In a free market economy, there will always be times of growth followed by times of contraction. Over the long term, the periods of growth have proven to be longer and stronger than the periods of contraction, but that doesn't mean an investor or manager can ignore the reality of recessions, credit contractions, or worse.
Founded less than 10 years ago, online lending marketplaces like LendingClub (NYSE:LC) and OnDeck Capital (NYSE:ONDK) were able to sidestep the financial crisis and have never faced an economic contraction that could damage their business. In the views of host Gaby Lapera and bank analyst Jay Jenkins of the Motley Fool's Industry Focus podcast, the eventual arrival of a credit contraction could present these companies with an existential crisis.
How could a recession mortally wound these lenders? When a recession does come, what's the most likely scenario for these stocks? To find out, click play below.
A transcript follows the video.
This podcast was recorded on May 16, 2016.
Gaby Lapera: Besides the economic 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.
Jay 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 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 favorite as to what happens. 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.
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.
Gaby Lapera has no position in any stocks mentioned. Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America. 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.