Like most companies that sell loans to investors, the digital marketplace bank LendingClub (LC 0.45%), which specializes in originating unsecured personal loans, has struggled as rapidly rising interest rates and normalizing credit conditions have created headwinds.

LendingClub has done a lot of work in recent years to change its business model, including the company's transformational acquisition of a bank charter in 2021. But ultimately, it will need the Federal Reserve's unprecedented rate-hiking campaign to cease so it can rejuvenate its business. Let me explain.

Crushing the marketplace

LendingClub specializes in credit card debt consolidation, allowing largely prime consumers to refinance their credit card debt and get a much cheaper interest rate.

LendingClub in turn gets a high-yielding loan, which it can either sell to various investors through its marketplace for a one-time fee or hold on its balance sheet for annual recurring monthly interest payments. Investors that purchase LendingClub's loans include banks, asset managers, and other institutional investors.

Person looking at computer screen while holding a pen under their chin.

Image source: Getty Images.

The problem is that a portion of LendingClub's institutional investors, such as asset managers, fund these loan purchases with capital that has a similar interest rate as the Federal Reserve's benchmark rate, the federal funds rate. Because the Fed has raised rates intensely, these investors have had a higher cost of capital, which then leads them to demand higher returns.

LendingClub can certainly raise its loan yields as the Fed raises rates, but it takes time. First, the Fed raises rates, then credit card companies, and then personal lenders can follow. The problem is that rates have not stopped rising and nobody has had a second to breathe, so while LendingClub has likely done some repricing, it hasn't been able to keep up with the Fed's hikes, which keep pumping up funding costs.

Credit quality

Credit is also on the mind of investors, as borrowers are starting to feel the pinch now that stimulus programs have ended, inflation is high, savings from the pandemic have been spent, and borrowing costs are up as well.

While credit is still largely performing as expected, LendingClub's management is expecting to raise its allowance for loan losses in the future to higher levels than initially expected. It's not a huge deal because the company has already taken a big allowance up front and the future build will also include a qualitative overlay, meaning that management is essentially building the reserve more conservatively, which I think is a good move right now. Still, investors are likely going to be on edge about credit until there is more visibility about how the economy and unemployment will fare this year.

With institutional investors that purchase LendingClub loans moving to the sidelines, marketplace revenue at the bank fell 28% in Q4, and this trend looks to be continuing in the current quarter. 

LendingClub actually makes more money by holding loans on its balance sheet, which are 3 times more profitable over their life than selling a loan into the marketplace. But the marketplace helps soak up the volume, and when the marketplace is humming, its revenue can cover the bulk of LendingClub's expenses. This allows most of the revenue made from loans on the balance sheet to fall to the bottom line in good times. 

The company continues to battle

I give props to LendingClub regarding how it has handled the difficult times. The company has reduced its workforce, pulled back on marketing, and tightened underwriting to adapt to the difficult macro outlook. In the fourth quarter, LendingClub generated close to a $24 million profit.

Based on guidance for the current quarter, it looks like LendingClub can break even or perhaps eke out a small profit.

But there is only so much in management's control. LendingClub really needs the Fed to end its rate-hiking campaign so it can raise loan yields appropriately. The end of rate hikes would also allow credit and the economy to hopefully stabilize, which would bring investors back into the marketplace. In a more normalized environment, LendingClub could rejuvenate its business and return to building on the strong progress it has made.