Season Investments

facebook-logo.pngtwitter.pnglinkedin-logo.png

Peer-To-Peer Is Here!

Posted on July 1, 2014

“We want to transform the banking system into a marketplace that is more competitive, more consumer-friendly, more transparent.” – Renaud Laplanche, CEO of Lending Club 

2014-07-01_blue_man.jpgLast year we wrote a post entitled The Hunt For Yield explaining the budding industry of peer-to-peer (P2P) lending. We followed this up with another post a couple months ago which went into a little more detail in the space and touched on some lessons we had learned from our research and personal experience. After over a year of due diligence on P2P lending, we are happy to announce a new managed account offering for our clients on the Lending Club platform. Lending Club is the leader in P2P lending having surpassed $2 billion in loan originations last year. For those that are still somewhat unfamiliar with P2P lending, we will review the industry and the P2P lending process in this week’s Insight.

As anyone with a savings account knows, banks are paying very little interest on their deposits at pretty close to zero. This “free ride” for the banks is no coincidence as the Fed has kept rates low in order to help banks recapitalize at the expense of depositors; something we like to call grandma subsidizing Goldman. This environment is the primary reason we began looking into alternative income sources such as P2P lending as we stated in our previous posts.

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. 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.

Around this time last year we decided to test the P2P waters by opening our own account and hand picking a basket of loans. This experience along with research and interviews we did with leading experts in this space, gave us a much deeper understanding of the industry. The popularity of P2P lending is growing rapidly. According to an interview Scott McGrew did with Lending Club CEO Renaud Laplanche (embedded below), “Nearly three million dollars changes hands on Lending Club every single day.”

This type of volume has caught the attention of not only individuals looking to earn a higher return on their capital, but also institutional investors such as hedge funds and pension funds. Although this wasn’t the original vision for the P2P lending space, it gives credence to the industry was we pointed out previously.

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. 

Lending Club and Prosper are not banks because they are not taking in deposits and pooling client’s money. They are simply platforms which connect lenders with borrowers by offering personal loans in the form of SEC registered securities.

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.

The whole process of borrowing or lending money through these platforms is extremely streamlined and efficient. The way the process works is as follows:

  1. A borrower submits an online application for a loan detailing how much they would like to borrow, the purpose of the loan (consolidate debt, pay off car loan, launch a new business, etc.) and background information on their financial situation.
  2. Computer algorithms screen and pull credit reports on applicants to weed out unqualified borrowers (Lending Club states that they reject 90% of applicants) and assign a risk score to qualified applicants. The risk score determines the rate the borrower will be charged ranging from 6% - 35%.
  3. Approved applications then go live on the platform where lenders/investors can scan a large variety of loans with different risk and return profiles. Investors than fund loans with investments as small as $25 in some cases. A typical loan is funded by over a hundred different investors all biting off small chunks of the total amount borrowed.
  4. After the loan is fully funded, the borrower must verify the answers on their application with an actual person working for the peer to peer lending platform. If a borrower is unable to provide proof in order to verify their application, the loan is cancelled and no money is exchanged. If the borrower is able to produce verification, the loan is issued, the platform collects an underwriting fee from the borrower, and funds are electronically transferred.
  5. The borrower makes monthly payments to the peer to peer lending platform which then collects a small servicing fee paid by the investors and distributes the funds received to the various different investors backing the loan.

As one might expect, not all loans are created equal and there are a variety of different factors investors can screen for when choosing their loans. Part of our research in this space included historical back testing of the various criteria borrowers disclose on their application to see which are relevant to the rate of default and subsequent return on investment (ROI). For example, the purpose of the loan (refinance, start a new business, etc.) is highly relevant to the default rate but whether someone owns their house outright, has a mortgage, or simply rents makes little to no difference. One problem that has arisen, which we encountered first hand, is that the popularity of this industry has made it almost impossible for individuals to hand select loans directly from the website. What we consider “choice loans” are snapped up in a matter of minutes if not seconds from when they are listed. For this reason we also did due diligence on a couple third party service providers which offer an application programing interface (API). The API allows investors, through automated computer programing, to grab a piece of the choice loans that meet all the necessary screening criteria.

The peer-to-peer lending space is still relatively young (started in 2007), but its growth and ability to make it through the biggest stress test of our time in the 2008 Financial Crisis, shows it has staying power. Making unsecured, personal loans to individuals is in no way a risk-free endeavor, but by diversifying exposure with small investments into hundreds of different loans, the risk of excessive defaults and fraud can greatly be diminished. Putting it all together, the long-term return potential in this space of 8%-10% for a full market cycle, with better returns during good markets, greatly outweighs the risk of excessive defaults.


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.


Subscribe to our Weekly Insight via email!

 


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.