By now every human on Earth knows about the dangers of easy credit and the securitization of esoteric debt — even not so esoteric debt. But consider this: Your clients, who might literally be jonesing for yield right now, could have gotten a princely 12.77 percent by investing in an unsecured bond — Lending Club member loan 50657, to be more specific.
As you might have surmised by the yield, the security is a below-investment grade bond. The debtor? The mother of a bride in San Pedro, Calif., who took out a three-year, unsecured loan to help fund her daughter's wedding. From the Lending Club prospectus, a thumbnail profile of the woman emerges. As she states in prospectus supplement 102, “My daughter and her fiance have paid for most of their wedding but there are always loose ends to tie up as it gets closer to the date. I just want to set aside a little something just in case they need my help!” We also learn that she rents, has worked at Kaiser Permanente for more than 10 years, grosses $31,200 a year and has a debt-to-income ratio of 24.88 percent.
That's right: A woman in California was in essence able to securitize herself — not for any business reason — but so that she could take out a loan for a wedding. The loan's yield was set according to her credit score range (679-713). It should be noted that her personal financial details were not verified independently. (That sounds familiar.) It's somewhat amazing that after the credit/housing debacle, a woman was able to get a loan (for $3,000) from willing private investors via the internet.
Or perhaps it isn't so amazing. After all, people go online to chat with strangers and even find someone to marry. Not surprisingly Lending Club started as an application on Facebook. Software entrepreneur and French sailing champion Renaud Laplanche co-founded Lending Club in 2007 to offer investors and borrowers better rates in a double-blind, auction-like process wherein multiple lenders bid to fund loans to borrowers. As of mid-May Lending Club has funded 11,654 loans totaling $112 million, and counting. And it is growing: There are 120,518 loans requested, and the number grows by roughly 9 percent per month. The site issued 185 percent more loans in the first quarter (totaling $23.5 million) compared to the second quarter last year ($8.23 million).
The largest peer-to-peer lending sites in the U.S., including Lending Club and rival site Prosper, have originated loans worth more than $200 million, just a tiny fraction of the $2.4 trillion in outstanding consumer loans (not including mortgages) in the U.S. According to Gartner, the peer-to-peer lending industry will “soar at least 66 percent to $5 billion of outstanding loans by 2013.”
The peer-to-peer lending websites are simple to use. Interested lenders merely sign up and troll through the various lending website loan applications. At the closing and funding of the loan, a series of notes are issued to the lenders. The notes are registered as securities with the Securities and Exchange Commission. The notes are tradable in a secondary market. The borrower is often seeking rates below the sometimes usurious rates of 18-plus percent offered by credit card companies. Indeed, it's no wonder 60 percent of Prosper loans (and peer-to-peer loans generally) are for debt consolidation purposes.
And lenders are looking to the websites for higher yields. For example, with an average interest rate of 12.07 percent and an average net annualized return of 9.65 percent, Lending Club notes have yields that are on par with those of high-yield corporate bonds. The 2.5 percent annual default rate on Lending Club loans is about the type of default investors might see on BA1 or BB rated bonds. The yield on the B1 or BB rated bond is about 6 percent now. So by returning 9.5 percent, Lending Club notes add 350 bps extra yield.
“I can envision a certain segment of advisors looking at this and saying here is a way of differentiating myself from other advisors, by having a skill set and understanding of this market, helping clients gains some additional points of return,” says Ron Shevlin, senior banking analyst at Aite Group. But, Shevlin adds, the evaluation and tracking of the investments might be too much work for the actual return.
The industry talks a big game. “As peer-to-peer lending enters the next stage of its evolution, it is clear that the industry will become a third way of banking,” says Chris Larsen, CEO and co-founder of Prosper. “A way of consumer lending that is more durable and transparent than the now discredited Wall Street securitization schemes; more opportunistic for lenders; and fairer for borrowers compared to credit card companies in particular.”
Clever, But Smart?
It's not just the industry that predicts big things. In its January 2009 issue, the Harvard Business Review dubbed peer-to-peer lending one of the 10 breakthrough business ideas for the coming year. Tighter consumer credit coupled with the economic downturn would kick off a boom in such loans, the article's author predicted, saying “in five years every major bank will probably have its own peer-to-peer lending network.”
But not everyone is a fan. Indeed, the whole concept seems to inspire either fascination or contempt. So inspired are some skeptics that they have established anti-peer-lending blogs dedicated to bashing the use of web broker loans.
Free Markets Have A Bad Name
For advisors, a couple of hundred basis points of yield might not be enough of a payday to generate much interest, given the risk that you are taking, to wit, loaning a stranger cash based exclusively on his credit score. Other concerns are the lack of an investment track record and the risk profile that underpins some of the loans. (“I am loaning money to a woman for what?! A wedding?!”) Peer-to-peer loans are usually unsecured and, in the event of defaults, the lender's notes are not covered by FDIC insurance. Even though peer-to-peer lending notes are registered as securities with the SEC and packaged with a disclosure, for some compliance officers, the standards for borrowers on these sites might not be stringent enough.
The only independently verified standard lenders have to evaluate is the borrower's credit scores gathered from the credit agencies and provided by the sites. Borrowers are allowed to add their income and employment details, and to explain the reason for their loan request, but this information is not verified by the sites. (This may remind some of the no-documentation “liar” loans that came to epitomize the housing/credit bubble.) Both Prosper and Lending Club require that the borrower meet a minimum FICO score; at least 660 at Lending Club and 640 at Prosper. They also take into account the borrower's debt-to-income ratio (excluding mortgage) and require a clean and established credit history. (Prosper doesn't have a debt-to-income ratio requirement; however, a high DTI will impact a borrower's Prosper rating.) Whereas Prosper allows borrowers and lenders to set their own rates, Lending Club underwrites the loan.
In addition to borrower's ratings, diversification is key to protecting capital and reducing the risk of low returns for investors. In fact, investors issue lots of little loans to spread around the risk; as a result, 99.6 percent of Lending Club investors have positive returns, according to Lending Club research. Most of the lenders who are earning a minimum yield of 4.9 percent are invested in at least 400 loans. Prosper also advises its small investors to spread cash across 100 different loans in micro amounts of money. Prosper encourages small investors to offer micro loans of $25.
Paul Tolley, chief compliance officer at Commonwealth Financial Network, says peer-to-peer lending has not reached his firm's radar screen, but if it does, he doubts it would even get through the initial due diligence process. “We would first have to determine if the product was suitable for anyone — I'm not even sure we would cross that point,” says Tolley. “A 640 credit score is laughable to me, and no income verification requirement is just mind-boggling with the mortgage crisis — that's how all the banks got into trouble for no verification of loans. What do you think is going to happen here?”