Investing

Peer-to-Peer Lending: Problems and Promise


Just when it might have proved most useful, peer-to-peer lending has been severely hamstrung by the U.S. Securities & Exchange Commission's efforts to get a regulatory handle on the fledgling industry. With the credit crisis making it harder and harder for cash-strapped households and small businesses to get bank loans, the opportunity for creditworthy applicants to borrow up to $25,000 from strangers at slightly higher interest rates was seen as something of a godsend.

In a cease-and-desist order to Prosper.com on Nov. 24, 2008, the SEC labeled the loan notes that Prosper issued to investors as securities and said the company violated sections of the Securities Act between January 2006 and mid-October 2008, by selling securities without an effective registration statement or valid exemption from registration. The order cited the definition of a security under two Supreme Court cases as the basis of its judgment that Prosper's notes qualify as securities.

That judgment could potentially sink Prosper, ultimately costing it up to $10 million, Jim Bruene, editor and founder of Netbanker.com, an online banking resource site, wrote in an open letter to the SEC posted on his Web site. The ruling also exposes Prosper to potential class-action suits from investors who may try to recoup losses on loans by arguing the platform was selling unregistered securities, he said.

Prosper, the leader in the peer-to-peer lending business with about 80% of total loan volume in 2008, stopped accepting new loan applications in mid-October, pending the SEC's review of its registration paperwork. Another P2P lender, Loania, is also registering with the SEC, while British import Zopa, an industry pioneer, retreated from the U.S. market very soon after entering it, probably to avoid onerous regulations and the resulting added expenses.

SEC Registration Lends Credibility

That leaves Lending Club and startup Pertuity Direct as the only social lending networks still operating. Lending Club was shuttered for six months last year while it awaited the SEC's approval of its registration. It emerged in November with tougher qualifications for investors: minimum household income of $70,000 a year and net worth of at least $70,000, excluding a person's primary residence. Pertuity's hybrid structure, where lenders don't choose individual loans to invest in but are automatically invested in the entire loan portfolio through a mutual fund, the National Retail Fund, already subjects it to SEC oversight.

Renaud Laplanche, founder and chief executive of Lending Club, sees registration with the SEC as giving more credibility to the business, as well as ensuring transparency. "There's a general sense of maturity in the space that comes out of [the process]," he says. "It made it possible for us to establish a secondary market for the loans to give lenders the ability to sell a loan if they need liquidity for any reason."

Some lenders, such as Jim Hoffman, who joined Lending Club in January 2007, are using the secondary market not to sell loans but to buy additional ones at a slight discount and with essentially less risk. That's because by the time they hit the secondary market, loans are partly paid off and have established a payment history.

Both Lending Club and Pertuity require prospective borrowers to have a minimum FICO score of 660; the average score is 714 at Lending Club and 740 at Pertuity. Lending Club pulls the credit report and quickly posts qualifying loans with assigned interest rates to the Web site for lenders to review and decide whether they want to fund them. Meanwhile, the platform's underwriters verify employment and income for a random sampling of about one-third of the loans posted. Fixed interest rates are assigned based on credit histories, with the lowest rate around 7.8% and an average rate of 13%. In March, Lending Club added a self-directed IRA account option to enable investors to defer paying taxes on their returns.

Possibly a $1 Billion Industry by 2011

Since it started as a Facebook application in May 2007, Lending Club has made more than $33 million in loans as of Apr. 3, and has turned down loan requests equaling nearly nine times that amount. Of the 3,904 loans issued, 4.2% have defaulted and another 3% are between 30 and 120 days late, while almost 6.2% have been prepaid. Prosper has issued 28,939 loans worth a total of $178 million, 20% of which have defaulted, with 20% prepaid and 4% at least 30 days late.

Michael Kalscheur, a financial consultant at Castle Wealth Advisors in Indianapolis, likes that Lending Club has declined most of the loans for which borrowers have applied. That tells him "that Lending Club protects the investors from bad apples who are likely to increase defaults and lower everyone's profits," he wrote in an e-mail.

Lending Club's loan volume has doubled since the fourth quarter of 2008 and Laplanche expects the platform to process $150 million worth of loans this year and $350 million in 2010. Depending on how many new players enter the market, it could grow to become a $1 billion market within two years, he says.

Given the $1 trillion size of the consumer lending business and the fact that the asset-backed securities marketplace that allowed it to expand is moribund and won't come back soon, Kim Muhota, founder and chief executive at Pertuity, also sees potential for peer-to-peer lending to grow to be a billion-dollar industry within the next two years.

Pertuity's Borrower Rewards Program

Peer-to-peer lending has been criticized for not making loans widely enough available to fill the gap left by the collapse of the asset-backed securities lending model, but Pertuity Direct, the newest entrant, which launched in late January, isn't interested in being the lender of last resort to high-risk borrowers. "It's set up to reward good borrowing behavior," says Muhota. Hence, the Pertuity Bucks program, which allows investors to review individual borrower profiles and track their repayment behavior before deciding to award a certain portion of their annual $500 reward allotment to those who consistently make payments on time.

Borrowers then use those reward dollars to pay down the principal on their loans. When multiple investors are rewarding the best performers, it can add up to significant principal reduction, says Lisa Lough, Pertuity's head of marketing.

The rewards strategy points up a key difference in approach between peer-to-peer and traditional lending. It's in stark contrast to credit-card companies that routinely cut borrowers' credit lines and jack up their interest rates across the board, without regard for whether people have never been late with a payment, says Muhota.

Perhaps as important, the rewards program is the only way for investors to interact with the community, since they play no part in the underwriting process. Although other platforms have given lenders access to lots of data about applicants, lenders recognize that doesn't give them the credit expertise to make loan decisions, says Muhota. What investors are looking for more and more is a platform that provides risk management and a way to put their money to use as quickly as possible, he adds.

Credit Crunch Affects P2P Lending, Too

There's not much difference, however, between a lending community like Pertuity that makes all the loan underwriting decisions, and a traditional bank, argues Bruene at Netbanker.com. "They've just replaced the FDIC-regulated intermediary with an SEC-regulated intermediary."

It's probably a wise idea not to base the underwriting process on the wisdom of crowds, says Bruene. That's what Prosper's auctions were all about and it led to underwriting decisions that "weren't that great," he adds.

Investors can put money into the mutual fund on any day but are only allowed to take redemptions once a quarter. Total redemptions each quarter can't exceed 25% of the fund's total value, but the liquidity they provide eliminates the need for a secondary market, says Muhota.

Muhota estimates that nearly half of the several hundred lenders have gotten involved with the rewards program so far, and virtually all lenders have at least begun reading through profiles as the initial step toward deciding who to reward.

Loan volume for the industry as a whole has fallen sharply with Prosper temporarily out of the picture. But the credit crunch may be hurting peer-to-peer lending just as much as it has other kinds of lending, says Bruene at Netbanker.com. Everyone has backed away from high-risk lending and "unsecured loans done over the Internet…is something investors—lenders—are rightly concerned about, given the economic woes," he says.

Another reason that investor demand may be down is that returns in the early years were smaller than expected after factoring in losses from defaults. "Most people who invested got their principal back and a couple [of interest] points of return," he says. "For a lot of them, it would have been better to put their money in a CD, but you can say that about almost anything over the last two to three years."

Social Lending Instead of Trusting Banks

Some financial advisers are leery of peer-to-peer networks as investment vehicles, citing insufficient diversification of risk and potential volatility of returns due to the relatively small number of borrowers available to invest in. But prudent asset allocation metrics fail to take into account one of the big attractions of social lending, the desire to help out borrowers with whom lenders feel an affinity, even if their credit profiles may be less than stellar.

"If I see a person who doesn't have a high credit rating, and who served in the military and is just getting started and maybe made some mistakes in the past—maybe they have three credit cards maxed out and they're trying to consolidate them—I'm more apt to invest in someone like that and give them a chance to get back on their feet," says Hoffman, a major in the U.S. Marines. But because this is primarily an investment, he restricts himself to no more than 15% of loans made to people with lower FICO scores. Of 330 loans he has made so far, seven have defaulted and another seven are late.

Hoffman believes the allure of social lending will outlast the economic crisis. "There's a general distrust [of] the banks. Even personally, I had lines of credit with banks that they closed not because of anything that was my fault but because they didn't have enough money to back up the credit," he says.

That's prompted people to seek out alternative ways to borrow and they've found a greater sense of community when they do. Anna Sinclair got a Lending Club loan for $20,000 in December to complete the financing for a house she bought in Manteno, Ill. She says she was surprised to see how many of her lenders had ties to Davis, Calif., where she attended college. Even though she was putting up cash for 80% of the house's value, has a FICO score above 750, and always pays her credit-card bills on time and in full, the fluctuating income she earns from her own business had caused five banks to reject her loan applications.

She says she takes her responsibility to repay the loan very seriously. "I like the fact that [the lenders are] making money, but I also like the idea that they're taking the risk to help someone else," Sinclair says. In fact, she's waiting to be approved to become a lender herself.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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