“Fascinating article. Clearly private investors in consumer loans and mortgages believe (correctly) that geography often matters when it comes to predicting credit losses and net returns, yet the government long-ago banned geography (for regulated banks and mortgage lenders), because of its often close association with race and/or lower incomes…
…Clearly, the government’s well-intended policy to ban geography and therefore prevent racial discrimination (“red-lining”), also means that consumer and mortgage underwriting and risk-based pricing models are flawed. In other words, well-intended government is once again distorting free and fair markets from making the most rational economic decision. This is just one simple example of how our government distorts rational private markets, yet when these markets fail, government inevitably blames the failure on the private sector and not the government’s distortions. That’s the 2008 financial crisis in a nut-shell.” Mike Perry, former Chairman and CEO, IndyMac Bank
March 8, 2016, Ianthe Jeanne Dugan and Telis Demos, The Wall Street Journal
Online Finance Draws on Geographical Data, Raising Questions
Traditional lenders have been sued by federal regulators for skipping neighborhoods
Harlan Seymour set up a computer program to invest in consumer loans that filtered out potential bets partly on geography. As a result, he put more money into thriving places such as La Jolla, Calif., above. PHOTO: GETTY IMAGES
By Ianthe Jeanne Dugan and Telis Demos
When Harlan Seymour wanted to invest in consumer loans in 2014, the software engineer set up a computer program that filtered out potential bets partly by where a borrower lives.
The strategy paid off. He said he earned about 8.5% over the next year on hundreds of thousands of dollars in loans he funded on electronic lending sites that arrange loans for borrowers and then sell the loans to investors. “I found that the economic health of a borrower’s city affected loan performance,” said Mr. Seymour, 54 years old, of San Mateo, Calif.
Mr. Seymour’s strategy shows how the fast-growing online-finance business has brought a new twist to one of the most sensitive topics in lending: geography. Lenders, including these online services known as “peer to peer” marketplaces, aren’t allowed to discriminate based on age, race and other factors. Skipping neighborhoods, or marketing to one neighborhood over another, has been the basis for “redlining” suits in which federal regulators accuse banks of discrimination.
The fair-lending rules were written before the boom in online lending. And they don’t deal specifically with the investors who fund the loans online.
That has created questions about whether it is appropriate for investors in online loans to look at geographic data, something some say is important to their investment choices.
“It may be unclear whether the investors in marketplace loans would have liability,” said Jo Ann Barefoot, a senior fellow at the John F. Kennedy School of Government’s Mossavar-Rahmani Center for Business and Government at Harvard University and a former adviser to the Consumer Financial Protection Bureau. “It almost certainly falls in the growing realm of regulatory gray space.”
The Equal Credit Opportunity Act, for example, defines creditors as lenders who make credit decisions and set terms, such as interest rates. It doesn’t specifically refer to investors in these platforms, which didn’t yet exist when the act was passed in the 1970s.
The CFPB, one of the agencies that enforce federal fair-lending laws, is beginning to review the structure of new lending platforms, said people with knowledge of the government agency’s research.
The agency said it aims to ensure that companies aren’t incorporating potentially discriminatory factors into marketing or underwriting.
More than $37 billion in U.S. consumer and business digital marketplace loans were made from 2007 to 2015, said analysts at Autonomous Research.
About 16% of people who buy loans from online marketplaces use a borrower’s state to make lending decisions, said NSR Invest, a marketplace-lending investment-advisory firm.
The two largest sites that sell loans to retail investors, LendingClub Corp. and Prosper Marketplace Inc., said they don’t discriminate or enable their investors to discriminate and don’t make potentially discriminatory data available. In late 2014, for example, LendingClub in its public filings stopped disclosing the city or neighborhood where a borrower lives beyond the first three digits of the ZIP Code, which often refers to a broader region.
The more broad the territory—skipping states for example—the less risky legally, regulators say. Some state regulators have at times barred online lending, so some states have been left out anyway.
Still, many investors say they consider geography and other unconventional factors when funding loans. Many hold loans that were made when more narrow data about geography was available.
“Plenty of investors, myself included, avoid Florida and Nevada,” said Simon Cunningham, a peer-to-peer investor who runs an online information service called LendingMemo Media LLC. He extolled his philosophy in a piece he posted online in 2014 titled, “The Joy of Redlining: Why I Never Lend Money to Florida.” He said the state had lower returns in his analysis.
“If you’re an investor and you’re not discriminating by race, then filtering by state seems like a great way to earn a higher return,” he said. “Why would I take on extra risk?”
Ashees Jain, a founder of a peer-to-peer investment firm called Blue Elephant Capital Management in Irvington, N.Y., with about $100 million in assets, said that when oil prices began dropping in 2014, the firm stopped lending in Texas, Pennsylvania and Virginia.
“We are now seeing unemployment going up there,” he said. “These are three- and five-year loans. So we need to think ahead.”
At Asset Avenue Inc., an online platform that connects investors with small real-estate entrepreneurs, ZIP Codes are among the criteria, along with type of property and the borrower’s credit rating. “Geography is a very large indicator of the quality of a loan,” said David Manshoory, president.
The program created by Mr. Seymour, the software engineer, weighed unemployment, per-capita income, real estate and other statistics to calculate the health of a city. He said he didn’t consider race or age.
Following the program, he put more money into thriving communities such as La Jolla in San Diego and less into less thriving places. He said the program could be applied to municipal bonds and other investments.
“It’s not my obligation to fund a whole region,” Mr. Seymour said. “Investors have a right to know the true default risk.”