Crowdfunded Lending: Why does this even exist?

Exploring the logic and sustainability of the P2P Lending business model

Brief Overview of P2P Lending in the US

While its flashier cousin Crowdfunded equity gets lots of press, Crowdfunded (aka Peer to Peer or P2P) lending has skyrocketed quietly. The two biggest platforms, Lending Club and Prosper, have together facilitated over $6B of loans in the last 5 years. Lending Club might even IPO soon!

How did this all start? The interest rate on the average unsecured consumer loan ranges is 10-13% while the average deposit rate in the US even for a 5-year CD is <1%. P2P lending platforms claim to deliver a lot of value to consumers by disintermediating the banking system and its bloated cost structure. Basically, why not lend directly to each other and earn that margin instead of letting the banks do it? I wanted to take this post to assess if it is logical for this market to be significant and sustainable given the scale and centuries old tested model of banks.

How does a bank work vs a P2P lender?

For our comparison purposes, I have created a VERY simplified/stylized set of financial statements of a consumer finance company, e.g. Discover, CapitalOne. Mobile link for image. (Note: This P&L is different from a major US bank whose net interest margins tend to hover around 3% because their loan books are heavily weighted towards mortgages and secured loans.)

When does P2P Lending make sense?

Borrower’s Perspective

Lending club claims their borrowers have an average FICO score of 700 (same as most consumer finance companies) but their lending rates appear to be significantly higher than banks. As always, it pays to shop around. Also, P2P loans are also currently only structured as fixed-rate loans vs most bank personal loans are floating.

Lender’s Perspective

Firstly, as you can see, the higher returns on P2P loans are coming from higher interest rates and NOT from the lower operating cost of an online platform: Cost structure of P2P lender is actually HIGHER than a bank (7% vs 6.2% of loans) for an ostensibly similar profile of borrowers. This should concern potential lenders about who is borrowing on this platform and its ability to diligence and weed-out bad apples.

Second and related, these US P2P platforms only took off 2010 onwards—after the global final crisis. We don’t know how these loans perform in a real down-turn. The charge-off ratios of 6% today might rise astronomically.

Verdict

If you want exposure to the consumer credit market and want to get paid for the risk you’re taking, in the long run, you might be better off buying stocks of well-run consumer finance companies (16% ROE) than lending on P2P platforms (9% ROE) given the potential risk in the latter.

(Full disclosure: As of now, I have a small account (<$10,000) open on Lending Club)