It’s a Tough Time to be a Peer-to-Peer Lender, and It’s Probably Only Going to Get Worse

After a tough first-quarter earnings report from OnDeck Capital (ONDK) was followed by the ouster of LendingClub's (LC) CEO, the market has sent these lenders and others like them plummeting.

On this Financials edition of the Motley Fool's Industry Focus podcast, host Gaby Lapera and analyst Jay Jenkins go beyond the headlines in their discussion to explain why these problems are much more than a short-term speed bump. Marketplace and peer-to-peer lenders have made tremendous innovations in the customer's experience of applying for a loan. However, in doing so, they forgot a critical characteristic of every successful lender: Credit risk management has to come first.

How did these companies get to this low point? What will it take for them to turn it around? Is it ever a good idea to make puns about something as boring as banking? To find out the answers to these questions and more, listen now. 

A full transcript follows the video.

This podcast was recorded on May 16, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the financials edition, filmed today on May 16th, 2016. Are peer-to-peer lenders operating on borrowed time? Sorry. I just crack myself up. Anyway, my name is Gaby Lapera. Joining me on the phone to talk about the heartburn-inducing world of P2P lenders is financial analyst Jay Jenkins. Welcome to the show!

Jay Jenkins: Hey, Gaby. Thank you. Pun very much intended there.

Lapera: Yeah. I was trying to think of a clever intro for this. There's just so many puns. Anyway, I think that a lot of people who follow this world have probably heard about the Lending Club...debacle. I think might be the best word for it. Their share prices dropped precipitously, around 87% at the time of this filming, and it's because they sold loans to investors that they weren't supposed to sell. But we want to really dig into this world and we want to tell you guys, and learn a little bit about how peer-to-peer lenders work and why this is happening, and maybe what the future of peer-to-peer lending is.

Jenkins: Absolutely. Gaby, a couple of my personal friends asked me what the deal was with Lending Club. They saw the news that was just a $22 million package of loans, and for a company that's originating millions of dollars of loans almost every single day, that sounds like peanuts, but the real story here is that those peanuts represent a much bigger problem that I view as a business model problem. That's why the board of directors reacted so swiftly to fire the CEO and a few of his lieutenants as well.

Lapera: Yeah. I think, then, what we should do is we should start with talking about what peer-to-peer lending is, because I think that maybe it's not a model that everyone's familiar with. Most of the time, people think, "Oh, I need a loan. I'm going to go to the bank. I'm going to talk to a loan officer and I'm going to get myself a loan." Peer-to-peer lending is, excuse the jargon, disrupting that business model.

Jenkins: It's trying to. You could argue that it's failing right now. There's two kinds of fundamental models that the peer-to-peer lending companies are using right now. The kind of original idea, which is your Lending Club kind of model, is where you or I go online and we need a personal loan. We fill in our information on their website, click apply. Then Lending Club goes out and recruits other individuals, potentially you or me again, to come in and invest some of our savings into that loan.

Where in a traditional bank, you would take your deposits to the bank, the bank would intermediary that process to originate loans with the deposit funding, Lending Club and the pure peer-to-peer model basically strips that out and says "we're going to replace the bank with a website and some computer algorithms and it's going to be super efficient and everyone's going to win." The second model, which is more business oriented at this point in time, but also somewhat on the personal consumer side, like a company like OnDeck Capital, they're originating their loans, but instead of funding it with peer-to-peer modeling, they're actually going out and recruiting capital investments.

It could be equity capital investments, it could be packaging these loans as securities and selling them, it could be credit facilities that they've got with major banks. But they're actually raising huge amounts of money, funding the loans themselves and then dealing with the loans by either selling them off to other investors, keeping them on their books or a number of different ways. Those are kind of the two models from consumer side. When you go to their site and click apply, the user experience is very similar. The real difference is in the nuts and bolts behind the scenes on how they actually fund the loans.

Lapera: It's basically where they're getting the funding for the loans. Like you said, OnDeck Capital is definitely more focused on small businesses. I want to drop a word of caution to our listeners that if you google OnDeck Capital, their ads will follow you all over the Internet for weeks.

Jenkins: We can talk about the peer-to-peer marketing and some of the problems they're having there because these guys are not shying away from spending money on ad dollars, that's for sure.

Lapera: Yeah, definitely. I have definitely been the recipient of that, despite the fact that I do not own small business nor am I in the market for a personal loan. They could maybe tighten up the algorithms that they're using to check. This is a really interesting idea. One of the things that I think most people are going to ask immediately with this is... banks have underwriters who check the risk of any individual who's applying for a loan. How do these online peer-to-peer companies manage that risk?

Jenkins: It's a fundamental question that I don't think they've fully answered yet. At the most fundamental level, basically, they're trying to replace that individual in the bank with a computer algorithm that says "this is your credit score, this is your income, this your net worth, this is do you own or do you rent." All these traditional credit factors. They dump all that data into some artificial intelligence kind of program and it spits out a risk rating. For the consumer, you plug in your information and you immediately know it's risk graded me whatever, and because of that risk grading my interest rate, should I get this loan, will be whatever that is.

If you're a high risk, your interest rate will be higher. If you're a low risk, your interest rate will be lower. The idea being that those computer algorithms are just as good, or better, than the traditional human underwriter that you would see at banks. Now, at traditional banks, that process doesn't just stop with that underwriter. Person applies for a loan in the branch, gets approved or not by an individual. If it's approved, that loan is later on, after the fact, reviewed by a loan review group that's traditionally housed in the credit department or loan administration department of these commercial and traditional banks. The problem that Lending Club is having right now is that their loan review process is, at best, weak, and at worst nonexistent. That led to the problems with this $22 million in sold loans that ultimately led to the CEO being fired last week.

Lapera: Yeah. It's a much more complicated process than a lot of people think. One of the things that you have torealize is that people vary in their risk when you're giving them a loan, and if you give people who are high risk a loan, they're probably going to default. That's why banks are so careful.

Jenkins: Absolutely. That's why they charge higher interest rates, too.

Lapera: Exactly.

Jenkins: The theory is they'll have more loan losses on those riskier loans, so they should charge more to cover those losses and still, hopefully, make a profit.

Lapera: Right. Just to be clear, they charge higher interest rates for people who are riskier. One of the easiest metrics to see is your FICO score, which says if it's above 750 these people are prime borrowers, or above 800, superprime borrowers. They're going to have the lowest interest rates. People below that are going to have much higher interest rates, which means that they're going to pay more over the life of the loan. But the banks do a really, really good job of checking and making sure that you are who you say you are, and that you make as much as you say you do, and getting all these factors about your life and making decisions, especially if you're applying for a business loan, making a decision about whether or not the business sounds feasible.

Jenkins: Absolutely. It always makes me think back to the financial crisis on the mortgage side. Subprime mortgages, no documentation loans, no income verification loans, and we all know what happened. Those loans were not repaid with any sort of regularity and it caused these tremendous losses at the banks that almost tipped the entire global economy over. Then you read, some of these online marketplaces, that what they're verifying is a lot of times even less than what was being verified for those subprime mortgage loans. I've got a number here for you. In Prosper's S1, currently it's privately owned, but it's an online marketplace lender just like Lending Club or OnDeck.

Lapera: Just so you know, an S-1 is what a company has to file with the SEC before they go public.

Jenkins: Correct. Thank you. According to their S-1, which they filed earlier this year, Prosper verified employment and/or income only on 59% of the loans on their marketplace. Just 59%. In theory, that means 41% of these loans, these individuals could have just popped on the website, made up a bunch of stuff, and then walked away with a pile of cash.

Lapera: Yeah.

Jenkins: That's fraudulent, of course, but from an investor perspective, that's a lot of risk that these companies are taking on, lending out huge amounts of capital. The thing about lending money is not only do you have to sell the loan, you also have to get it back. That's fundamentally different when you sell a widget or some other kind of service. If a bank or lender doesn't get their loan money back, that lender's going to fail pretty doggone quick.

Lapera: I think even more horrifying than the fact that they only checked 59% of the loans, is of those 59% they checked, they pulled 15% of the listings, saying 15% weren't real or weren't good listings.

Jenkins: That's right. Of the ones they checked, one in six was wrong or fraudulent or just fabricated.

Lapera: That's a lot. The chances of that happening at a bank are so, so much lower.

Jenkins: Especially in today's environment. With Dodd-Frank and all these regulations, Know Your Customer regulations, it's a real serious thing.

Lapera: Yeah.

Jenkins: It's one that banks have perfected. Banks have been doing this for literally thousands of years and there's value in that institutional and kind of cultural knowledge in the industry. I don't want to be too negative. I really like the concept of using the Internet and using peer-to-peer as a channel to enhance. People who need credit and are maybe a subprime but are still willing and able to pay, improving the access to credit can go a long way to helping these individuals' lives. And an investor who's in a company that's doing that effectively and taking the proper risk management steps... There's a lot of money to be made. I was reading a PricewaterhouseCoopers report last week, as all this news was breaking that predicted that the online lending marketplace industry could reach $150 billion in originations per year by 2025. That's a huge number, but that huge number only represents 10% of the current revolving consumer debt market, plus 5% of the non-revolving market.

This is a gigantic ocean where these guys are playing. It's the kind of market that if disrupted properly, there's a lot of money to be made. It's just at this point I think they're failing on the risk management front, so we're just not quite there yet.

Lapera: Right. This also brings up another really interesting idea that we could do an entire podcast on, which is, there are some people who need access to loans but, you're right, they have low credit ratings or they have other risk factors associated with them. They can't get loans from a bank. A lot of these people turn to payday lenders, which a lot of the time, I'm going to say most of the time, are predatory lenders, right? They end up in much more debt than they with have otherwise.

Jenkins: That's right.

Lapera: This could potentially present an avenue for these people, but the way it's being done now is just so risky.

Jenkins: It absolutely is. I'm not smart enough to find the solution to this problem, but to me, there is an answer in online and in payday lending. I'll give you an example of a couple traditional banks doing it right. Wells Fargo (WFC 2.73%) has rolled out an online business application. Wells Fargo is the number one, by number of loans, SBA lender. SBA loans are government-guaranteed small business loans. The number two SBA lender is a small private bank in Wilmington, North Carolina. Both of those banks accept SBA applications online, the user experience is smooth, it's easy, it's intuitive. But in both those cases, it's not 100% automated. There is a human being that gets routed this information, all the stuff is verified, human eyes with human instinct and gut make a decision, and they can move forward on the loan.

It's this nice balance where you get the benefits of online, the speed, the transparency, plus you get the benefits of a traditional risk management department who can protect deposit holders and protect investors from all these undue losses from perhaps unscrupulous borrowers who might try to do something shady.

Lapera: Right. This brings us to second part. You mentioned Dodd-Frank earlier, which is the regulation that surrounds how banks are capitalized and their liquidity ratios and all this stuff to make sure that banks don't fail.

Jenkins: Right. It also gave rise to the Consumer Financial Protection Bureau.

Lapera: Right.

Jenkins: It's a behemoth these days. It's really making a lot of changes throughout the whole industry.

Lapera: They're having some problems of their own, which could also be another podcast episode, that bureau is. The banks, my point is, have a lot of regulation surrounding them. These online lenders have a lot less because D.C. is a slow-moving city. They just haven't quite caught up with the times yet.

Jenkins: Sure, sure. These lenders are subject to a lot of the same regulations. Truth in Lending, Know Your Customer. Even some of the securities laws. Blue Sky laws, the Securities Acts of 1933 and 1940. All these laws do apply and they are regulated, but it is kind of the Wild West. The CFPB has not yet truly turned their attention to Lending Club or OnDeck or any of these other players, but I'll tell you all of the bad headlines, this event last week, OnDeck Capital had a pretty bad quarter... all this stuff is drawing a lot of attention, and a lot of people in Washington are expecting the cross hairs to move in a little bit more quickly than thank you with have otherwise. It's just yet another headwind that has to be overcome.

Lapera: One of the things that happened at the banks is when they instituted Dodd-Frank, a lot of smaller banks went out of business or were acquired by larger banks because they just couldn't keep up with the amount of money required to come up to par with federal regulation. Who knows what will happen to these online lenders, especially because their balance sheets are very interesting when you look at them.

Jenkins: Sure. If their whole argument is that they have better economics than a traditional bank, because they're online only, because there's fewer heads to pay salaries, no branches that you have to pay rent or keep the lights on. That really brings into question if those economics are really there when you layer on some of these additional operator costs from having to do the same regulatory work that a trillion dollar or hundred billion dollar bank has to do. It's a big question mark.

Then on the cost front, too -- I wanted to come back to marketing -- again, their argument is that their economics are better. They can make more money more efficiently because of this lower overhead. However, when you look at look at their numbers, their customer acquisition costs are extremely high. Routinely, 35% to 45% of their revenue goes to marketing. You might be thinking they're spending a lot of money on marketing because they're trying to brand and do all these things they have to do. But tracking it over time, their marketing expense has been moving up in lock step as their revenues have increased. They're really not achieving any scale with consumers. That's problematic for them because it's a transactional model. They don't really have any way to kind of go back to the well and get one customer; how can we expand that relationship?

Again, clearly you can tell I'm in favor of traditional banks at this point in time on this, because that's the biggest benefit of traditional banks, is that relationship. Wells Fargo was famous in '80s. Their slogan was, "Eight is great," meaning for every customer they wanted to sell eight products.

Lapera: Yeah. That's something that they've actually achieved, which is great.

Jenkins: It's amazing. The best banks in the U.S., that's what they do. First Republic, over seven accounts per new customer. You walk into the bank, most likely you're walking out with seven accounts or more. That's fantastic for profits. That's fantastic for long-term wealth building. It's something that at this point I don't see how Lending Club, or OnDeck, or some of these others are going to replicate. It just seems so transactional.

Lapera: Right. When we say accounts, it's not just loans, right? We're talking credit cards, debit cards, savings accounts. All these types of things.

Jenkins: Wealth management. Checking accounts. Savings accounts.

Lapera: Exactly. These are all things that these online lenders just can't do, not unless they decide to become a bank and then they're no longer what they were.

Jenkins: That's right. That's what some of them are doing. Some of the smaller ones. They're actually going out and trying to buy community banks for that reason, and also another advantage traditional banks have is their cost of funding. I'm sure everyone listening and watching knows that if you go and open up a savings account today, the bank's really not going to pay any interest on it, maybe a few basis points. That money is free money for the bank to go out and make loans and drive their yields higher. But on the online lending marketplace, that money is either going directly to some other person in a peer-to-peer, at a really high yield, or it's going to some capital investor whose cost of funds might be 7%, 8%, 9% as opposed to seven, eight, nine basis points. That's a huge advantage for traditional banks and it's going to be really challenging and it's going to be really interesting to see how these online lenders kind of overcome and try to manage that. I wouldn't be surprised if a lot of them end up with bank charters and accept deposits, just like some of the existing online-only banks.

Lapera: Right. Besides the economics, and the potential for... Sorry. It's totally fine. Listeners, just so you know, Jay has a really cute dog and he's hanging out with him in his room.

Jenkins: In the home office today. We're here together.

Lapera: Besides the economics and regulatory issues that these people potentially face, the other thing is a lot of these companies started in 2007, 2008, and they're very, very small and their growth has been huge since then. You wouldn't expect them to grow a lot during the middle of the financial crisis.

Jenkins: Their timing was perfect. It really was.

Lapera: It was. Because there's a lot of people looking for loans with easy money. [...] A lot of banks, they have ridden out multiple credit cycles. We have no idea what's going to happen to these online lenders.

Jenkins: That's right. To me that's the biggest question mark. That's the elephant in the room. It's a true unknown and it's extremely dangerous. The credit cycle is a fact of life. Credit expands. Money is easy. Economy hits a bump, maybe recession. Maybe even just like deceleration of growth. The credit cycle will contract. Defaults go up. Loan losses mount. You mentioned Dodd-Frank. Nowadays, especially, banks have so much capital, so much liquidity, more than likely they're going to be OK to ride out those losses while the credit cycle does its thing before it turns back to a positive growth cycle. These online lenders have never dealt with that. There's a couple of different scenarios that I think could cause serious problems.

On the peer-to-peer side, where do those investors and those loans go after they take some pretty big losses? If you are used to a savings account or a CD where your money's there, backed by the FDIC, you put it into this loan with a 10% interest rate, and then suddenly that loan loses 50% of its principal balance, because the person just stops paying. Do you ever come back? Does the market for investors just disappear overnight? It could. It might not. We don't know, and that's the big point here, is we don't know. Will some of these big mega banks be willing to continue funding online lenders if default rates triple or quadruple from what they were projected to be? We don't know. Could those lines of credit dry up, and if they do, what does OnDeck do, what does Lending Club do? How do they fund their loans at that point?

Lapera: Right. Part of this is that the people that thank you are giving loans out to, Lending Club and OnDeck potentially, these people tend to be higher credit risks. These are already the people who maybe they're choosing to go online because the traditional bank wouldn't work with them. Potentially. I'm sure there's plenty of other people on the platform who are good credit risks. I think you said your girlfriend was using Lending Club to pay off her student loans, right?

Jenkins: Yeah, to great effect. Saved a bunch of money on interest. Knocked it right on out. For her, it was a great match.

Lapera: I'm sure there's plenty of people like that on the platforms, but I think proportionately you're going to have a lot more people who are higher credit risks than you would with banks.

Jenkins: Absolutely. I doubt very seriously there's many high net worth customers coming to Lending Club for a personal loan.

Lapera: Yeah. Overall, it's a very, very complicated environment and there's a lot of questions right now about the feasibility of the model, what's going to happen with regulation. I would personally have a really, really hard time investing in these stocks.

Jenkins: I'm right there with you. To me, the risk is just far too great at this point, and these companies have kind of shown us they're not equipped, today, to manage the risk of what they're doing. That's a shame, too, because like I said, the market is huge, and when someone figures this out, it's going to be a game changer, I think. That's day's just not today.

Lapera: Yeah. Who knows, maybe traditional banks will figure it out. That could totally be coming down the pipeline.

Jenkins: Absolutely. In my view, that's probably the odds on favor to what happened. Wells Fargo's already doing it pretty effectively. It's already been on the credit card market. You can apply online seamlessly for years now. Quicken Loans has their new Rocket Mortgage product which they're marketing like crazy, where you apply online. You go through the process really quick, really easy. That's the next generation of lending.

Lapera: I got my credit limit increased the other day. I went on the Bank of America website, and a button had appeared saying "would you like to raise your credit limit?" and I said sure, I would love to.

Jenkins: Automatic.

Lapera: It came through in five minutes that my limit had been raised by X amount. I don't think I should say how much on the air, right? That's like a please hack me thing. I don't know. Do you have any closing thoughts that you'd like to say on this?

Jenkins: It's been an interesting couple of weeks, and I think it's only going to get more interesting as we move through the rest of this year. Lending Club and OnDeck, they need to respond, and I'm not sure exactly what or how they're going to do it. Can't wait to find out.

Lapera: Lending Club did fire their CEO, but is that enough? I don't think so. If you go online right now and type in "Lending Club class action suit," they've got a ton that have popped up because of this whole mess.

Jenkins: That's right. It's probably going to get uglier before it gets pretty.

Lapera: An interesting ride.

Jenkins: That's right.

Lapera: It's going to give me anxiety just thinking about it. Thank you, guys, very much for listening in. If you're interested, those numbers that we talked about from Prosper and Lending Club verifying loans, that came from an article done by one of the other analysts who's on the show. His name is Jordan Wathen. If you'd like a link to that, just shoot me an email at [email protected] or by tweeting us @MFindustryfocus. Let us know if you have any questions about peer-to-peer lending or anything else. I'd love to answer them.

As usual, people on the program may have interest in the stocks they talk about and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks for joining us and I hope everyone has a great week!