Peer-to-peer lending, also known as marketplace lending, has gained in popularity as an alternative investment in the past few years. The practice is fairly simple: match borrowers with lenders using online platforms, eliminating the role and costs of traditional banks.
Borrowers are attracted to these platforms because they allow quicker access to funds, often at lower interest rates than typically offered by banks. Lenders have the advantage of loaning money at a range of interest rates on peer-to-peer platforms, usually investing in a spread of loans that can deliver steady returns with lower default risk.
While individual and retail investors originally dominated P2P lending markets, institutional investors have recently rushed in. Lending volumes have increased sharply since 2007, growing at an average 84% per quarter, and PricewaterhouseCoopers analysts have projected the space could reach $150 billion by 2025.
Brian Weinstein is Chief Investment Officer of Blue Elephant Capital Management, a New York-based investment manager specializing in short-term prime consumer loans issued on marketplace lending platforms. Blue Elephant has also become a leading authority on the quickly emerging peer-to-peer lending industry in the United States.
Weinstein, formerly the managing director of BlackRock’s fixed income team, sat down with Hedge Connection to explain how peer-to-peer lending works, some common misunderstandings, and where these markets are potentially headed.
Hedge Connection: What is your peer-to-peer lending elevator pitch?
Brian Weinstein: The basic idea behind peer-to-peer lending is that you don’t need a bank to make a loan. If you have the data underlying how loans are made—the underwriting standards and credit scores, things like that—as well as access to capital, a loan can be made without having someone at a bank sitting behind a desk deciding what your rate should be. It can be done more efficiently, quicker, and almost instantaneously in some cases.
HC: These quicker, more efficient loans are being facilitated by peer-to-peer lending markets. Who are the major players in the space right now?
BW: There are two dominant players. Prosper Marketplace, which was the first mover in 2005, and Lending Club, which is the first publicly-traded consumer loan lender. The other notable players, in terms of size, are two public companies: OnDeck and SoFi. OnDeck provides merchant cash advances and small business loans. SoFi handles student loans. There are hundreds of other platforms trying to make headway in various lending markets across the globe.
HC: How are peer-to-peer lending markets structured? Are they banks?
BW: No, they’re not. Each is structured very differently, each with multiple entities. You generally have a technology arm, a servicing entity, and a marketplace entity. But they’re not banks and don’t claim to be. Some of these platforms work with national banks to originate loans, including Web Bank, Cross River Bank, and others. Other platforms directly originate loans without a bank intermediary.
HC: Where was the first peer-to-peer lending platform developed?
BW: The UK had a bit of a first mover advantage, but the real growth and emergence has been between the US and the UK. There’s been some other movement in the dollar block—so, Canada, New Zealand, Australia….
HC: How big is the peer-to-peer lending space right now?
BW: In the US this year it’s going to be between $12 and $15 billion. What it’s going to be is a function of a lot of different things, not just growth. It’s a function of market cycles, credit cycles, interest rate cycles.
HC: What kinds of loans are being made through these platforms?
BW: Prosper and Lending Club loans are generally debt consolidation loans. This makes up almost 75% of loans. People who have credit card debt at a high rate use these platforms to get rid of that debt—which obviously, if you don’t pay back every month, can become more problematic. Using these peer-to-peer lending platforms, you can consolidate your debt, pay it off at a lower rate, and when you’re done with the monthly payments, it’s gone. On the consumer loan side, we see many emerging platforms in near and sub-prime lending, where data is more scarce.
HC: What about small business lending?
BW: There is a small business category. Funding Circle—an English company, from whom we buy loans and has an entity here in the US – does secured business lending. They’re very fast compared to banks. If you have run a successful business for around 10 years and can show 3 years of tax returns, and you need to borrow money, it could take anywhere from 6 to 12 weeks at a bank to go through the whole process. Funding Circle will get you through in a week or two assuming you get approved. The average Funding Circle loan is about $150,000, as opposed to the average Prosper loan, which is about $12,000.
HC: Who are the average types of loan seekers in these marketplaces?
BW: The most common looks like the very average American borrower, income-wise, but a little bit younger in age. These loans particularly appeal to people who don’t want to talk to anybody , like bank officers. You need to be somewhat internet savvy to apply for them.
HC: What does the average loan process look like?
BW: On the borrower’s end, you can go to either Prosper or Lending Club’s website—the experiences are not wildly different—and they’ll ask you for basic information: name, address, social security number. From there, you’ll get a rate indication or get denied. There’s a pretty significant percentage that gets denied. If you’re approved, it will happen in a couple of minutes. Then, someone like us, or an individual, or an institutional investor, will fund your loan. The borrower never sees who funds their loan. They just receive a message that they’ve been funded. From there the borrower has a couple of days to supply other information that lenders will ask you to supply. They might say, “send us a W-2 or your bank account information.” About two-thirds of borrowers do this, and about one-third of borrowers were either lying or just forgot about it and fail to fund. From start to finish, if you went on one of these websites, applied, and got funded, you’d have your money within 3-5 business days.
HC: How do platforms like Prosper and Lending club vet these loans?
BW: They’re doing the same thing any bank or credit card company would do along with a host of new variables. They’re looking at FICO score, how many accounts you’ve opened, how many times you’ve missed credit cards payments. Have you ever filed for bankruptcy? Does anyone have a lien against you? How big is your mortgage? What’s your debt to income ratio? These platforms have to play by the same rules as banks. They’re lending standards are very similar. The information they use to reject you—’you have too much debt’, ‘you have late payments’—is fairly standard.
HC: The types of lenders in these markets have shifted significantly over the past few years from individual investors to institutional investors. Why?
BW: Coming out of 2008, Prosper and Lending Club had to prove they’d learned their lesson. I think the other thing they realized was the fundamental idea behind P2P lending marketplaces was wrong. The idea that there’s a lender for every borrower is logistically incorrect. The problem is, a lot of money that could potentially be lent is sitting in pension funds, in large family offices, etc. You’re not just going to have 200 million Americans trying to lend money, and 200 million Americans trying to borrow money, and every one is going to match up. Prosper and Lending Club realized they had to get onto the more institutional path.
HC: What do you see as being the big risks for investors who put money in these markets?
BW: I think a lot of people make logical jumps in their thinking, that “well, if Prosper and Lending Club could be successful lending money in markets where there’s a lot of data, I can take markets with very little data and lend there too, because technology has solved all lending issues.” I think the pitfall comes from people going too far down in quality too quickly. I also think people fail to recognize where we are in this cycle. There are some very simple rules you can follow, which is when you’re at all-time lows in consumer defaults, which is effectively where we are right now, it’s generally not the best time to go down in quality. It’s the opposite. Sub-prime was a great buy in 2009, 2010, and 2011.
It’s a much worse buy today. I’d speculate it’s not any different in the P2P lending markets. As people scrounge and fight for borrowers, lenders are going to loosen their standards—because that’s what happens. That’s the mistake lenders make. They’re willing to go down in quality too quickly.
HC: How are big banks approaching the P2P lending space?
BW: I don’t think they particularly care, to be honest. If you’re Bank of America—just to pick a really, really big bank—the truth is, you already touch one in four consumers. You have exposure and you don’t need more. You can’t lower your brick and mortar costs any time soon. There’s no way they’re going to reach out to their credit card borrowers, and say, “hey, we’ll lower your rate from 18% to 14%,” because, effectively, it’s very hard for them to raise that rate again. I think where P2P markets will get really interesting over time are the less-than-a-million-dollar credit loans. And banks just aren’t going to do that business. They could eventually do something on the technology side, but they’re just not going to compete on costs or time. Now, as these markets grow, they may change their minds, but we’re a long way from that critical mass.
HC: What about smaller banks? Is there an opportunity for them?
BW: I think smaller banks will find more creative ways to play the P2P space. Prosper has no interest in partnering with ‘Bank of America,’ because I think in some ways they’re a competitor. But if you owned a small bank in Spokane, Washington, and all of your loans are from Spokane, Washington, and you want to have a more diverse book—which you probably do—you could say, “Hey, Prosper, I’ll sell you my Spokane, Washington loan book in exchange for a loan book of the 50 states.” They can support each other, and that’s a healthy relationship.
HC: Are there untapped markets that the P2P lending could potentially service?
BW: Again, the big winner is going to be the consumer space. I think it will happen in other places too. Funding Circle’s model of secured small businesses will be another big spot. The student loan space is interesting. It plays off government inefficiency, so who knows how long that market goes for. That’s another one where there’s probably some opportunity as well. The truth is, capital markets have figured out a lot of the places where you do big lending. Real estate, commercial real estate—capital markets do that very, very well. Autos, also, are done well in the capital markets already. It will take longer to make headway in those markets.
HC: Are there any regulatory challenges facing P2P lending?
BW: There’s a bunch. If you look at both the security code and the tax code, they don’t really contemplate this type of activity. I think the market could use some regulatory clarity. The problem is there’s no real precedent for peer-to-peer lenders to be acting like banks with different funding sources. The Treasury put out a request for comment on peer-to-peer lending, marketplace lending. We have an answer. It’s public and there have been a few articles written about it.
HC: Is there a range of returns investors can expect when investing in these markets?
BW: Totally. There’s all kinds of different things going on. You can do some really safe stuff in different place, including securitizations, where you get very low-to-mid single returns. I would say that the bulk of the space is in the 6% to 15% return range.
Broadly as an industry, loss adjusted returns are in the low teens. Obviously, you can do funny things with leverage. If you look at what Prosper and Lending Club promise, they’re more in the 6% to 7% range over a cycle. It’s a nice return with a very short duration
HC: What are the risks for the market as a whole? How does a P2P lending crisis emerge?
BW: Lending Club was making loans in ‘08, so you can actually go back and look at how they defaulted. I think the lesson is, the default will always be higher than you think in a downturn. That was a particularly interesting case because in ‘08 lending standards were far too easy, and Lending Club was no different. You want to keep an eye on making sure the lending standards are staying relatively strict. A general rule is always assume that whatever the assumed default rates are, especially as you go down the capital structure into riskier stuff, that the losses will be worse. So, you want to pick investments where there’s actually data. Don’t be lured by the fact they’re calling this ‘fintech.’ It’s still finance. The lending is still what matters. As data gets better—which means going through cycles—don’t be afraid to go into some newer spaces. But generally, people who reach for yield at this point in the cycle are going to get burned, and people who are trying to create lending where there shouldn’t be lending will certainly fall into that category.
This interview has been edited for content and clarity.