Is Peer-to-Peer Lending a Good Investment?

Recently, peer-to-peer (P2P) lending has cropped up as a new possibility for investors, through which they can earn relatively high interest on a short-term loan. Sound too good to be true? Unfortunately, it might be.

In this clip, Gaby Lapera and John Maxfield explain what P2P lending is, how the platform works, and the huge risks that you need to know before putting money into them. The also offer a look at the incredibly smart and experienced people on the board of P2P platform Lending Club (LC -3.17%), and what they're looking to achieve with the site.

A transcript follows the video.

This podcast was recorded on Feb. 2, 2016. 

Gaby Lapera: Levi asked, "What's your take on peer-to-peer lending?" He says, "I'm returning 11% on the platform of Lending Club, but I'm down around 40% on the stock. Would you talk about peer-to-peer lending and what hurdles/regulations are needed to clear before these companies can do well?" Do you want to give a basic description of what peer-to-peer lending -- which we're probably just going to call P2P -- is?

John Maxfield: Yeah. So, P2P lending is basically, you have a company that sets up a platform, and then, if you want to get a loan for ... I don't know, in the example we were talking about earlier, you want to start a company that makes coffee cups with pictures of cats on them, and the cats are doing things like riding bikes or things like that, like, that's your thing, that's your business idea, and you go to a bank and you're explaining this to the loan officer, and you're like, "Look, it's a great idea. There's going to be coffee cups, and there's going to be pictures of cats riding bikes and they'll be saying things to other cats that are riding on hoverboards." And then the bank is like, "I don't know, that doesn't seem like a very viable business model to me."

So then, you would still need capital, so where would you go get it? So, you could go to one of these marketplaces and put your idea on the marketplace, and people on the other side effect, like you and me, we have a few extra thousand dollars that we're looking to invest and we wanted to diversify away from stocks or real estate or whatever your thing is, and these people say, "I'll borrow you money and give you an 8% return on that so that you can find my business to make these awesome cat mugs."

So, that's what peer-to-peer lending is. It's me, a guy with a little extra money going on to this platform and loaning it to, say, Joe Schmo, who wants to start this business making cat mugs, which I'm sure is going to be awesome and profitable, but the banks don't realize the potential.

Lapera: Right, and people use this for all sorts of things besides starting small businesses. They use it to fund, the most recent one I saw was student loans, mortgages, stuff like that, loans for money for home renovations. And when you go into the loan, when you click on it, it'll give you a description of the person and the thing they're using the loan for. It'll be like, "It's a nurse and she's between 30-35, and she makes ... " I don't know how much nurses make, "$70K a year."

Maxfield: Yeah. And let me be clear, I'm not trying to belittle what peer-to-peer lending is, but you're talking about a very niche market, where people probably aren't going to be able to get mainstream credit. And when you think about, why aren't these people going to be able to get mainstream credit, then you start thinking about credit risks. Because banks want to give credit, right?

What banks do is sell money via loans. But they're not going to sell money to people that their risk models say are not good credit risk, or at least ... that has been in the past. That's what the financial crisis was all about. But theoretically speaking, the banks don't want to do that.

Lapera: Right, and then the financial crisis beat them up, so they're very interested in not doing that again. And the thing with banks is, they have these super sophisticated models that give them a pretty good idea of whether or not a person is a good risk or not, which, when you compare to some of these peer-to-peer lending sites -- for example, Jordan Wathen wrote an article the other day that showed in it that the Prosper loans marketplace, which is one of these peer-to-peer lending sites -- it's not public yet, but they submitted an S1, which is part of the paperwork you need to submit to get yourself listed.

It says that Prosper verified employment and/or income for 59% of the loans originated on their site. Banks very that for 100% of people that they give loans to, not 59% (laughs). That's a huge difference. And then, from those loans, where they verified the income and/or employment, they delisted 15% of those. That's quite a few. You know what I mean?

Maxfield: Yeah. Let me get this straight -- they check the income and the credit risk of 59%, and then 15% of those 59%? Is that right? Are those the ones they then pick out?

Lapera: Yeah.

Maxfield: So then, what happened to the other 41%? 

Lapera: They didn't get checked at all. They just left them up on their site. 

Maxfield: They just -- (laughs)

Lapera: So, who knows how many more (laughs) would have been delisted?

Maxfield: Yeah, that's right. That's great. And, I mean, this is really, really, really risky. That's the point you're making.

Lapera: Yeah. It's super risky. And Prosper is not alone. Lending Club, it doesn't disclose how many of its loans it checks, it just says it doesn't check all of them. So, who knows what that percentage is? (laughs)

Maxfield: (laughs) It's like Russian Roulette.

Lapera: (laughs) Yeah, pretty much.

Maxfield: Now, here's the other interesting thing, to talk about another specific company, then you look at Lending Club. Lending Club, if you go to their board of directors, and you see who's sitting on that board, you have Larry Summers, a former Treasury secretary, and Gaby and I have talked about this in the past, Larry Summers can be controversial in terms of some of the things that he says, but there aren't a lot of people out there in the financial world who really know what's going on who would question his intelligence and what he knows about finance and economy and stuff like that.

You also have John Mack, who was a former CEO of Morgan Stanley (NYSE: MS). You also have Mary Meeker, who's a partner at Kleiner Perkins. Lending Club in particular is not some fly by-night company. These are established people who know what they're doing. But they're evolving toward a difference business model than the "John Maxfield is lending to Joe Schmo." They're involving to where they will originate small business loans and then syndicate those to a whole bunch of community banks who don't otherwise have exposure out of their local markets.

Lapera: Yeah, and I could actually totally see that working. But I think part of the reason that people are down on the actual stocks themselves vs whatever loans they've made within the platform is because there is so much uncertainty there. And it seemed like a great idea when it first came out, and then people started reading more and more about it, and stuff, like I said, that came up with them actually checking who's listing these loans ... if that's not even certain, it's kind of sketchy.

So, until these things get worked out, I don't know that it's a great idea to invest in these in particular. Also, this is an area that's ripe for regulation that hasn't been done yet. And until that happens, it's very hit or miss whether or not this will survive in general. You know what I mean?

Maxfield: Yeah, that's a really good point, that regulatory point is actually a really good point I hadn't thought about. My real specialty is the history of banking, and the history of banking is made up of credit cycles. If you go back to, basically, the start of the United States, we've had something like 20 of these huge, large credit cycles. What I mean by that is, where loan losses are really low when the economy is going great, and then loan losses go really high when things turn bad, which is what we saw in the Great Depression and the financial crisis and stuff like that.

So the big question to me, and I'll provide an answer after I state the question, is whether or not these companies or this model will survive a serious downturn in the credit market. It's my opinion that there is no way they're going to make it through one of those. I could be totally wrong on that. But the quality of the borrowers that are on these platforms, as I understand it, are the bottom of the barrel. And in the bottom of the barrel, in terms of your credit statistics, you see huge loan losses on those when the cycle turns down.

Lapera: Yeah. I mean, I guess the other side of that would be, where else would these people get money from? The answer would be payday lenders, and that's probably way worse than this, for them especially.

Maxfield: Well yeah, for them, it's way worse, but--

Lapera: But for the people investing in it, it's way worse for us.

Maxfield: Exactly. And you could also say, maybe they shouldn't be going out -- if a bank looks at their business plan or whatever they want money for and is not willing to lend it, maybe they should look for other things to do, because if a bank thinks they're going to default, and they do default, it doesn't matter what the platform is, that's going to ruin your credit. Right? So, maybe that should be a sign to people who are looking for loans over these platforms.

Lapera: Yeah. It's a hard question, because if people need the money, where did they get it from? But, if they're such a bad risk ... Anyways, this is a question that is not for you and I to solve, Maxfield. (laughs)

Maxfield: (laughs) This is philosophy.