Interview: “Transparency is key in fintech credibility”

Emmanuel Daniel, The Asian Banker (ED): I’ve been speaking to fintech originators and the entrepreneur community that has been building the fintech proposition around the world. When did Landbay start this peer-to-peer (P2P) lending platform?

Gray Stern (GS): We started working on the business back in August 2013. It was very nascent, an acorn of an idea at that point. It took us about six months to settle on lending against Buy-to-Let property, and another two years to get to this point. We could classify this as our proof of concept stage.

ED: And that’s because unlike other lending platforms that are more of a consumer credit type of businesses where there are no assets at the back-end, you had the need for legal documentation and infrastructure to be put in place?

GS: That’s correct. We went into this business first and foremost looking at the quality of the credit that we’re going to offer our clients. We looked at being a traditional mortgage lender first, which requires a quite complex infrastructure to be put in place, a lot of relationships in terms of servicing loans, legal documentation, valuation, and a framework to potentially enable us to offer our mortgages through capital market securitisation.

ED: Which is what you want to do eventually.

GS: Yes, at this stage we’re originating some of our debt into a rated warehouse that will be securitised, but ultimately we would like to get a balance between retail investment and institutional investment. There’s a lot more value in building a retail brand for a business like Landbay.

ED: I want to distinguish what you do and what other players in the UK such as Zopa and Lending Club do today. You are different only in that you are an asset-backed lending platform. You talk about cost of funds as if you have to be the lender of sorts. In a P2P environment, I don’t see the need for cost of funds as a concept because it’s really the rate at which the lender wants to lend that matters. In that sense, are you more of a broker in this regard, or do you actually fund the lending?

GS: That’s a good question. The way our model works is, we give exposure to our investors in diversified portfolios of mortgages that match their risk rates and terms. The only way we can do that in a compelling way is to originate those mortgages, ensure that they meet very strict underwriting credit quality, and pre-fund them. It can take 6–12 weeks to actually complete the process of the mortgage so we don’t have the liberty to take investors’ funds and ask them to wait for 6–12 weeks, earning zero interest. So we essentially create mini-warehouses of mortgages and structurally package those as products that investors can buy online within a couple of minutes.

ED: You have more hands and legs into the process than an average P2P platform, in that you have to build a warehouse, an inventory, and a proposition to the lender that he is lending into a diversified risk portfolio. This means that you also take a view on the risk portfolio that you are building. From the time that you’ve started, how differentiated is your risk profile, appetite, and methodology from what a traditional bank does today?

GS: From a retail investor’s perspective, there are big differences in risk between putting your money in protected bank savings and in businesses such as Landbay. In the UK, if you operate a bank, you are covered by the Financial Services Compensation Scheme, which gives you a cover up to £75000. So, it’s guaranteed by the government. With Landbay, we’re offering exposure to mortgages over property investments to experienced landlords. We typically lend 60%–65% of the property’s value. Most importantly, we are very concerned with the cash flows associated with the property, i.e., the rent. Rent is incredibly important in terms of our underwriting criteria because it ensures that if we lend into areas with high rental demand, our mortgages can be serviced.

ED: So you don’t lend to owner-occupied?

GS: No. The reason is that our cost of funds is too high at this stage to go up against the high-street banks. In the UK, if you’re a good credit risk, you can get a mortgage at 2%–3% per annum. This is very difficult for us, to be offering 2%–3% with an at-risk investment proposition.

ED: What can you say about the customers or borrowers who are approaching you online? Are they geography-centric? Is it national? Do they tend to be salaried and wishing for a second property? Are they high-risk players, entrepreneurs themselves?

GS: Our core borrower profile is an experienced landlord who owns five or more properties. The niche that we play in isn’t well served by the mainstream high-street banks because they see these clients as not owner-occupiers. They are professional commercial borrowers but are not big enough to invest their commercial teams or their corporate property teams in, so they straddle a sector that is too complex an underwriting for their algorithms to deal with; and too small with not enough money for them to make, to push them to corporate. In the UK, we’re competing against challenger banks and specialist lenders. Companies like Paragon—new banks—have been established mainly to attack this part of the market. And in the UK, the professional property investment market is probably between £10 and £20 billion per annum, depending on whom you speak to.

ED: When you say proof of concept, would you say about 10 clients on either side?

GS We started lending seriously, and had the infrastructure in place to start scaling up, probably 12 months ago. We have done 200 mortgages in that time. We’re now doing 30–40 a month and we would expect that growth trajectory to continue into the future.

ED: So the 20–30 coming on stream, that’s six weeks of due diligence and then the inventory gets added on to the portfolio. At the same time, do you have another team that goes out to build an investor portfolio to match that?

GS: Yes, so the key challenge for Landbay is a bit different to say, Zopa. Their challenge is origination, that is, getting the stock of consumer credit; for example, people borrowing for holidays, home improvements, or small and medium-sized enterprise lending in the case of Funding Circle. They spend the vast majority of their marketing resources just on finding opportunities to lend. Landbay is quite different from that because we operate in such a large market that is underserved by the high-street banks. We don’t have a problem with origination. We’re doing £5 million a month in a market that’s spitting out £2–£3 billion a month. It will become a challenge in the future but at this stage, we’re restricted by capital. Our efforts are spent on building a credible retail investment product that attracts more retail investors, as well as working on the wholesale side with investment banks.

ED: How is that part of the equation coming along?

GS: Very well. It was a bit naïve of my co-founder John and I to initially think that it would be quick to get institutional investment on board. But we started talking to the investment banks two years ago and it became quite apparent at that time that in order for them to get comfortable with the credit quality, what we were doing, and our ability to scale, we would have to put the right infrastructure in. That means recruiting people who have a huge amount of mortgage experience in the UK market, getting ourselves securitisation-ready, which, whether we sell our mortgages to banks or retail investors, requires putting a structure in place.

ED: How much of that is technology and how much is deal making on either side?

GS: You can overstate the value of the technology in what we’re doing. For institutional investors, however, unless they’re investing in the fintech business, if they’re just looking at the debt, they are not affected by how we operate, technology-wise.

ED: But do you need to parade them, do you need to make them and the borrowers visible on your site? How much transparency do you need of the information on both sides?

GS: Transparency for Landbay is the absolute key to survival and building trust. We’re competing against companies like Zopa that have been around for 10 years. Funding Circle has been around for 5, doing meaningful volumes of business. We’re offering a product that has similar interest rates to those, so how do we differentiate ourselves? It’s security, it’s the quality of the asset. We’re very forthcoming in terms of telling our investors what they’re investing in. We publish our whole loan book. It’s quite small at this stage; we have done £40 million at this stage. We’re very lucky in that because of the quality of the debt that we’re bringing on board, we haven’t had any late payments and we have had zero defaults—it’s robust. It’s in our interest to be transparent because it a unique selling point.

ED: In terms of the risk premium, what are your rates like relative to high street banks?

GS: On a UK high-street savings account, if you’re talking about the big banks—the Lloyds and the Barclays, Santanders—you’re going to be earning anything between 0% and 1.5% on your money. With second-tier challenger banks, the people we’re competing with on the borrower side, like Paragon, Shawbrook, you might get 2.5% on your money. Landbay, being not protected by the FSCS government guarantee, offers 4%–4.5% and we’re lending out at between 5% and 6%.

ED: If you take the fintech phenomenon, is there other information you’re adding on to your portal that makes it a much more compelling proposition?

GS: We have a vision of where we’ll take our business. Our strategy was to put in place a mortgage engine, to be able to bring in both retail and institutional investment at a level where we could write a meaningful number of mortgages against the challenger banks. We don’t do short-term lending at this stage, high-risk lending, like bridging development finance. We just target vanilla mortgages. Our view was that once we have the mortgage engine in place, it works much like a conveyor belt. Once you have the infrastructure in, you have money coming in, you can scale very well. We took the view that once that’s in place, we can start bolting on complementary products. The view is that if you can make money on your core products then the key to growth is to start looking at new products as a way to originate more volume for our mortgage engine.

ED: And on the investor side, how retail will you go? You sound like an institutional business, almost like private banking.

GS: We operate a low-margin business and we need to scale. Just to keep the lights on, we need to build a loan book that is small in terms of banking, but in P2P, £250 million just to stand still. It was very important for us to get institutional money just to get to that point. It has always been our view that we use institutional money to scale and grow the retail brand organically in the background. That’s the ultimate ambition of any P2P business. We have credibility now. We do not market much but we do see opportunities to differentiate Landbay as a retail investment play.

ED: Although your position is as a fintech phenomenon, your costs will be on the risk, origination, and documentation side. If you want to securitise, that’s where a lot of costs come from.

GS: It’s interesting. The whole securitisation market is probably one that’s massively ripe for disruption, more so than anything else we’re doing. And to some extent, the whole concept of what we’re doing a P2P mortgage bond is essentially a mini-securitisation—taking those portfolios, potentially tranching them by risk, and offering something that’s standardised and transparent. The transparency is the key point of difference. Obviously, the global financial crisis was caused by a lack of transparency. Landbay takes the good things from that structure and packages them up in a way that the man on the street can understand and make an educated decision on where their money is going.

ED: When you talk to investors on the investor side, is it both as an investor in your portfolio and in your company?

GS: We’re nascent. So we have probably grown slower than many fintech P2P businesses because we have a different business model: it’s more old school financial services. And then you start bolting on the tech and the e-commerce sides. So when we talk to investors, there are two potential equity investors—the Silicon Valley style venture capitalists who want to hear about us changing the world, reinventing the mortgage, the uberisation of finance. And then you’ve got the FS (financial services) type of investors, the hedge funds, the investment banks, who ask you, is your credit of good quality, can we see ourselves giving you money to lend? They almost see the value of Landbay on the fintech side as a bonus. It’s a bonus if they make money on us, or if we manage to IPO because we’re the next Lending Club.

There is a bit of smoke with people talking about the huge disruption that a lot of fintechs say they are doing. I don’t think they’re quite at that level at this stage. We’re just making meaningful improvements. We’re not curing cancer or reinventing the infrastructure that financial services are built upon. We’re really just nipping at little specialist segments within the broader market.

ED: Do you think you’ve come to a point where you affect either funding costs or a trigger point where you actually become a phenomenon? Because you’re talking about two things here: banking, or the funding business; and fintech, which is a different thing. At what point do you think your tipping point would arrive?

GS: It’s a tricky one. With the product that we have at the moment in terms of scale, our tipping point will come when pension funds and insurance start funding our mortgages. That’s when we could potentially get into the broader mortgage market. On the retail side, in terms of investment coming in, that just takes time. That’s going to be largely driven by being able to prove to our customers that our credit quality can move through circles. We haven’t experienced a downturn at this stage so while it is all well and good for us to say that lending on Landbay is a good risk, people have to trust us at this stage. And the easiest way for that to happen is to prove it through a downturn.

ED: So you’re doing £5 million a month in the assets you’re originating? That’s only 60% funded, which means that the risk is pretty low. You’re asking for equity on the part of the borrower, which then further prequalifies the borrower to an even smaller community.

GS: In the UK, the number of properties that are bought with cash is about 50% of the total market. So there isn’t a shortage of borrowers with significant equity out there. The people that we target are prepared to leverage to get their yields up. But we’re not talking 100% mortgages. We’re talking about people looking at the UK rental market as a low-risk asset class. So we have done quite a bit of work using Bank of England stress testing, the same stress test that they apply to high-street banks. We have done internal modelling against our loan book based on what’s there now and how it will evolve over time. We’re comfortable that it performs well. The last stress test we did was based on a similar economic event to 2008, and we were forecasting a loss of 0.5%. Bear in mind that we provision from our origination fees about 0.6, so we always look to provide our retail investors with enough cover through provisioning to offset losses.

ED: How does liquidity feature in your model?

GS: Liquidity is a key challenge for us because if there is an economic downturn, there’s likely to be a run on alternative financiers like Landbay. Because our investors are a direct match to the underlying asset, if we don’t have redemptions coming through or there’s no new investment coming onto the platform, those investors will have to wait until the underlying assets redeem.

ED: And is it part of the clause that you put in place?

GS: That’s correct. That is a risk borne by our investors. We think that by diversifying our funding mix across retail, getting our loans in a format that enables them to attract institutional investors, we can reduce risk. The more options we have to essentially exit the mortgages, the better, and that’s what will drive liquidity. We also try to offer mortgages at different terms to try and smooth out the repayments.

ED: It would be good to follow through and see where you are in about two years’ time!

GS: We probably underestimated how much traditional financial services were required for us to put that initial infrastructure in place in order to get that credibility to start scaling.

ED: How much was that in funding?

GS: It hasn’t cost us a huge amount. Probably about £4 million to get to this point. We have a team of about 25 now and we think that we can, based on the overhead structure we have in place now, to get to £20–£30 million a month of origination by the end of 2016. Our goal is to take meaningful market share in that particular segment of the UK market. As a business we can get to £1 billion per annum of lending in the UK. I think the broader opportunity for our business is to take our business model, technology, and brand and potentially move into other niches. But I don’t think there’s much value in us trying to take on one of the big banks, though over time that will potentially become more interesting for us, particularly if we can get our cost of funds down.