The idea of peer-to-peer lending, P2P, is attractive to many people. Borrowers and lenders circumvent the banks and get receive better rates. These businesses really took off following the financial crisis, as the actions of many financial institutions left a bad taste in the mouth of mom and pop customers.
The David and Goliath concept of accessing various financial services without actually using a bank appealed to many. As Lending tree’s motto says, ‘when banks compete, you win’.
While online lending is still small potatoes compared to traditional lending (a typical online loan is only a few thousand dollars) there is big money to be made. As credit standards have tightened up among traditional banks, less credit-worthy borrowers are turning to P2P sites for loans.
The interest rates are high, but typically not as high as credit cards. On the other side, investors are lining up to provide the funding for these loans (unlike banks that use depositor’s money for loans) for their high rates of return.
But remember, P2P loans are unsecured, meaning lenders have little recourse against a default with no claim on collateral.
But many are beginning to realize that most of the lending is not done ‘peer-to-peer’, but in fact done by institutions. A Forbes article reports “A new class of institutional lenders have eradicated the peer-to-peer nature of the business.”1 80-90% of money loaned through Lending Club and Prosper Marketplace are from institutions, which can include insurance companies, hedge funds, private equity funds and endowments. This adds a wrinkle to the David and Goliath comparison.
The altruistic promise may have been too good to be true, as sentiment has turned more critical of peer-to-peer platforms. Regulators are now setting their sights on the $13.8 billion fintech industry, with the Department of Justice and the Securities and Exchange Commission have both announced investigations and inquiries. And when regulatory scrutiny starts, it rarely stops.
Remember, P2P ‘lenders’ are simply originators, matching borrowers and lenders. This means they don’t actually carry the loans on their own books like a bank would. As such, they don’t always verify borrower information, including income, employment or debt-to-equity ratios.
Limited due diligence by the lender has led some to believe the loans, which are unsecured, are riskier than first believed. This reminds some of the NINJA (no income no job) loans of a decade ago.
Another concern is that most P2P lenders use the same Utah-chartered industrial bank, WebBank, for the actual lending.2 Unlike traditional banks, industrial banks aren’t governed by the Federal Reserve, only the FDIC and state banking regulations.3 Utah’s banking regulations themselves are notoriously relaxed. Tracking individual transactions at a Utah industrial bank is extremely difficult since they aren’t regulated by the Federal Reserve. This secrecy is akin to an offshore entity that hides the identity of owners.
Finally, for investors there are high fees associated with the loans. The investor is charged with debt collection fees by the P2P lender for delinquent loans-typically 35% of the amount recovered.4 This can really eat into returns, even at the hefty average interest rate of 7.72%.5
Factoring in collection fees, loan servicing fees and loan losses, median returns for a portfolio of Lending Club returns was 6.2% for investors.6 These loans are comparable to high yield bond returns and the two classes often ebb and flow together.
Lending Club Scandal
It has been a rough year for publicly traded, P2P lenders. At ground zero is one of the biggest names, Lending Club.
Since it went public about a year and a half ago, shareholders have watched its stock (symbol: LC) drop over 82%, from $24.75 to $4.30.
Lending Club’s founder and CEO, Renaud Laplanche, was forced to resign amid a couple scandals. The first involved the alteration of application documents to facilitate a lending transaction. The second was Laplanche’s failure to disclose a personal interest in a fund that Lending Club was pitching its own board to invest in, Cirrix Capital, LP.7 This has caused a slight boycott of funding by its investors as dust settles on the scandal. This is causing the company to examine other ways to fund the loans, potentially through dilutive equity offerings.
Lending Club has been increasingly relying on hedge funds and Wall Street firms to find new, yield-hungry investors. It’s not hard to imagine what the next step is for Wall Street-the pooling, securitizing and listing of subprime P2P loans for investors.
The other main peer-to-peer lender isn’t without scrutiny as well. San Francisco-based Prosper made headlines following last December’s mass shooting in San Bernardino by Syed Farook, a disgruntled radical. Through Prosper’s platform, Farook was able to obtain a loan and access funds right before his rampage. It is believed Farook used the loan to fund the attack.8
While there is no evidence that Prosper had any knowledge of anything nefarious, their lax background checks for borrowers is likely to result in stricter regulation via tightening credit standards. The FBI is reportedly investigating the payment but is encountering difficulty tracking the payment from a non-Federal Reserve-regulated bank.9 Expect further scrutiny into industrial banks which is a potential risk for the P2P lending industry.
Chinese Fintech Fraud
Just as scandal is harming sentiment here in the United States, the international fintech space is succumbing to similar behavior. It was uncovered that online Chinese peer-to-peer lender Ezubao was, in fact, a $7.6 billion Ponzi scheme.10 A Ponzi scheme is a fraudulent investment scheme, where returns are paid out to existing investors not from actual investment returns, but from the money contributed by newer investors, creating a cycle of deception. The largest Ponzi scheme ever was orchestrated by the now incarcerated Bernie Madoff, who stole $50 billion from investors through his hedge fund, Ascot Partners.
Ezubao had an elaborate lending platform where investors could lend money to fund various projects on the site. The problem was that over 95% of the projects didn’t exist, they were simply made up by Ezubao while legitimate investment money was pouring in. And this wasn’t some small-time operation. Ezubao had over 900,000 different investors on its platform.11 Risks with investing in China abound and this is another example. The regulations for online finance in China are not well enforced.
As expected, regulation is starting to increase for P2P lenders. Last summer, the Treasury department requested information on P2P lender’s risk management systems with regard to cybersecurity and fraud. The Department of Justice has subpoenaed Lending Club into its lack of disclosures and some worry the company will be required to carry loans on its own balance sheet. Lending Club has admitted ‘control deficiencies’ in its business. Finally, there has been litigation filed against the WebBank and the industrial bank.12
A probable consequence is more fintech startups remaining private. Who wants to deal with the scrutiny of regulators including the SEC and the result a plunging stock price has reputation, not to mention future business. While staying private may mean less business for the investment bankers and financial advisors who sell the deals, it should be offset by more compliance and auditing hires.
These stories provide a cautionary reminder of the potential dangers of online lending. As we mused in a past article, fintech startups won’t be the end of the financial industry as we know it. And while these developments are discouraging for the growth of peer-to-peer lending, it won’t be the end of them either. As long as interest rates remain low around the world, you can expect steady demand for alternative lending platforms offering higher yields. If your career in finance involves compliance (internal auditing and control) you should be in demand no matter what type of financial institution you are employed with.