Peer-to-peer lending has hit the big time. It started just before the financial crisis as a fresh idea among Silicon Valley entrepreneurs to connect lenders directly with borrowers — to have “the little guys helping the little guys” as one borrower has described it. But now, under relatively stringent SEC regulation, it has changed its face entirely — and is attracting big money from institutional investors hungry for yield. And as you can imagine, it has also attracted leverage. Borrowing at 4.5 percent and investing for a 10 percent return of course seems like easy money — until the risk analysis proves inadequate.
The largest U.S. peer-to-peer lenders are Prosper Marketplace and LendingClub. The former boasts John Mack (former CEO of Morgan Stanley) and Larry Summers as board members.
The model is fairly simple. Individuals sign up to borrow money for a given purpose — often the consolidation of credit-card debt. The platform vets them and assigns an interest rate (more on this process below). Then lenders who log in can choose loans to fund — from lower-rate, safer loans, to higher-rate riskier ones. Their returns currently average 9 to 10 percent according to company prospecti. Not bad in the current environment.
Of course, since this is an investment, not a deposit, there’s no guarantee that you won’t sustain a loss from a nonperforming loan. (A class action suit by former Prosper lenders who lost funds was recently settled — although this action derived from loans that were made before Prosper and the other lenders came under the purview of the SEC.)
Investors, then, are putting all their trust in the capacity of the platform to accurately vet and assess the borrowers. And it turned out that the platforms were initially not doing that job very well.
In 2011, a U.K. peer-to-peer lender called Quackle went bust. It had attempted crowd-sourced peer ratings (think eBay or Yelp), in which creditworthiness would be assessed by peer reviews. Not a good system — they ended up with a near 100 percent default rate.
Prosper’s initial data weren’t much better. From 2006 until a 2008 revamp of its vetting process, it had a 36.1 percent default rate, according to data from an industry website. That was “Prosper 1.0.” In 2008, the company shut down voluntarily to comply with new SEC oversight. With a more stringent vetting process now in place, one that eliminates up to 90 percent of applicants, the subsequent loans are producing much more robust returns.
In fact, with the peer-to-peer model projected to reach $20 billion in loans annually by 2016, the returns have proven almost too robust. Now big institutions want to snap up all the available loans — and they’re starting to do it on margin.
The founder of Prosper left the firm in 2012. He laments that the arrival of big institutional money has derailed his original vision of the project — a slightly utopian Silicon Valley dream of democratic banking in action. The CEO of LendingClub is wary as well, pledging to pursue “sustainability” by ensuring that no single investor will control more than 5 percent of the loans, and leverage no more than 15 percent of them.
While peer-to-peer lending is obviously meeting an unmet need, we’re wary of it ourselves for a variety of reasons. One, we’re somewhat skeptical that peer-to-peer lenders can adequately control risk — and if they do, that they will end up being very different from traditional financing sources in terms of their willingness to lend. The prospect of adding leverage to a mix of unsecured loans for borrowers whose ability to repay is determined by algorithmic analysis also gives us pause, and reminds us a little of the history of the subprime debacle. Big investors are very excited about the returns… but to us, the message is still caveat emptor until the companies improve their risk underwriting techniques.
For more commentary or information on Guild Investment Management, please go to guildinvestment.com.