Lending Club (NYSE:LC) and OnDeck Capital (NYSE:ONDK), the two leading online marketplace lenders, are trying their best to disrupt the established banking industry. If successful, their investors would stand to make an incredible multiple over their share prices today. The problem, at least in their brief existence, is that the current crop of so-called peer-to-peer lenders have focused too much on growth and not enough on risk.
Over hundreds of years and dozens of economic booms and busts, the banking industry (and its regulators) have learned that making loans is not enough. For lenders like LendingClub and OnDeck Capital that sell their loans to investors on the secondary market, the loans must be verified, reviewed, and delivered as promised to the investors. Without strong internal controls and risk management, all the loan growth in the world won't save a lender from eventually failing.
In this segment from the Motley Fool's Industry Focus podcast, host Gaby Lapera and bank analyst Jay Jenkins discuss how peer-to-peer lenders attempted to disrupt traditional risk management practices, and how these innovations have thus far failed.
A transcript follows the video.
This podcast was recorded on May 16, 2016.
Gaby Lapera: One of the things that you have to realize 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.
Jay Jenkins: Absolutely. That's why they charge higher interest rates, too.
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, super prime 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 S-1, 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.
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.
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.
Gaby Lapera has no position in any stocks mentioned. Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.