income-prediction algorithm that takes profession, college, major, standardized test scores, grades, projected inflation and more into account.
A higher standard
America’s mortgage lending market certainly wasn’t always as wildly irresponsible as it became during the height of the housing bubble. Lending standards gradually loosened over time right under the nose of regulators. This underscores a key reality: As the explosive growth in marketplace lending continues, governments will need to monitor the practices of the industry’s leading players. For now, though, it’s clear the space is holding itself to a much higher standard than subprime mortgage lenders did almost a decade ago.
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