Innovation is important. But not all innovations are necessarily great ideas. In the latter case, I'm referring to Lending Club (NYSE:LC), the online peer-to-peer lender that describes itself as the "world's largest online marketplace connecting borrowers and sellers."
Want a loan? You no longer have to walk into a bank branch and deal with a loan officer. Now all it takes is opening an online account with Lending Club and filling out a "simple and fast online application that improves the often time-consuming and frustrating loan application process." Lending Club then matches you with investors looking to "earn attractive risk-adjusted returns from an asset class that has generally been closed to [individual] investors."
In this way, Lending Club is more Nasdaq than Wells Fargo. It's the E*Trade Financial of lending. The company doesn't put its own capital at risk, it instead allows investors to do so with theirs (for discerning readers, I am, of course, oversimplifying E*Trade's business model for the purpose of illustration).
To say this model has proven successful thus far would be an understatement. Since 2007, Lending Club has facilitated $6.2 billion in consumer and small business loans via its marketplace. In the third quarter of 2014 alone, it brokered $1.2 billion in various types of credit.
But the strength of Lending Club's model is also its biggest weakness. Democratizing credit risk exposes individual investors to something even the best banks in the world have failed to tame on a consistent basis. Lending Club's response is that it relies on "proprietary credit decisioning and scoring models and extensive historical loan performance data." But every new lender makes this claim. It isn't until credit risk actually asserts itself through higher defaults that they discover they were wrong.
It's also important to note that diversification is one of the principal ways to combat credit risk. Banks do this by lending money to borrowers in varied geographic regions. They do it by carefully watching their exposure to individual industries. And they do it by diversifying their income streams so that, when the credit cycle does exact its pound of flesh, they have income to offset the losses.
Suffice it to say most individual lenders using Lending Club's platform don't have the means to diversify to the same degree. As a result, it's hard to imagine the next wholesale downturn in the consumer credit market won't have a demonstrably negative impact on the investors in Lending Club's marketplace, and, in turn, on the investors in Lending Club itself. It seems safe to assume the two ultimately go hand in hand.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.