When peer-to-peer online lending first became possible in the United States five years ago, using the Web to make money by lending it to fellow citizens in need seemed wonderfully subversive.
No more banks! Let the people play loan officer! The hype was literally suffused with the rhetoric of revolution when a company called Prosper began operations in February 2006. "Prosper gives people the opportunity to take back the marketplace for consumer credit," the company's co-founder, Chris Larsen, said in its news release.
The big idea went something like this: Borrowers would post a request for funds and explain why they needed the money. Lenders could put money into part or all of any loan that caught their fancy. And Prosper (and later, Lending Club) would run credit checks of aspiring borrowers for the lenders, watch for fraud, collect and distribute monthly payments and take some money off the top for itself.
People borrowed for breast implants and home renovations, and lenders pored over payment data in search of patterns that could help them select better borrowers in the future. To the Securities and Exchange Commission, however, all of this looked like investing, not lending, and both companies stopped taking in new lenders for months in parts of 2008 and 2009 to get their regulatory houses in order.
Even today, the companies are still trying to persuade more than 20 states, including sizable ones like Texas, New Jersey, Pennsylvania and Ohio, to let individual lenders there put money into loans. The industry appears to be settling into something both less and potentially more than it once promised.
There's a far more basic function that these companies actually serve: The majority of customers who borrow use the loans to pay off higher-interest debt. They are paying 18 percent or more to credit card companies, and they seek Prosper or Lending Club loans that charge, say, 10, 12 or 14 percent. As an investor, your return would be the interest rate that borrowers pay, minus the companies' fee and whatever money the borrowers fail to repay.
This has attracted investors who are hardly motivated by helping the little guy or needling the banks. Hedge funds are writing seven-figure checks to Lending Club to get in on the action. More conservative types, like money managers for wealthy families, are also dipping their toes in. In total, borrowers have signed up for more than $400 million in loans through the two companies in the last five years.
And so the question is this: Just how badly could you get burned if you invested a little money?
I've been asking this question since Prosper made its debut. While the basic outline of the business hasn't changed much, there was more room to do something foolish when Prosper began.
Back then, the company would accept loan applications from people with FICO credit scores as low as the subprime 520 (or lower in the first couple of months, before the frightening default rates caused the company to establish a floor).
Human nature being what it is, starry-eyed lenders were attracted to the higher interest rates that people with low credit scores seemed willing to pay.
And wouldn't you know it? Of all of the loans that Prosper helped originate in its first three years, more than one-third went bad. The average investor lost 4.95 percent annually on the loans made during that period. Former lenders now spew bile toward the company on the user forums at Prospers.org, and the company is the target of a class-action suit.
Lending Club was more conservative when it began in 2007. Its minimum credit score for borrowers was 640, and now it's 660, though most borrowers have had scores higher than 700. It set the interest rates for loans based on borrowers' credit history and other factors. Lending Club's co-founder, Renaud Laplanche, said that no lender who had invested more than $10,000 on his platform (generally spreading money among loans) had ever lost money.
Prosper is now aping Lending Club's approach, raising its credit standards and getting rid of the loan auctions so it can set the loan terms itself.
Lending Club states in its government filings that its estimated default rates for loans of varying credit quality are not based on its own experience. Instead, it bases the guesses on decades of credit bureau data that looks at repayment rates on other types of loans.
But peer-to-peer loans may well perform differently. Aspiring borrowers, for instance, can and do make up all sorts of stories to be more attractive or sympathetic.
Lending Club does not necessarily check out all these tales.
And if you cannot necessarily trust some percentage of the borrowers, and the still-young companies do not have much data on completed three-year loans, which are the most popular ones, this sure seems less a bond purchase than a new type of casino game in Las Vegas.