Friday, April 24, 2009

The attraction of Lending Club

Posted on Reuters by Felix Salmon:

I just had a very interesting meeting with Renaud Laplanche, the CEO of Lending Club, the peer-to-peer lender, and I’ve come out very enthusiastic about what he’s doing there.

Lending Club is the most advanced of the US peer-to-peer lenders, in that it has gone through all the legal pain needed to get full SEC registration and therefore has less in the way of legal question marks hanging over it. It also seems in some way the most professional: rather than scrolling through sob stories looking for someone sympathetic to lend to, lenders never even know the identifying details of the individuals they’re lending to, and generally just invest a lump sum over a couple of hundred different people.

The returns so far have been good: according to a report from Javelin Research,

At the close of November, the overall investment return averaged 9.05%, with a median return of 10.48%, based on a Weighted Average Return on Invested Capital (WAROIC). That calculation accounts for Lending Club’s 1% service charge, as well as for loans paid off early, hobbled by late payments or defaulted.

That’s a healthy return, for a fixed-income investment, without being usurous as far as the borrowers are concerned. Indeed, that’s one of the reasons I like this model so much: it allows people to pay off their credit-card debts, which might be well over 20% or even 30% per annum, at a much cheaper rate, over a reasonable three-year time period. You can even prepay your loan at any time without penalty.

Lending Club isn’t trying to lend to people who can’t borrow money elsewhere: indeed, it has pretty stringent underwriting standards, and turns down 90% of the would-be borrowers at its site. The ones who do qualify end up paying somewhere between 8% and 19% interest, depending on their creditworthiness; the interest rate is set by Lending Club, rather than bilaterally between borrowers and lenders.

The company’s default rate is more or less where you’d expect, in the 3% to 4% range; once a loan has defaulted, the recovery is very low. But recoveries on loans which are 60 days delinquent are actually very high, in the 75% range: borrowers really want to repay these loans, and don’t hate Lending Club in the way they hate their bank or credit-card company. What’s more, because the loans amortize over three years, a substantial chunk of the principal amount has generally already been paid back even by those borrowers who do end up going into default.

Another thing I like about Lending Club is that it isn’t only stringent about its borrowers; it’s stringent about its lenders, too, requiring an income of at least $70,000 a year and liquid assets of at least $70,000. In California, where right now most of the lenders are based, those numbers actually rise, to $100,000. For the time being, substantially all of the company’s lenders are individuals — there are a lot of angel-investor Silicon Valley types who consider this kind of investing to be extremely low-risk and a way of making the world a better place. But moving forwards, there’s no reason why Lending Club shouldn’t get substantial institutional investments as well, especially once it’s been going for three to five years.

That said, this kind of investment is particularly well suited to retail investors, because of its three-year time horizon. (It recently launched an IRA product, too, with income reinvested.) There is a secondary marketplace for loans, but it’s not a major feature of the site, and most investors are very much buy-and-hold.

Lending Club is not the best way of looking for particularly sympathetic borrowers, or for lending in an arm’s-length and legally-binding way to a friend. (Virgin Money is the place to go for that.) Instead, it’s just a way of disintermediating a banking system with which many Americans have become increasingly disgusted, with both sides happy with the deal.

How safe an investment is Lending Club? This is the bit I like the most: it’s safe, but not too safe. The desire for safety was one of the main drivers of the financial crisis, and I believe that people with thousands of dollars to invest over a three-year time horizon should be comfortable taking a certain amount of risk. Going forwards, it’s possible that Lending Club will find an insurer willing to offer a principal guarantee in return for a certain insurance premium of say 300 basis points, but in a weird way I like it more this way: it forces investors to worry just a tiny bit about the prospect of losing some of their money, and that worry is ultimately healthy.

No investment yielding 9% a year can ever be risk-free, but I don’t think the amount of risk embedded in a diversified portfolio of Lending Tree loans is at all excessive, given the yield. It’s certainly much lower than the risk of investing in a diversified portfolio of stocks, which is something that hundreds of millions of Americans do as a matter of course. Plus, you get to help out people who are really grateful for your money. So if you want to diversify out of the markets and make more money than on a bank CD, it’s definitely something to consider.

Should you borrow from Lending Club? Well, you can try — but most people who do try, fail. For the time being the demand for loans greatly exceeds the amount of money available, so there’s not a great chance you’ll get what you want. But if and when Lending Club takes off, it could become a great place to borrow money easily and at much lower rates than your credit-card company is charging. Banks have been making it increasingly difficult to get a personal loan in recent years, because they make so much more money from credit cards. Lending Club is now offering a product which really the banks should have been offering all along, but weren’t. I wish it very well.

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