Peer-to-peer lenders like Lending Club (LC) and OnDeck Capital (ONDK) have had a brutal month. Stocks across the niche finance industry have been pummeled following OnDeck's weak first-quarter results and the surprise firing of Lending Club CEO Renaud Laplanche.
Both companies IPO'd in December 2014 with much fanfare as the future of lending. Investors piled in, believing that these companies could disrupt the entrenched, regulation-addled banking industry. While their stock prices today clearly show that this enthusiasm was premature, the reason why requires a deeper understanding of exactly how these companies make money.
In this segment from the Motley Fool's Industry Focus podcast, host Gaby Lapera and banking analyst Jay Jenkins break down the fundamental business model of these online lenders to give investors better context as to why the events of this month are such a big deal.
A transcript follows the video.
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This podcast was recorded on May 16, 2016.
Gaby Lapera: 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.
Jay 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 kind 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 sites 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 a 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.
