Manatt Fintech’s Top 5 Takeaways of 2018

[Editor’s Note: This is a guest post from Brian S. Korn, Leader, Digital Finance and Marketplace Lending, Partner, Manatt Financial Services (above left) and Benjamin T. Brickner, Associate, Corporate and Finance. You can learn more Manatt’s work in digital finance and marketplace lending by visiting their website.]

In the financial technology industry (fintech), 2018 was a fascinating and fast-paced year. The digital finance industry has started to mature and flourish, with more creative niche originators than ever before, more investments now available online and general acceptance of marketplace lending as a bona fide securitization vertical.

It was also the second year of the Trump administration, and unlike in prior years, the industry avoided major scandal and enjoyed a lighter-touch regulatory environment at the federal level. Without further ado, here are our top five fintech takeaways for 2018:

  1. Now accepting fintech charter applications. Hello? Is this thing on??

The third time was the charm for special purpose fintech charters issued by the Office of the Comptroller of the Currency (OCC). After three comptrollers—first Comptroller Thomas Curry, then Keith Noreika and now Joseph Otting—each had a hand in promulgating fintech charters, the OCC finally announced in July that it will accept applications from fintech companies for special purpose national bank charters.

The announcement was accompanied by a helpful OCC policy statement and a Department of the Treasury fact sheet that effectively endorsed marketplace lending and the prospect of special purpose fintech banks. Fintech charters promise a national pre-emptive lending license that removes the risk of the prevailing bank partnership model and the compliance burden of state-by-state licensing.

Raining lightly on this parade was news that fintech chartered banks would be subject to the same capital and compliance burdens as other banks. But they will not be required to accept deposits, and therefore will be exempt from obtaining deposit insurance and from Federal Deposit Insurance Corporation oversight.

Raining harder, however, is the prospect that the first applicant likely will be joined with the OCC in a pending lawsuit by the New York State Department of Financial Services (DFS) and other state regulators. A previous lawsuit challenging the authority of the OCC to grant fintech charters was dismissed for lack of ripeness—the OCC had yet to receive an application, much less grant one.

With a live fish on the hook, however, the new suit presumably will proceed on the merits. The OCC and state regulators are likely to have deeper staff and legal budgets than a fintech charter applicant caught in the crossfire. However, Superintendent Maria T. Vullo, one of fintech’s toughest critics, recently announced her departure from DFS in February 2019. It is unclear how this fierce consumer protection advocate’s departure will affect New York’s position on fintech charters.

With the promise of greater market access tempered by legal uncertainty, we expect to see a rush to be second in line for a fintech charter in 2019. Despite the risks, we believe the OCC stands on solid ground and expect their view ultimately will prevail.

  1. Fintech has weathered recent market volatility well and shows little sign of slowing.

The final months of 2018 have seen increasing volatility and downward pressure in equities, with triple-digit declines in major U.S. indices a regular occurrence. At the same time, loan volume is up and investment in loan-based and other fintech products is higher than ever. While this might seem counterintuitive, we believe investors have grown comfortable with online investing and major platforms now have an established record of delivering forecasted returns. These maturing trends may be making inroads into public equity markets’ inherent liquidity and transparency.

Moreover, fixed rate returns, limited losses of principal and a relatively steady consumer borrowing base with historically low unemployment (for now) have increased crowdfunding platforms’ appeal as increasingly safe and secure investment vehicles. Given the checkered history of crowdfunding and predicted parade of horribles following the 2007–09 financial crisis, it is ironic to now see alternative online finance becoming a benchmark of safety and security.

  1. Credit markets are open and borrowers are increasingly flexible.

The credit market for online lending is deeper and wider than ever before, with several platforms accessing these resources in the latter half of 2018. Platforms that previously could not attract institutional funding until originating at least $100 million now have their choice of facilities at earlier stages of growth. Banks are using platform facilities as early entrees to securitization relationships as banks seek to develop footholds farther upstream. We see the overlap between recent Structured Finance Industry Group ABS and LendIt conferences as evidence of this trend.

At the same time, U.S. consumers (and to some extent, small businesses and real estate industry members) have shown a willingness to borrow at rates higher than their actual default risk would normally dictate. This affords platforms greater flexibility to access capital from different sources. Banks tend to lend at mid- to high-single-digit rates, and we have even seen some platforms attract Libor+250 and +200 pricing, down from +450 and +600 one year earlier. Some banks are even using these facilities to comply with Community Reinvestment Act requirements to provide banking services to low- and moderate-income individuals.

Advance rates are also creeping back over 90%, with less capital needing to be raised from mezzanine funding and equity in order to maximize a facility. Family offices, hedge funds and hard money lenders are still providing facilities to earlier-stage platforms and those with riskier borrowers at rates around 11–15% plus 1–3% warrant coverage. Committed facilities are also a higher percentage of the credit deals we see today, whereas the prior year was dominated by forward flow and option loan purchase programs. In other words, if a platform originates within a predetermined definition of “Eligible Loan,” the facility gets funded.

  1. Marketplace lending is a bona fide securitization vertical.

Break out the champagne! The dire predictions of a slowdown in marketplace lending securitization as a result of the 5% risk retention rule and just plain unfamiliarity with the sector have not come to fruition, as 2018 was the most robust yet. More deals were done, more sponsors completed transactions (now more than ten sectorwide) and the market seems finally to have shaken off the 2016 LendingClub scandal. According to PeerIQ, through the third quarter of 2018, more than $40 billion was issued across 134 transactions, up 34% from the prior year. Upstart, Upgrade and Laurel Road joined the roster of new issuers, along with repeat issuers LendingClub, Prosper, SoFi and CommonBond.

Banks are taking the sector seriously, with Citigroup, Deutsche Bank and Credit Suisse leading the league tables. Also of note is that marketplace lending rating agencies were led by DBRS and Kroll Bond Ratings, with traditional powerhouses S&P, Moody’s and Fitch lagging behind.

It remains to be seen, however, whether the party will continue in 2019 given possible weakness in economic growth and the threat of divided government and future government shutdowns.

  1. States and “regulation by class action” are running counter to relatively relaxed federal oversight.

State financial agencies continue to wield the hammer in the fintech industry. Strict enforcement of states’ securities laws (often referred to as “blue-sky laws”) is a staple of any fintech legal department, as are frequent notices on failures to license, charge a lawful interest rate, calculate the rate correctly (including origination fees) and make required disclosures. Federal consumer lending compliance—including Truth in Lending, Fair Credit Reporting, and Unfair, Deceptive or Abusive Acts or Practices—provide important structure to much of the compliance a platform must undertake.

The federal agencies regulating unlawful and unfair lending conduct have noticeably taken their foot off the gas in the last year. For example, the Consumer Financial Protection Bureau, which for most of last year was headed by Trump appointee Mick Mulvaney, brought only nine enforcement cases in 2018. At the same time (and perhaps also as a result), states have become more aggressive in enforcing conduct by members of the financial services industry.

The bank partnership model of lending—wherein loans are originated through fintech platforms by chartered banks and then sold back to the platforms—has been under regulatory assault for several years. The 2017 Madden v. Midland decision still looms large over originator and investor behavior in the Second Circuit states of New York, Connecticut and Vermont, where the decision now applies.

True lender cases have since been decided, even in preliminary motions, that have had wide impact on online lending and the bank partnership model in the states or jurisdictions in which they are brought. The most prominent pending case is the one brought by the Colorado attorney general against Avant and Marlette, with a countersuit by WebBank and Cross River Bank, the two banks that originate loans from borrowers sourced by these platforms. The case is pending, but we expect the final decision will have far-reaching effects on the industry.