P2P Lending: 2B or Not 2B?

Peer-to-peer lending is popping up a lot in banking circles all of a sudden, and reactions run the gamut.

At Wells Fargo, some employees received an email late last year saying they cannot participate in P2P lending because companies in that space are considered part of the competition. At the other extreme, tiny Titan Bank in Mineral Wells, Texas, is buying P2P loans for its own portfolio in an unusual alliance with the largest originator in this niche.

But even as more bankers take sides on what some see as a newly emerging battleground, it's fair to say that most have given little thought to the P2P sector so far. Websites such as Lending Club and Prosper, which match up consumers seeking to borrow money with other consumers willing to use their own money to fund those loans, are just not on their radar.

That's about to change.

Though still a microscopic part of the estimated $11 trillion consumer lending market, P2P is going to matter in a big way sooner than you think, say those familiar with the sector. The pioneers in this space are moving past the early losses and regulatory hiccups that held them back for years. They are growing fast, mostly through loans to consolidate credit card debt, and taking some of banks' best customers in the process.

Thanks to their success, more P2P startups are proliferating. Some, like Funding Circle, are using the same model to offer small-business loans.

Now P2P lenders are starting to recruit traditional players in financial services—banks like Titan and institutional investors—to help fund their loans and fuel their growth. A few also are paying banks for customer referrals.

And some online direct lending startups, though still considered part of the P2P sector, do not use "peers" at all in the funding part of the equation. Instead of having individual mom-and-pop contributors risk small amounts, they line up big investors like hedge funds to buy their loans in bulk.

Brendan Ross, president and portfolio manager at the hedge fund Direct Lending Investments, buys small-business loans from online lenders such as IOU Central and QuarterSpot for his fund. The way he sees it, P2P has created an entirely new bank model. It may not be fueled by "peers" as once envisioned. But it is all the more powerful in this new incarnation.

"People think of P2P lending as an Internet phenomenon, but it's not," Ross says. "It's a banking phenomenon."

He says P2P players do almost everything that banks do—market products, evaluate borrowers, underwrite and service loans. "The only thing they're not doing that a bank does is lending their own capital. They're lending other people's capital," he says. "They're like a bank without a balance sheet."

Unlike the spread lending done by traditional banks, this platform lending model, as Ross calls it, makes starting a new bank—or at least the functional equivalent of one—easier than ever, he says. Partly because they don't have the same regulatory burdens as traditional banks, the players in this space can use technology to evaluate risk in new ways and help borrowers that banks reject.

P2P makes sense for sophisticated investors as well. Ross says he generally buys loans that mature in a year or less, with interest rates ranging from 15% to 40%. Default rates usually run from 6% to 8%.

Ross predicts P2P is going to become a major force in lending and he says traditional banks need to figure out how they fit into the new paradigm.

"I believe this decade will see platform lending emerge to rival spread lending," he says.

In his view, the opportunity for banks is in "monetizing their declines," by vetting these new types of lenders, partnering with reputable ones, and referring customers who get turned down for bank loans. QuarterSpot recently began working with banks in this way, paying an origination fee for the referrals.

If bankers are skeptical, the peer-to-peer sector's bumpy start could be partly to blame. But those familiar with P2P say it is now in its "2.0" stage.

Companies like Lending Club and Prosper, which helped create this niche, look much different than they used to. Over the past year, they have been making headlines that illustrate as much.

Lending Club, for example, received a $125 million investment from Google and added Larry Summers, the former U.S. Treasurer, to an already substantial board that includes former Morgan Stanley titans John Mack and Mary Meeker. It has plans to do an initial public offering sometime this year.

Prosper received a $20 million investment from Sequoia Capital upon bringing in a new management team in early 2013. The team quickly made changes to improve the borrowing and lending experience. Just as significantly, it settled a longstanding class-action lawsuit by Prosper "1.0" investors for $10 million, putting a close to a problematic first stage in which defaults soared above 36%. The company also has high-profile board members of its own, including the Consumer Financial Protection Bureau's former deputy director, Raj Date.

Both Lending Club and Prosper expect this year to be particularly momentous for the P2P sector, given the growth tear they are on. Prosper, which began operating in 2006, surpassed the $1 billion mark in total loan issuance last year. Ron Suber, its head of global sales, says he expects the company will loan out another $1 billion in 2014 alone.

Lending Club, launched in mid-2007, had just $3.5 million in first-year originations. But its total lending has grown to $3.4 billion, with $2 billion of that coming in 2013. December was another record month, with $240 million issued through more than 17,000 personal loans.

Scott Sanborn, Lending Club's chief operating officer, says loan volume roughly doubled every year since inception. "We believe now we're one of the top five issuers of personal loans in the U.S."

With the economy recovering, the websites are attracting consumers with improving credit scores who want to swap their credit card debt for a loan. Applicants with high enough FICO scores can apply for a maximum of $35,000. Loan sizes average $13,625 through Lending Club and $6,830 through Prosper.

Peter Renton, whose LendAcademy.com blog tracks the P2P industry, says small-business owners also are increasingly turning to social- and direct-lending sites as a way to obtain credit that isn't available from banks, or as a less-onerous alternative to asset-backed or factor-type lending. He cites Funding Circle, QuarterSpot, and Fundation as examples.

"Some of these newer online lenders are providing lower interest rates than most cash-advance people, and providing same speed, and that's what I consider very interesting," says Renton. "If you can pay 18% APR on a loan, and have it in two days, that's a very attractive proposition for a lot of small-business owners."

But what's truly driving the market lately is a surge in interest from institutional investors like hedge funds, insurance companies and private equity looking to buy up loans.

According to Sanborn, more of these investors have been coming to Lending Club to shop for loans to add to portfolios, in search of high yields, short duration and tolerable risk.

"Over the last two to three years, we've seen a broad diversification on who's investing," Sanborn says. Instead of smaller investors placing opening lender accounts of $10,000 to $20,000, "we've moved into higher net worth individuals, and increased dealings with those individuals through registered investment advisors, family offices, and broker-dealers like Morgan Stanley."

Lending Club began adding community banks to the funding mix last summer as well. It has signed up seven so far, including Titan, and is recruiting more.

Based on the average one-month interest rate of 14.63% charged to Lending Club borrowers since 2007, minus fees and an annual default rate of 3%, Sanborn estimates investors are getting 6% to 10% returns on P2P loan portfolios.

A chief goal of the new management team at Prosper was to make the service more friendly to institutional investors. Aaron Vermut, Prosper's president, and his father, Stephan, the CEO, have experience in that market, as does Suber, from running their prime brokerage and hedge-fund advisor Merlin Securities. (All three moved to Wells Fargo after the San Francisco banking company bought Merlin from Sequoia Capital in 2012.)

What's attractive to institutional investors, says Vermut, is the opportunity "to get access to consumer credit directly" rather than through derivatives and securitization. He says P2P is "a totally unique asset class and value proposition" that allows them to create a customized portfolio comprised of pieces of loans or whole loans that fit their specific investment criteria.

Under its new management, Prosper adopted a bankruptcy-remote business model that shields the notes held by lenders from the company's business operations. This reassured investors that they were only exposed to the risk of the loans they held, and not any corporate misfortunes. (A similar structure already existed with Lending Club.)

Both Prosper and Lending Club make money from fees and interest. They charge a one-time fee to borrowers when the loan is originated, and a monthly fee to lenders for servicing. The fees equate to a small percentage of the loan amount. Lacking charters themselves, both companies originate their loans through WebBank, a $138 million-asset state-chartered industrial bank in Utah.

The online format means the operation costs are one-third that of a retail bank, according to Lending Club. "We don't have branch infrastructures and don't have capital reserve requirements," says Sanborn.

In its P2P arrangement with community banks, Lending Club originates the loans, which Titan (and the others) buy at face value. The banks receive the monthly loan payments and pay a monthly servicing fee, equal to a percentage of the underlying balance, back to Lending Club, which keeps the relationship with the borrower.

"Banks have been buying loans and participations forever," says Jonathan Morris, who oversees the P2P initiative at the $63 million-asset Titan and is president of its parent company, BMC Bancshares. "Nothing here is really that different."

Morris says new loans available to be purchased are posted four times a day. He says Titan electronically sifts through the loans, evaluates their credit quality based on its own criteria (it requires a FICO score of at least 700, for example), and chooses the ones it wants to take. He says Titan is still building up its portfolio of Lending Club loans, and would not disclose the size of it.

The bank typically buys credits rated "A" or "B" by Lending Club (the ratings go as low as "G"). The average interest rate is 7.82% for "A" loans and 11.74% for "B" loans, according to Lending Club's website, and the average return is 5.19% and 7.82%, respectively.

So far Morris is pleased with the performance of the loans, which typically have a duration of 36 months. "We're doing above average."

He says he started talking with Lending Club more than a year before the bank started buying the loans, partly because he likes to know about "what's emerging on the forefront of banking."

Working out the kinks in how a bank partnership might work also took a while. "We were really waiting for compliance and other components to be in place, where it made sense for a bank to play in this space," Morris says. "Once that all came together, we were pretty eager to get involved."

The biggest benefit for Titan is diversification. It concentrates on small-business lending, but is now able to put on its balance sheet unsecured consumer loans, which is a type of lending it could not afford to do on its own. "Lending Club has allowed our bank and other banks to play in a sector that wasn't efficient enough to be profitable—in many cases even if the loans performed," Morris says.

He dismisses the notion of Lending Club being a competitor, at least for community banks. "Lending Club is clearly meeting some kind of customer need that's not being filled," he says. "Who are they displacing? They're not displacing the small and medium banks. Let's face it: [those banks] haven't been making zero to $10,000 consumer loans with no collateral for a long time. It's not even an asset class that gets tracked anymore."

The biggest banks fill the need for such loans with credit cards, which Morris says is not a great product for consumers because of the high rates and fees, and not a viable product for small banks like his. "There's no way to compete in the credit card business against Wells Fargo and Citibank. How do we do that? We can't," he says. "Now that we have Lending Club as a data processor—which is how I look at them—all of a sudden we have that ability."

In an email to what it describes as a "small group" of employees who requested an ethics ruling on P2P, Wells Fargo reportedly deemed it a competitive activity.

"Going forward, please refrain from making any new P2P investments/loans," the message said, according to the Financial Times, which saw a copy and published a story about it in January. "If possible, exit existing investments as soon as practical (without forcing a loss) or when the loans are paid off."

Though the email mentions "loans" at least twice, a Wells Fargo spokeswoman says her understanding is that the guidance was meant to apply to investments in the stock of P2P companies. She says Wells Fargo's code of ethics prohibits employees from investing in businesses that compete with the bank.

She did not directly answer a question about whether that meant Wells Fargo employees are allowed to participate in P2P lending. She said employees would have to ask their compliance officer.

Ross, who operates the hedge fund, says banks are correct to view P2P lenders as competitors but short-sighted if they use that as a reason to steer clear.

"It's almost like we're literally watching the ostrich with its head in the sand," he says. "They should be figuring it out."

Morris was amused by Wells Fargo's email, and, like others, interprets it as a validation of sorts for P2P lending.

"Titan Bank is excited to be a competitive threat to Wells Fargo," Morris says. "If that's the perception of Wells Fargo—that this technology has been such an equalizer that even a Titan Bank is a competitive threat to them—I think it's a good thing for small banks and it's a good thing for the market."

The P2P pitch is attractive to consumers, says Ross, who also suggests that banks can pick up valuable lessons from it. "People seem to like the idea of being able to get out of debt in five years, and they're willing to pay an origination fee to do it," he says.

They are perhaps more willing now that the P2P industry has put some of its early reputational hits behind it.

A 2008 dispute with the Securities and Exchange Commission is often viewed as the dividing line between today's market and the original lending models envisioned by Prosper founder Chris Larsen (of E-Loan fame) and Lending Club founder Renaud Laplanche.

Both had been looking to erode dependence on traditional financial institutions in the personal loan space. But the SEC filed a cease-and-desist letter, arguing that they were selling unregistered securities in the form of loan promissory notes. Both firms settled and went through a formal registration process, complete with a dormant quiet period in which neither sold loans to the investing public. (Lending Club continued to issue loans to borrowers with its own funds.)

The prospect of waiting for registration approval prompted Zopa, a British player, to drop plans for a U.S. expansion. But by 2009, Prosper and Lending Club were back selling to investors in states where they were permitted to do so.

Regulation is still a threat now that the CFPB is in place, however. Questions emerged shortly after the passage of the Dodd-Frank Act as to what authority the bureau would have over P2P and direct online lenders, particularly those already under the auspices of SEC oversight.

In 2011, the U.S. Government Accountability Office released a much-anticipated study outlining the future roadmap of regulation for the P2P market. One path would continue with SEC oversight where federal-level securities regulation would govern lenders while states ensure compliance to borrowers' rights; another would involve the reclassification of P2P loan investments as consumer financial products that would place the industry under the CFPB's watch. The GAO did not recommend any particular option.

The surge in peer-to-peer lending volumes isn't the only evidence of the market taking off. So is the growing number of P2P startups.

Funding Circle, a U.K. P2P lender, has opened a U.S. arm based in San Francisco with a $35 million investment. Another fresh entry, FreedomPlus, a Freedom Financial Networks affiliate company that is headed by former Prosper and Lending Club executive Joseph Toms, plans to expand P2P to consumers with FICO scores below 660 (which is the cutoff for Prosper and Lending Club).

Given Prosper's poor experience with bad-credit borrowers, this would seem to be folly. But in working with debt-consolidation companies over the past five years, Freedom Financial has done well with a product targeting consumers who have average credit card balances of $16,300 and an average FICO of 576, according to Toms. "The default running rate was under 2%," Toms says. "There are a lot of people out there with large balances that have poor credit scores but have fundamentally put into place the necessary things that allow them to become better credit scores."

Then there are the P2P mainstays who are getting better at what they do and trying out new things, too.

Lending Club, for example, is testing a service with two community banks (Titan is one of them) in which they can offer a customized Lending Club application to bank customers who would otherwise get turned down for an unsecured personal loan. The bank gets a "little" referral fee, according to Titan's Morris, who says the larger appeal is in helping a customer. "I'd always rather have a solution for somebody than just a flat 'no.'"

Bonnie McGeer is managing editor of American Banker Magazine. Glen Fest is a senior editor at Leveraged Finance News.