Two of the biggest online consumer lenders don't always check whether borrowers are lying to them, and if they find errors in an application, they may still approve the loan.
Prosper Marketplace doesn't verify key information like income and employment for around a quarter of the loans it makes, according to documents tied to bonds that Prosper sold last month. LendingClub Corp. said it only verified income about a third of the time for one of the most popular loans it made in 2016, according to company data seen by Bloomberg. If either lender finds mistakes in a borrower's application, such as overstated income, they may still go ahead with the loan, according to disclosures linked to bond sales from the companies, including documents for securities that LendingClub is offering now.
Prosper may choose not to validate borrower information because the loan is relatively small, or the borrower is a repeat customer, said a person with knowledge of the matter, who wasn't authorized to speak on the record. Sarah Cain, a company spokeswoman, said in a statement that Prosper has "developed some of the industry's leading risk-mitigation controls" to find and prevent fraud. For 100 percent of its loans, the company verifies borrowers' identities and the existence of their U.S. bank accounts, Cain said.
Alia Dudum, a LendingClub representative, said the company uses "machine learning and other techniques to build robust models that segment which borrower applications need verification and which do not."
The disclosures shed new light on the risks that investors in online loans are taking in their pursuit of higher returns. Loans made on platforms including Prosper and LendingClub have gone bad faster than security underwriters had expected, according to data from Morgan Stanley, and most of the startups have seen their funding costs rise over the last year. These hiccups have come before any real broader sign of economic trouble. The startups are finding that disrupting banks isn't always easy.
Online loans usually don't have have collateral, so when they go bad, investors can lose out. Traditional consumer finance companies and banks tend to check incomes and employment on closer to 100 percent of new customers before making these kinds of loans, according to industry executives. Credit card companies typically do less verification, and accept stated incomes similar to online lenders, said Raj Date, a former deputy head of the Consumer Financial Protection Bureau and a current backer of a subprime credit card issuer. But they also tend to make smaller loans and they often charge higher rates, giving them more of a cushion against losses, Date said.
The online lending industry has benefited from a decade of low interest rates, which has spurred money managers to take more risk in an effort to goose their returns. Investors in LendingClub loans earn average annual returns of around 4.3 percent, about three percentage points higher than the yield for two-year U.S. Treasuries. Those kinds of returns helped nonbank startups arrange more than $36 billion of loans in 2015, mainly for consumers, according to a report from KPMG.
Investors are taking bigger risks outside of online loans as well. Consumers' income wasn't verified for groups of mortgages from Sterling Bank & Trust and auto loans from Santander Consumer USA Holdings Inc. that were successfully packaged into bonds in the last two months, according to reports from bond graders. Representatives for Sterling and Santander did not return calls seeking comment for this story. As the Fed raises rates and consumer delinquencies creep higher, investors may end up encountering more fraud than they had anticipated.
The online lending industry has sought to clamp down on fraud, and at this stage, it's not clear how prevalent it is. LendingClub said in documents for the bonds it is looking to sell now that it tried to verify income or employment for 91.3 percent of the loans it is packaging into the securities. It found that borrowers had overstated their income by a material amount in about 11 percent of the loans.
"Internet-based lending is inherently riskier than in-person lending as there is a greater potential for falsification of information and borrower fraud," Kroll Bond Rating Agency says in many of its reports on bonds backed by consumer loans that were arranged over the web.
In the past, other types of lenders have been clobbered by fraud. During last decade's housing bubble, banks and mortgage finance companies made so-called stated-income loans, and other types of home loans that promised little verification of the data that consumers provided. Customers, or their mortgage brokers, often inflated key metrics like their income. In theory the lenders were protected by collateral even if the borrower stopped paying. But in practice, as foreclosures soared and home prices plunged, lenders worldwide lost big.
Personal loans are usually guaranteed by nothing more than a consumer's promise to repay, so checking his or her ability to make good on their obligation is critical. Even for loans that have collateral, such as mortgages, lenders usually vet borrowers' income and employment, said Andy Pollock, chief revenue officer of Clayton Holdings, a mortgage bond due diligence company that documented wide-scale lending documentation problems running up to the 2008 crisis.
To get a loan offer from Prosper, applicants submit personal information on its website, including name, address, birth date, and annual income, according to a Kroll report on the latest bond offering. Prosper uses this information to obtain a credit report and calculate how much the consumer could borrow and at what rate. Subsequent verification procedures include checking identity and bank account information, the Kroll document says. Those checks often come after the site has already listed the loan for funding from investors, according to Prosper's disclosures.
Prosper can make an up to 5 percent fee for making a loan. It says in its bond offering documents that investors should assume borrowers' income and employment data have not been verified, and that the information may be "incomplete, inaccurate, or intentionally false." In general when it does find an error in an application, it only goes through with the loan if it believes the mistake wasn't material. Prosper checks income and employment data for more than 70 percent of the loans made on its platform, spokeswoman Cain said.
LendingClub verified income on 35.6 percent of one of its most popular types of loans in 2016, according to company data obtained by Bloomberg. That figure has bounced around over time: it was 16 percent in 2008, and 47 percent in 2013. When LendingClub finds an error, it may still fund the loan if it does not view the mistake as material, and it does not update the information given to investors that buy its loans, according to a discussion of its business practices in disclosures from a recent deal backed by its loans. On its website, it says that its verifying income on all applications could lead the best borrowers to seek loans elsewhere.
LendingClub has had to write off a growing percentage of its loans — 8.5 percent, annualized, in the first three months, compared with 5 percent the same quarter a year ago. On a conference call last month, the company's chief executive said it had started using new data sources and technology to reduce fraud and improve borrowers' experience with the platform.
The U.S. Treasury Department last year recommended more robust regulatory oversight for online lending, as well as greater protections for borrowers.
