Riding The Waves Of The P2P Lending Market

Congrats to all involved with the Lending Club IPO. This is what it’s all about: Building something from scratch, enduring the ups and downs, then going public and making a boatload of money.

I’m no Wall Street analyst, so I couldn’t tell you if the ~$8.5 billion valuation that Lending Club (LC) hit at the end of its first day of trading is a fair assessment of its current or future value. But what I can tell you is that there are people who are deceiving themselves about what Lending Club is, and what its future prospects are. The delusions are reflected in articles like CNBC’s How LendingClub Aims To End Banking As We Know It, which states:

“LendingClub is setting out to transform the banking world. To get there, it’s following a playbook popularized by some of the world’s biggest tech companies. Any true comparison between LendingClub and the world’s most valuable tech companies is premature, of course.”

I guess any “true” comparisons between LendingClub and the world’s most valuable lending and investment providers aren’t comparisons worth making, eh?

My take: The conditions which made Lending Club possible and got it this far are temporal and likely to change in the next few years–to LC’s detriment.

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First of all, can’t somebody out there come up with a better term for what Lending Club is than calling it a “peer-to-peer” lender? The institutional investors providing funds on the marketplace are anything but “peers” to the people looking to borrow money on the site.

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There are two conditions that have enabled Lending Club to exist and prosper (get it?). The first is a pool of investors that would like to get a better return on their available capital than what they can get from other (i.e., existing) investment alternatives.

The second is a pool of borrowers who need funds and are willing to pay a higher rate than they would have to pay elsewhere, or, more likely, that need funds and are unable to get those funds from other (i.e., existing) sources.

The size of these two pools–and their willingness to use Lending Club to meet their needs–have been sufficiently large, and growing over the past few years to fuel Lending Club’s growth and drive the IPO.

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The questions to answer are: 1) Why did these pools grow over the past few years? 2) Will they continue to grow in the future?

The investor pool grew largely because of two reasons: 1) incredibly low interest rates, making it hard to find acceptable returns, and 2) even in the face of an increasing DJIA, professional money managers are always looking for superior returns to outshine the competition.

Why did the borrower pool grow? Because the economy sucked, and, to some extent, because some  (many?) individuals are mismanaging their financial lives–many are, or have been, unable to pay off existing loans and credit card balances. In fact, 83%of Lending Club borrowers report using their LC loans to refinance existing loans or pay off their credit cards.

Reported Loan Purpose

20141215 LendingClubSource: Lending Club

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So what happens going forward? It mostly depends on the state of the economy, the direction that interest rates go in, and the P2P lending market itself.

If we experience a period of economic prosperity, and people are more able to pay off their loans and credit cards, Lending Club may very well see a steep drop in loan volume. Roughly 62% of Lending Club’s 2014 loan volume came from borrowers with a Grade C or lower rating. What happens when the economy improves and the Gen Y population–who start off adult life with lower credit scores and grades–mature and move into higher creditworthiness classes? Is there another pool of risky borrowers to fill the void? And if interest rates rise, could the rates that borrowers must pay on the LC platform might be even too high for them to stomach? Grades E, F, and G are already paying interest rates in excess of 20%. We’re getting close to payday lending territory, no?

Will the investor pool grow? This is comprised of two components: 1) the number of investors, and 2) the amount of funds those investors put into the marketplace. I can’t talk to #2, but it seems likely there are limitations to the number of investors who can or will participate in LC. As the marketplace has grown, competition to fund the best borrowing opportunities has grown, and has even spawned new companies who help investors identify their best opportunities. As a result–much like the stock market itself–professional investors have an edge over individual, amateur investors. As a result, the number of individuals investing in LC will likely remain capped.

And with a first day valuation of $8.5 billion, I’m guessing that venture capitalists across Silicon Valley are firing up their bongs and thinking “Dude! I gotta invest in one of these pee-pee lending marketplaces!” And that means more competition for Lending Club. Increased competition will likely result in some erosion of LC’s overall share.

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Claims that Lending Club is “disruptive” or that it will “end banking as we know it” are so totally ridiculous that it has to make you wonder what the claimants were smoking when they made these claims. Lending Club is a niche player in the lending market, a fringe player.

According to the Federal Reserve, consumer loans issued by the 100 largest banks (ranked by assets) grew 6.5% between Q1 2012 and Q3 2014 to nearly $1.18 trillion. From the 2015 Financial Brand Marketing Survey, 43% of respondents indicated that their FI’s loan volume increased by more than 10% in 2014 over 2013 levels.

Disruption? Ending banking as we know it? Hardly. More like creating a niche somewhere between credit card borrowing and payday lending.

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Bottom line: I can’t tell if you $8.5 billion is a fair valuation for Lending Club. What I can tell you is that, if and when the economy improves, it’s going to face some stiff challenges.

That said, I would love to have a ride on the boat.

Delusions Of UnBanking

In a TechCringe (cuz that’s what most articles on that site make me do) titled Startups And The Un-Banking Of America, a VC writes:

“While critical to our economy, banks are generally inefficient, have high fixed costs and don’t exactly elicit happy thoughts from the average consumer. It’s for these reasons, among others, that the biggest opportunities in the financial world revolve around the disintermediation of these banks and core financial services.”

My take: The same could be said of dentists, yet the world of dentistry doesn’t seem to garner even .001% of the disruptive-related attention that banks do.

There are some assertions in the TC article that make me wonder if VC really means “very confused” instead of “venture capitalist.” Let’s look at some of these statements, and my take on them.

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VC: “It’s not hard to imagine that a majority of the people in the U.S. could be “banking” with startups, in one form or another, in the next three to five years.”

My take: For this sentence to be true, we need to make one of a couple of edits:

1) If you’re tripping on some groovy LSD, it’s not hard to imagine that a majority of the people in the U.S. could be “banking” with startups, in one form or another, in the next three to five years.

or…

2) It’s not hard to imagine that a majority of the people in the U.S. could be “banking” with startups, in one form or another, in the next three to five years, if you consider firms like Bank of America and Wells Fargo to be “startups” (since they’ve only been around for ~150 of the millions of years that life has existed on this planet).

I guess that, strictly speaking, it’s not hard to imagine that a majority of Americans could be banking with startups in three to five years, but it’s complete delusion to think that a majority of Americans will be banking with startups in that time frame.

After five years of being in business, Simple (according to its own accidentally leaked email) has just a little more than 33k active customers. That’s about one-tenth of one percent of the number of customers that Bank of America has. I don’t care how evil and bad you think that bank is–no where close to any meaningful number of people will be leaving the bank any time soon.

And, in fact, when consumers have left their banks in the past few years, it’s a lot more likely that they will leave to go other established banks and credit unions.

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VC: “The credit crisis showed the tech industry that one of the biggest areas of opportunity for startups was in re-imagining consumer lending. People were looking to alternative forms of lending for answers and thanks to the problems above, interest in solutions like peer-to-peer lending were on the rise. Not surprisingly, a cohort of companies emerged to take advantage of these trends, beginning with Prosper, which was soon followed by Lending Club and a litany of others. At the core of this emerging market was the desire to take banks out of the equation and connect investors directly with those in need of capital. In other words, disintermediation.”

My take: Nothing like re-writing history to suit your own purposes. Prosper was founded in 2005, Lending Club in 2006–well before the credit crisis. These firms did not “emerge to take advantage of these trends” caused by the credit crisis.

People did, indeed, look to alternative forms of lending for credit, however. Not because of some interest in startups looking to disintermediate (or disrupt) traditional banks, but because they needed money.The statement “at the core of this emerging market was the desire to take banks out of the equation” may be true from the startups’ perspective, but it’s not true of consumers.

And, in fact, Lending Club has evolved to become anything but a P2P marketplace. Today, the majority of funds provided to the marketplace come from institutional investors. Bottom line: There is little evidence to suggest that the traditional banking system is being disintermediated in providing credit to consumers.

p.s. Citing Lending Club’s cumulative lending numbers–which so many P2P lending proponents do to apparently demonstrate the “growing” trend–is quantipulative. Why don’t we show Wells Fargo’s cumulative lending over the past five years and see how it compares?

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VC: “The growing mobility of the average consumer has allowed businesses to spring up and grow by assuming roles traditionally reserved for banks. Check is one of these businesses trying to do an “end-around” on banks by giving consumers the ability to aggregate and manage all of their critical banking information and bills in one place — on their smartphones. Rather than consumers being forced to go to their banks’ websites, their utility company’s website and so on, it put all of these services in one place.”

My take: I have done the sizing/forecasting of consumers’ bill pay behaviors–twice, first in 2010 and again in late 2013. I can tell you that, while third-party sites (like Check) have achieved some gains in bill pay volume over the past few years, the percentage of consumers’ monthly bills that are paid through these sites are miniscule.

What kind of delusion fuels a statement like “rather than consumers being forced to go to their banks’ websites, their utility company’s website and so on, it put all of these services in one place”? What do you think bank sites do? (Answer: They put bill pay capabilities in one place).

Banks used to think that their bill pay sites were superior to biller sites because consumers didn’t have to “hunt all over the Internet” to pay their bills. I really have had bankers tell me that over the years. It still stands as one of the stupidest things I’ve ever heard a banker say.

Not only is it perfectly convenient for consumers to get an email from their biller, click a link, and pay the bill, but the real trend in consumer bill pay isn’t a move to third-party sites (i.e. disintermediation), it’s the shift to direct debit. You wacky Gen Yers are happy to set up your monthly bills to be paid automatically every month!

The other reality in the bill pay space is that the success of Check (in particular) has come more from its work to simplify and improve the billing process for billers than for consumers.

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The TC article goes on to talk about the “disintermediation of the second tier” and the potential impact of Bitcoin. I’m not qualified to comment on these areas (although you might argue I wasn’t qualified to comment on the topics I did discuss), so maybe whatever the VC said about these things are right. I don’t know.

But I do know–or at least, I’m willing to assert and bet–that that un-banking of America (as is relates to debit, credit, and bill pay) is nowhere in the making. Especially not in the next three to five years.

Big thanks go out to @sytaylor for bringing the TC article to my attention.

Credit Unions: Reinvent P2P Lending

Some university professors recently researched the effect of personal relationships on P2P lending platforms. They discovered three “effects”:

  • Pipe effect. Friends of a borrower, especially close and off-line friends, act as financial “pipes” by lending money to the borrower.
  • Social herding effect. When friends of a potential lender, especially close friends, place a bid, a “social herding” effect occurs as the potential lender is likely to follow with a bid.
  • Prism effect. A friend’s endorsements via partially funding a loan reflects negatively (i.e., becomes a “prism”) on the value of the loan to a third party.

What the study shows is that the volume and patterns of lending and borrowing are influenced by, and strengthened by, the extent of the relationship between participating borrowers and lenders.

My take: Credit unions (and community banks) should interpret these findings to find ways of introducing P2P lending-type practices into their lending processes.

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The 2013 Financial Brand survey of marketers found that — not surprisingly — lending is at the top of the list of marketing priorities for the near future.

How are credit unions and community unions going to compete for the borrowing business that’s out there? If it’s going to be by berating big banks, pointing to the results of bogus customer experience surveys, and going on and on about how great their customer service is…then I’m not sure the results will be all that much better than they’ve been in the past.

Which is to say, not very successful.

What the results of the academic study suggests to me is that a credit union or community bank could improve its market share of the lending business in an area by creating a community of lenders and borrowers to redirect and/or insulate the flow of funds away from other sources and destinations to the CU or community bank.

I’m not suggesting that a credit union or community bank try to recreate a Prosper or Lending Club. Those firms have gone through a regulatory rigamaroll that no CU or bank wants to go through.

But I can’t help but think that are ways to avoid that regulatory nightmare and still achieve some of the feel of the P2P lending platform.

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On a P2P platform like Prosper, a lender (or multiple lenders) — OK, wait. Let’s call them for what they really are: Investors. On a P2P platform, an investor or investors lend(s) money to a borrower. The platform isn’t really an intermediary, it’s simply an enabler — i.e., enabling two or more parties to find each other and execute a transaction.

What does a bank/CU do? It finds depositors, takes their money, and promises something in return (where that something may or may not be financial). It then takes those deposits and lends some portion of it out to borrowers it deems worthy of receiving those funds.

The bank/CU is an intermediary. Depositors have no idea who gets the money, nor do they have any say in who gets the money or at what rate. There is no relationship or connection between depositors and borrowers.

But what if there was a relationship or connection? The academic study implies that the “platform” — in this case, the bank or CU — would benefit because lenders (in this case, depositors) and borrowers would be more likely to transact with each other.

In other words, one way for credit unions and community banks to gain market share in the lending market is to create a mechanism for depositors (lenders) and borrowers to create and strengthen a relationship.

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That “relationship” doesn’t necessarily have to be a one-to-one, named connection. A bank or CU depositor could provide input into determining who receives their deposits (or some percentage of it) by some dimension that characterized a borrower. For example, the depositor could indicate that they would like their funds lent to someone buying their first home, or to a small business owner who needs funds to grow their business, or to someone looking to pay off debts. They wouldn’t necessarily get to direct 100% of their deposits, but by giving depositors an ability to direct some percentage of the funds, it would approximate what’s happening on a P2P lending platform.

By making the elections of funds deployment public, other community members would see where their peers are looking to direct funds, and — as the study implies — become more likely to elect that their funds go to the same places. With publicly available information about where depositors would like to direct their funds, potential borrowers who fit the description(s) would become more likely to turn to the bank/CU for a loan, knowing that the FI is looking for borrowers like them. 

The deposit nature of the relationship wouldn’t be changed — that is, the deposits would not become investments in the sense that they are on a P2P lending platform. The bank/CU is still an intermediary determining the creditworthiness of a borrower and the rate at which that borrower qualifies for a loan. But the depositor gets to provide some input into who gets the money (or some percentage of it).

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I realize I haven’t thought through this completely, and, for all I know, there’s  some regulatory issue that stops this in its tracks. I’m just thinking about how smaller FIs are going to compete with the big ones for the coveted lending market.