The secret driver behind one of the fastest-growing online lending startups

Here’s to the future!
Here’s to the future!
Image: AP/Michael Dwyer
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A once-hot corner of the student loan market that was nearly killed off by the financial crisis has found new life.

On Friday, peer-to-peer lending startup Social Finance, also known as SoFi, said it has surpassed a major milestone: It has doled out more than $3 billion in loans since launching in 2011. It’s now the second-biggest online lender after industry leader Lending Club.

There’s an IPO on the horizon for SoFi, and the online lender—which began by enlisting Stanford alumni to make online loans to college students —is expanding from student loans into personal loans and mortgages.

So what’s really behind the growth? Essentially, Wall Street.

SoFi is growing at such a fast clip (on pace to hit $4 billion in loans by the end of 2015) by serving up a hot investment that had fallen by the wayside during the financial crisis.

Known as asset-backed securities, SoFi is bundling up student loans into securities backed by those loans. SoFi sells the securities to giant financial firms and hedge funds, which trade them like stocks and bonds or use them as collateral to borrow more money. Each time borrowers make student loan payments, the money trickles down to the long line of investors who own a piece of those loan payments.

“It’s an extremely important part of our business,” SoFi CEO Mike Cagney tells Quartz. “Securitization drives down the costs of funds, translates into lower loan rates for borrowers, and then attracts more customers.”

Financial firms jumped head first into student loans in the run-up to last decade’s financial crisis, “packaging anything that resembles student debt, including loans for college, primary school, tutorials for casino dealers in California and yoga instructors in Iowa,” according to a 2006 Bloomberg article.

But investors soured on student loan and other asset-backed securities during the crisis. They suffered losses tied to risky investments that were improperly rated and marketed as safe. Banks shied away from all consumer loans and a 2010 federal overhaul left the US government in charge of lending money directly to students, ending the bank subsidies that made the student loan business profitable.

Through peer-to-peer lenders like SoFi and competitor CommonBond, bankers are again finding a way back into student loans. SoFi says it will issue more than $720 million in asset-backed securities this year and will start bundling up personal loans and mortgages.

To be sure, this market is only a fraction of where it stood ahead of the crisis and represents a tiny piece of the bigger financial universe. But it’s worth remembering what happened the last time Wall Street sliced and diced loans, packaging investments that made their way across banks, insurance companies, and hedge funds.

Moody’s, the rating agency which rated the most recent bunch of SoFi securities pretty favorably, warns investors of some hefty risks. Most notably, we don’t really know how these loans would perform during another financial crisis. For SoFi, whose three only defaults stemmed from borrower deaths, there is zero real-life data on what happens when a customer defaults.

“I’ve joked even my daughter could write an underwriting model based on what bands you like, and she’d be right in this virtuous credit cycle,” Cagney tells Quartz. “We know it’s up to us to prove our underwriting model is solid.”