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A Banking Phenomenon

Posted on March 18, 2014

"People think of P2P lending as an Internet phenomenon, but it's not. It's a banking phenomenon." – Brendan Ross, portfolio manager for Direct Lending Investments

2014-03-18_bank.jpgLast year we wrote an Insight entitled The Hunt For Yield in which we looked at the blossoming sector of peer to peer (P2P) lending. The current savings environment of negative real returns on risk free investments like short-term government bonds or FDIC insured certificates of deposit, has created a glut of viable income options for investors. The Federal Reserve continues to maintain its zero interest rate policy to help the most lackluster economic recovery in post-World War history reach escape velocity, and as long as the threat of a Japan-like, deflationary spiral is still a real possibility, the Fed will not be in any rush to raise interest rates. As such, investors must turn to alternative sources for income generation. This week we are going to take another look at P2P lending and further explain why we like this asset class as a part of a well-diversified portfolio.

The consumer lending market is enormous here in the US. The vast majority of this market is dominated by banks and credit card companies who lend funds to qualified borrowers. Traditionally, would-be borrowers that could not qualify for a bank loan would have to turn to credit cards or personal loans for financing. These borrowers are obviously higher risk, so credit card companies charge very high interest rates as compensation for the risk of extending unsecured credit to these borrowers. 

P2P platforms such as Lending Club and Prosper are evaluating borrowers, underwriting, and servicing loans similar to banks and credit card companies. The big difference is that rather than investing their own capital, they are simply creating a marketplace where borrowers and lenders can meet and cut out the middle man. The P2P business model is much leaner than a bank or credit card company, which translates into savings for the borrower and/or higher returns for the investors. Scott Sanborn, Lending Club’s chief operating officer, estimates that their operating costs are roughly one-third that of a retail bank. All of this has created a snowball effect for P2P lending which just surpassed $2.4 billion in loan originations last year in the US.

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Although some people see P2P lending as competition to banks, it really is more of a disruptive force for credit card companies. When is that last time you ever heard of someone getting a $15,000 unsecured loan from a bank? As previously mentioned, credit card companies are in the business of making high risk, high return, unsecured loans to individuals, which has been an extremely profitable endeavor. P2P platforms are stepping on credit card companies toes by taking them out of the equation and offering up these juicy returns to investors. Although the original vision for P2P lending, according to Chris Larsen who pioneered the industry back in 2006 when he founded Prosper, was to “completely disintermediate the Wall Street model;” today, institutional and ultra-high net worth investors account for roughly 2/3 of the P2P market according to The Economist. On the margin, this gives credence to the industry as it has attracted the “smart money” of Wall Street. For further evidence, Google made a $125 million investment into Lending Club which counts former US Treasury Secretary Larry Summers as a board member. Additionally, Wells Fargo issued a directive last year for their employees to cease and desist all P2P lending activity (a directive that was recently reversed) on the grounds that it was considered a competing business.

It is safe to say that P2P lending is carving out a nice little niche in the consumer lending industry and although its history is short, it has survived a fairly turbulent span of time in our nation's history. P2P lending was birthed during the dawning of the Financial Crisis in 2008. We think of this rather turbulent stretch of time as a great stress test for the industry. The table below from P2P data aggregator Nickel Steamroller, shows the return on investment (ROI) for completed loans on the Lending Club platform broken out by issue date. Since all loans on the platform are either 3 or 5 years in duration, the dataset ends in 2011 as loans beyond this date have not yet matured. The ROI calculation is using a passive investment strategy of investing an equal dollar amount into every loan on the platform. As a side note, by utilizing some advanced screening techniques, returns can be dramatically improved from this baseline analysis. That being said, even when looking at the baseline, the consistency of returns and overall risk profile is compelling. It would have been extremely valuable to have an asset class in a well-diversified portfolio which would have squeaked out a positive return (1.3%) in 2008 while almost everything else was dropping precipitously. Since the industry has only improved with more oversight and regulation over time, we would expect better results if history were to repeat itself with another crisis of the 2008 magnitude.

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Although ripe with opportunity, P2P lending is not without its warts and a somewhat steep learning curve. No matter how much screening platforms do on their applicants, fraudulent individuals are sure to slip through the cracks. The only defense an investor has against these individuals is to make small investments in a large number of loans to dampen the impact on the entire loan portfolio. Some experts that we have spoken to have indicated that 400-500 loans is sort of the "sweet spot" for diversification. Any number beyond that amount adds very little incremental value to the portfolio.

We have been working with tools on Nickel Steamroller to better understand the intricacies of the P2P lending space. Additionally, we set up a small portfolio at Lending Club to test out different strategies and put live money to work. Both resources have been extremely valuable as our knowledge and experience in this space has continued to grow. Here are a couple tidbits we’ve picked up along the way.

  • Fraudulent borrowers are most likely to default after they have made one or two payments as a showing of “good faith” that they were not intentionally committing fraud.
  • Finances get tight around Christmas time and some borrowers will miss payments. We had four loans miss payments during the holidays, of which three are now back to being current on their loans.
  • There is a big difference in lending to someone who is refinancing existing debt with existing payments versus someone who wants to start a business or do a home renovation.
  • It is almost impossible to have “first crack” at new loans without the use of an "application programing interface" (API), such as the one being offered by Nickel Steamroller. The demand for “choice loans” is so great that individuals investing directly through their Lending Club or Prosper accounts can’t pull the trigger fast enough to lock them up.

In summary, we continue to like the P2P lending space and think it offers a compelling return/risk profile. Although somewhat correlated with the economy, similar to stocks, we think it still can add a good degree of diversification benefit to a portfolio invested in other asset classes. Our goal is to be able to provide access to this market for our investors in the not too distant future and will keep everyone abreast on that development. 


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.