The real flaw of online lenders LendingClub, OnDeck

The market turmoil earlier this year revealed deep flaws in the business models of online lenders. Although not all are equally vulnerable, they share a common problem: dependence on short-term financing.

After uncovering deceptive sales practices and firing its general manager, LendingClub LC -2.78%

scours the market for loan buyers. So far, the jury is out on whether he will succeed. Last week, the company canceled a shareholders’ meeting at the last minute, citing its inability to provide clear guidance on where the company is headed.

Meanwhile, another top publicly listed online lender, OnDeck Capital,

boasts of having a more stable funding model. That’s true to some degree, but it still seems vulnerable to disruption.

OnDeck provides loans to small businesses and LendingClub to consumers. But the most important difference is OnDeck’s relative flexibility in terms of what it does with loans once they’re made. Instead of holding loans, LendingClub sells them to individuals, hedge funds and other investors. If they stop buying loans, as many did in the first quarter, this pattern is subject to instant disruption.

In contrast, OnDeck has the ability to hold loans on its balance sheet, which LendingClub is now considering. OnDeck now retains 74% of its loans, up from 60% last year.

This, however, is not a real solution. Holding loans requires financing. The company says its funding sources are diverse – it uses its own equity, securitizations and lines of credit from banks and other lenders.

The available capital is by nature limited. And the other two sources are wholesale forms of funding, which can be fickle. Securitization markets can dry up at first glance, and credit lines, most of which expire in 2017, need to be renewed regularly.

What could induce creditors to pull out? An economic downturn could hit the company’s small business customers hard, especially when they pay very high rates, averaging 40% in the first quarter.

The company, which was founded in 2007, says it has experience handling a recession. But it was much smaller back then, and every downturn is different.

OnDeck also has unique risk characteristics. About a quarter of its loans come from what it calls funding advisor program partners. These are independent sales agents who refer customers for a fee. In its annual filing, OnDeck states in its risk factors that these agents charge upfront fees without recourse, and therefore may be incentivized to mislead loan applicants or help them submit false application data.

As LendingClub shows, all it takes is a single scare for market participants to pull back abruptly. OnDeck’s funding sources may be more diverse than LendingClub, but they still don’t compare to the sticky long-term deposits of traditional banks.

Obviously, online lenders still have lessons to learn from old-fashioned banks.

Write to Aaron Back at [email protected]

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Appeared in the June 13, 2016 print edition.

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