Frequently asked questions

 

The marketplace lending industry

+ What is marketplace lending?

Individuals and small businesses are no longer limited to applying to banks when they want credit. They can now apply online to marketplace lending platforms. The platform vets the application and, if approved, sets an interest rate and places it on the platform. Qualified investors who use the platform can choose to fund the loan at the agreed rate for a fixed time. The platform takes fees from the borrower and the investor.

+ Who are the borrowers?

On consumer platforms, borrowers are individuals looking for a loan for any number of reasons. The majority are taking advantage of better interest rates to consolidate existing debt, such as credit card debt.

On small business platforms, there are a broad range of potential borrowers, depending on the business type. The funds are typically used to fund expansion and growth. They are usually short-term in nature. The majority of small business platforms have minimum requirements for the borrower before they will consider originating a loan, such as minimum time in business. Many take personal guarantees from the owners of the business as well as security over business assets.

+ How do the online marketplace lending platforms get paid?

Platforms collect fees from borrowers and investors. Borrowers pay an upfront origination fee, ranging from ~1-5% of the loan size, and investors pay fees (usually 1%) for the platforms to service the loans.

+ Why invest in marketplace lending?

Accepted best practice globally is for up to half of an investment portfolio to be in credit and fixed income investments. Investing in our funds is a way to diversify your portfolio with an asset that is:

  • Low volatility
  • Offering high yields at lower risk
  • Defensive because of its low correlation to other asset classes like shares and bonds

+ How big are the loans?

Loan sizes range from $1,000 to $500,000. The typical loan is in the region of $14,000.

+ Are the interests of marketplace lending platforms aligned with the interests of investors or those of borrowers?

Marketplace lending platforms have aligned themselves with investors in numerous ways. Platforms receive income from investors on a monthly basis as payment for servicing the loans. This 1% fee is charged based on the outstanding balance of the loan. If the borrower defaults on the loan, the platform does not get paid. The platforms also have an obvious incentive to originate high-quality loans that are likely to make all their repayments. If the platforms do not ensure quality control on their borrowers, investors will not purchase their loans. This will, in turn, lead to failure of the platform. Finally, the vast majority of platforms will reimburse any investor in the case of borrower identity fraud.

+ How accurate are the credit models of the marketplace lending platforms?

The credit models are based on current and past credit behaviour provided by a number of sources including the credit bureaus, application information from the applicant, and credit and payment data from third parties. Leading US consumer platforms believe their credit models are far more effective as generic credit bureau models. The software of marketplace lending platforms is built for online transactions. Their fraud prevention models are running at significantly better statistics than industry standards.

+ What is the quality of borrowers?

The average borrower on leading US consumer platforms are well into the prime category. The average FICO score is ~695 (anything > 660 is considered prime) while the average income is above US$70,000 which places them in the top 10% of all US earners. Typically, only 5-10% of applications get approved for a loan.

+ How different are these loans to those of the subprime crisis in 2008?

Very different.

1. A focus on the ability to repay

The 2008 crisis originated from lending by financial institutions to un-creditworthy borrowers looking to benefit from the seemingly unstoppable rise in US housing prices. The lenders’ focus was on the asset not on the borrowers ability (or inability) to repay. The complete opposite is true for marketplace lending. Since the majority of these consumer loans are unsecured (i.e. there is no asset backing them), the entire decision on whether to lend money is based on the borrower's ability to repay.

2. Credit scores of the borrowers

The vast majority of borrowers on the major platforms’ standard programs have FICO scores of more than 660. We fund loans to borrowers whose FICO score is, on average, closer to 700. This ensures that the borrowers are prime borrowers, not sub-prime.

3. Different incentives to write loans

In the sub-prime mortgage crisis of 2008, intermediaries (such as mortgage brokers) had an incentive to write as many loans as possible because they received a commission for writing the loan. It didn’t matter to the intermediary if the borrower eventually defaulted — they already had their commission — so there was no incentive to assess the borrower correctly. The complete opposite is true in marketplace lending. Firstly, the platforms are paid to service the loans based on their outstanding balance. Secondly, if the platforms relax borrowing standards and have a large spike in default rates, investors will abandon that particular marketplace. Without investors to fund loans, the platform has put itself out of business.

The role of Global Credit Investments (GCI)

+ What is GCI’s role?

We aim to buy the best loans from marketplace lending platforms and make them available to investors via a managed investment scheme. Our fund offers investors the prospect of a high yield with reduced risk due to our expertise and the diversification provided by hundreds of loans and multiple platforms.

+ Why don’t I just fund loans directly through a marketplace lending platform myself?

Some advantages of investing through our fund include:

  • Diversification - instead of investing in one or a handful of loans, your investment (and risk) is spread over a large number of loans
  • Due Diligence - we know which marketplace lending platforms are doing the best job of assessing credit risk
  • Loan Selection - we know how to choose the most valuable loans from those platforms
  • Ongoing Expertise - we are investing at scale, which means we are learning at scale and refining accordingly

Investing in the GCI fund gives you access to our expertise and spreads your risk over multiple loans approved through multiple platforms.

+ How can you assess the platforms’ performance?

Unlike traditional banking, marketplace lending is highly transparent. To raise confidence and encourage investment, the platforms release volumes of loan data. This data allows us to run quantitative analysis and modelling to build and refine a proprietary algorithm that chooses the best platforms and the best loans on those platforms.

+ Who does the screening of loans in the fund?

Marketplace lending platforms screen borrowers just as a bank would. Like banks, they use traditional underwriting techniques like FICO score and debt-to-income ratios. They also apply additional technological checks that are available in the new age of social media. Only around 5-10% of applications pass this screening process and are approved by the platform.

The approved loans are then placed on the platform where investors can see them and choose whether to fund them. At that point, we apply our algorithm to choose only the best of those loans to fund.

+ How have you decided which platforms to invest through?

We have several criteria we consider. They include a platform’s:

  • Underwriting standards
  • Management team
  • Financial soundness
  • Track record of returns

+ How do you decide which loans to buy?

Our algorithm has one job: to rank the loans approved by the marketplace lending platforms and select the ones that we believe will perform best. It makes that decision based on a range of critical factors that we have determined affect a borrower’s ability to repay.

Because we are investing at scale, the algorithm is always being tested and refined.

Risks

+ What about the risk of default?

It’s impossible to negate entirely the risk of borrowers defaulting. We significantly reduce the risk through rigorous screening. And we reduce the impact of individual defaults because our fund contains hundreds of loans. Defaults are factored into our return calculations at the outset and we focus on what net returns will be to our investors.

+ What happens when a borrower defaults?

It is unavoidable that some borrowers will stop making payments regardless of any additional collection efforts. However, these are not “virtual” loans. They are real-world loans with the same consequences for defaulting as if the money were borrowed from a bank. A borrower who defaults will damage their credit score and likely see the debt handed over to a collection agency.

A “charge off” (when there is no longer a reasonable expectation of further payments) typically occurs when a loan is 150 days past due. Platforms may sell charged-off loans to a third party that attempts to collect the outstanding payments. If funds are recovered, investors receive a pro rata share of the recovery amount, less any collection fees.

Some of these bad debts are recovered, but others are not. The best tool at an investor’s disposal is diversification. By having a portfolio that comprises hundreds of loans, investors can limit the impact of a single default on their portfolio.

+ What happens to the loans when interests rates go up?

Delinquencies and charge-offs are more strongly influenced by underlying macroeconomic conditions such as recession and unemployment than by rising interest rates. All loans generated on marketplace lending platforms are fixed rate and fixed term. We can’t say that rising interest rates won’t squeeze a borrower’s overall financial position, but we can say a rise won’t affect the size of the repayments on their existing loans. New loans will likely have a higher interest rate attached as platforms respond to an increase in interest rates, but that depends on the platform. (And of course, borrowers can decline a loan that’s approved but at an interest rate they think is unmanageable.)

+ How will these loans perform in a downturn?

The majority of loans that marketplace lending platforms have originated have come during a relatively benign macroeconomic environment. For that reason, it is difficult to predict exactly how these loans will perform in a downturn. Marketplace lending did exist during the Global Financial Crisis of 2008. Although small in absolute dollar amount, we are still able to analyse the performance of these loans over that time. Our analysis shows that even during a poor macroeconomic environment, such as that during the GFC, marketplace lending assets would still have made a return in a highly diversified fund like ours. Defaults on loans would have to more than double from current levels for investors to lose any of their investment.

+ What happens if a platform goes bankrupt?

Almost all the platforms (and all of the platforms that GCI will be investing through) hold the loans in a bankruptcy remote vehicle. Should the platform go bankrupt, a third party will step in to take over the servicing of the loans.

+ Could I suffer a capital loss?

Marketplace lending platforms make their data available to investors and potential investors because the transparency encourages investment. GCI has analysed the available data extensively and stress tested loan portfolios. These portfolios are highly resilient to downturns in macroeconomic conditions. Defaults would have to more than double from current levels before investors would experience any capital loss, let alone lose all of their investment. To offer a reference point: defaults rose to approximately 1.5x current levels during the GFC in 2007-2009.

+ What is my currency risk?

The GCI Diversified Income Fund is denominated in US dollars and is not hedged to the fund’s US dollar asset exposure.

Fund information

+ What is the policy for cashing out?

Redemptions are processed quarterly, subject to portfolio liquidity. Ninety days’ notice is required.

+ Will my returns be taxed?

Yes, your returns are taxable. At the end of each year, we will send you a statement of the interest you have earned, net of our fees, to make it easy to fill out your tax return. You should obtain specific taxation advice relating to your particular circumstances from a suitably qualified taxation advisor before investing in the GCI Diversified Income Fund.

+ How do you report?

You will receive a monthly email from the fund administrator with key data such as net asset value (NAV). You will also receive a monthly performance update from GCI.

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