Loans That Avoid Banks? Maybe Not
It was that rare thing, scarcely seen in the financial world since the debut of the A.T.M. or microfinancing: an innovation to help regular people. When peer-to-peer, or P2P, lending began in the middle of the last decade, it offered an easy way for people to lend money to each other over the Internet.
On sites like Prosper Marketplace and Lending Club, prospective borrowers could list their requests, often alongside their personal stories, and people with spare cash could decide whether to finance them.
By cutting banks out of the process, borrowers typically got a lower interest rate than they would have paid on a credit card or a loan without collateral. And individual lenders earned higher returns — averaging in the high single digits — than they would have received by parking their money in a savings account or a certificate of deposit.
That blend of altruism and yield attracted many individual investors, particularly in the wake of the financial crisis, when interest rates, and trust in banks, hit historic lows.
Now, as the industry matures, a new class of investors is storming the P2P gates, and they include the very institutions that P2P had set out to bypass. Today, big financial firms, not small investors, dominate lending on the two platforms. At Prosper, which has been courting institutional lenders over the past year, more than 80 percent of the loans issued in March went to those firms. More than a dozen investment funds have been formed with the sole purpose of investing in peer-to-peer loans.
P2P sites are also attracting some of Wall Street’s biggest names as board members and investors, and investment banks are vying to manage Lending Club’s hotly anticipated initial public offering.
The influx of institutional money has supercharged the sector, allowing Prosper and Lending Club and a host of newcomers to extend more loans to more borrowers. Lending Club figures that it has saved borrowers $250 million in interest charges. The two platforms say they have made more than $5 billion in loans to date and have been doubling in growth every year.
But investor demand is now outstripping the loan supply, spurring fierce competition among investors to snatch the best loans first. And the original P2P investors — the dentists, dabblers and stay-at-home moms who helped establish the market — are finding themselves outgunned by the cash-rich, algorithm-wielding arrivistes.
P2P insiders say the new institutional investors benefit the industry. “It will drive competition, drive down rates and allow us to serve customers better,” says Alex Tonelli, a founder and managing director at Funding Circle, a San Francisco-based P2P market for small-business loans.
Still, the Wall Street makeover — some would say takeover — of P2P lending is raising concerns as the new players begin securitizing loans and clamoring for more. Insiders predict a day when the loans are regularly sliced, diced and securitized, hedged, traded on secondary markets and tracked by exchange-traded funds.
At the very least, the big players’ entry runs counter to the original notion of P2P lending as a populist alternative to the high stakes world of Wall Street. The term “peer to peer” has become something of a misnomer. Some of the latest lending platforms are ditching individual investors altogether to focus on big lenders.
Acknowledging the growing role of institutions, Ron Suber, the president of Prosper, says the industry as a whole is better described as “online consumer finance.”
Jeremiah Owyang, the founder of Crowd Companies, an organization that helps corporations navigate the so-called sharing economy to which P2P belongs, was more blunt. “It won’t be P2P for long,” he said.
When Len Kendall, a digital-marketing executive in Chicago, was considering striking out on his own in 2012, he knew that he would have to live leaner. One place to cut back was his credit cards. Despite having an excellent credit score, over 700, he was paying 17 percent interest on about $10,000 in credit card debt. That was when he heard about Prosper.
He applied for a loan and within days was approved for $10,000 to be paid back over three years at 7.5 percent interest. This loan was funded by dozens of small investors, who typically split investments over a large number of loans to diversify their risk. “It was a pretty simple decision,” Mr. Kendall says. “Why should I pay more in interest than I have to?”
Lending Club and Prosper focus on prime and near-prime borrowers, that is, consumers with FICO scores higher than 640. The platforms apply their own credit models and assign borrowers to categories reflecting their level of risk. In the case of traditional loans, banks pocket the profit. On P2P sites, the individual lenders do. “The difference is who’s benefiting from it,” says Renaud Laplanche, the founder and chief executive of Lending Club. Prosper and Lending Club take a small origination fee from the borrower and 1 percent of interest payments to the lenders.
The sites’ business model relies on scale: Lending Club, the market leader, earned $7 million on revenue of $98 million in 2013, its first full year of profitability after seven years. That was on loan volume of $2 billion.
The fastest, and some say only, way to reach the kind of scale needed is to turn to institutions with boatloads of money to lend. Attracted by peer-to-peer’s relatively high and predictable yields in a low-interest environment, big investors have jumped at the opportunity.
The first in were hedge funds, like Eaglewood Capital Management and Arcadia Funds, which borrow money to amplify their returns and use their own algorithms to increase yields into the midteens or more. Soon, pension funds, asset managers, community banks and even sovereign wealth funds joined in. Santander Consumer USA, the United States arm of the Spanish bank, has an agreement to buy up to 25 percent of Lending Club’s loans.
Today, P2P loans that once took days or weeks to finance are snapped up in minutes, particularly those with higher yields. “There is at least twice as much demand as there is supply today,” says Matt Burton, the C.E.O. of Orchard, a firm that helps institutions invest in peer-to-peer loans. Lending Club and Prosper now set aside a randomly selected pool of loans for institutions, which prefer to swallow up whole loans rather than finance a piece of them. To eke out better returns, many fund managers then use their own credit algorithms to identify loans that may be underpriced or overpriced, and cherry-pick the ones they want.
For example, the Ranger Capital Group, a Dallas-based investment group that raised a $15 million P2P fund last fall, deploys a proprietary algorithm it calls TruSight to exploit variances in credit models. “Everyone’s got their own secret sauce on how they evaluate loans,” says Bill Kassul, a partner in the Ranger Specialty Income fund.
The loans not taken by these sophisticated investors go back to a fractional lending pool that is open to both individual investors and institutions. That doesn’t sit well with some. “The institutional investors are snapping up all the worthwhile loans,” one investor wrote on Prosper’s blog, echoing many comments.
“By cherry-picking, almost by definition what they leave behind is not as good,” says Giles Andrews, founder and chief executive of Zopa, a British peer-to-peer lender that so far has dealt only with individual lenders.
Scrambling to Meet Demand
Like high-frequency trading, P2P lending has become a game of speed. Much of the investing done by institutions these days is automated, and some hedge funds have installed computer servers close to Lending Club and Prosper to gain an edge. “The fastest computer right now is getting the most loans,” says Peter Renton, the founder of Lend Academy, a site that follows the P2P market and co-hosts the annual LendIt conference, which runs through Tuesday in San Francisco.
Prosper and Lending Club have created speed limits, known as governors, to counter these moves, and they have instituted purchase limits to ensure that big buyers don’t hog all the loans. “It’s kind of an arms race,” Mr. Kassul says. “They put a governor on, but then everyone tries to trick the governor.”
Lending Club and Prosper say they are trying to balance their lender mix among individuals, institutions and active fund managers. “We want to be extremely careful and not let a handful of investors drive our expansion,” Mr. Laplanche of Lending Club says.
And Mr. Suber of Prosper says, “We’re making sure we stay true to our original business of P2P finance.”
Still, to meet demand, P2P executives are pushing into new, higher-yield markets. In March, Lending Club expanded into small-business lending, an area where a wide range of online lenders already operate, and in April it acquired Springstone Financial, which lends money to students and people undergoing elective surgery. This $140 million deal was financed in part by a $65 million equity infusion by T. Rowe Price, BlackRock and other institutional funds, which valued Lending Club at nearly $4 billion.
The new loans will be part of Lending Club’s Policy 2 program, a catchall category for new, higher-risk loan types that is available, for now, only to big investors. Prosper, too, is expected to move into new areas of consumer loans. Mr. Laplanche and Mr. Suber say they have no plans to enter subprime lending, generally considered to be loans to people with credit scores below 620 or so. Other P2P sites, such as FreedomPlus, are targeting what they call “emerging prime markets,” consisting of people building credit or those with low FICO credit scores who are trying to build or rebuild their credit.
The changes worry some investors. “They already have a problem keeping up with demand,” says Ian Ippolito, an entrepreneur in Tampa, Fla., who invests on Lending Club. “The question is, would they be tempted to lower their quality to attract more borrowers?”
The first P2P loan portfolios have been securitized, ratings agencies are looking at the market, and insurance companies are considering products that would allow investors to hedge against loan defaults.
The dynamics taking shape — high demand for riskier loan categories, hedge funds leveraging and securitizing their investments — raise troublesome parallels to the mortgage crisis of 2008.
Many in the industry see little risk of a crisis, at least for now. At several billion dollars, the current P2P market is far too small to present any systemic risk, and P2P executives say lending has been handled responsibly. However, unlike a bank loan that requires collateral, the loans are unsecured. Also in contrast to a bank’s typical practice, the P2P sites don’t always verify a borrower’s income. These factors result in higher risk and potential higher return.
All the peer-to-peer lending sites are regulated by the Securities and Exchange Commission, among other agencies. Because Prosper and Lending Club work with individual investors, they are required to register each loan they offer to the public as a security.
In the event of another downturn, defaults would probably rise. But P2P executives say their underwriting is more transparent and their marketplace model more resilient than those of the banking system. “You would have to have a catastrophic default,” says Mr. Kassul at Ranger Capital.
To assert some control, Lending Club and Prosper insist on approving leverage levels and securitization plans in their financial agreements with big lenders. “We get all sorts of financial engineers come to us saying they want to create a derivative market, a credit default swap market,” Mr. Suber says, “and we say no, we are not participating in that.”
No matter where the bulk of the money is coming from, marketers like to emphasize the human face of P2P lending. A direct-mail solicitation from Lending Club reads, “Instead of paying interest to a credit card company or on a traditional bank loan, you get your loan through ordinary people like YOU who want to invest in YOUR success.”
That’s because the notion of P2P as a marketplace of individuals resonates with the public. On Zopa, which has underwritten more than 500 million pounds, or $840 million, in loans with only retail lenders, borrowers have reported feeling more responsibility to repay a loan when they know that another person has lent the money. The site’s tiny default rate of less than 0.2 percent seems to back that up.
“We’re proof you can have a market of reasonable scale with just retail lenders,” says Mr. Andrews, Zopa’s chief executive. Lately, he has been approached by British institutions about investing on Zopa. “We welcome that,” he adds. “The key is how to manage it.”
Some start-ups, such as Lendvious, LendingRobot and Lend Academy, are creating tools to help small investors achieve better returns. And new platforms will arise that cater to retail investors, Mr. Renton at Lend Academy predicts. “We’ll see more niche sites emerge that say, ‘Let’s get back to the roots of this,’ ” he says.
Small investors, it turns out, add much-needed stability to the market. Hedge funds and institutions tend to pull out of an asset class when another sector becomes more attractive. With retail investors, “it’s not just a handful of institutional investors behaving the same way at the same time,” Mr. Laplanche says. “It’s tens of thousands of people making their own decisions.” It was individual investors, after all, who stuck with Prosper and Lending Club as they grappled with regulatory and operational hurdles in the early days.
Given the stability and the cachet that small investors bring, the online consumer lenders will try hard to maintain a balance. But it’s a challenge.
Like other sectors of the collaborative economy, where people directly rent out or lend assets such as cars, homes and skills to others, P2P lending originated in part as a way to take back some economic control from institutions that had lost public trust. So the shift to large institutions causes some to pause.
“Scale can be a good thing,” says Rachel Botsman, the founder of Collaborative Lab, a consulting firm. “But do we come full circle, where the middleman is the same institution we were trying to get away from?”