Peer-to-Peer Lending’s New Ways Look a Lot Like the Old Ones

(Bloomberg) -- LendingClub Corp., in its prospectus when it went public in late 2014, said it was part of a “new approach to consumer finance.” The company’s website says “transforming an industry requires new ways of thinking and doing.” This type of language is common in the so-called peer-to-peer, and tech-enabled, lending space. LendUp, essentially a payday lender backed by big Silicon Valley names, including Google parent Alphabet Inc.’s venture arm, pitches itself as consumer friendly and socially conscious.

But as the peer-to-peer lending business matures, it appears increasingly to be adopting the bad habits of the industry it said it was going to improve on. Last week, the Federal Trade Commission accused LendingClub, the largest of the peer-to-peer lenders, of misleading consumers with hidden fees and continuing to charge borrowers even after they had paid off their loans. Shares of the online lender fell to nearly $2.50, its all-time low. LendingClub denies the accusations. LendUp, too, has paid fines and refunds for illegal fees and in general treating some of its customers poorly. 

Peer-to-Peer Lending’s New Ways Look a Lot Like the Old Ones

The marketplace lending industry, which is less and less peer to peer these days and relies more on packaging and selling bonds to fund its business, also seems to be taking a page from recent troubled banking history. It appears to be ratings shopping, which was widely credited for exacerbating the housing credit boom that ended in the financial crisis. It’s a basic conflict of interest that was never cleaned up: Bond issuers pay for the ratings, so they get to select who makes them, and they naturally migrate to those who put them in the best light. Ratings shopping may now be masking higher default rates and the true health of peer-to-peer lending from investors as well as leading to inflated ratings and more offerings. In the first quarter, peer-to-peer lenders sold $4.3 billion in asset-backed securities, according to industry tracker PeerIQ. That was slightly down from $4.4 billion in issuance in the last three months of 2017, which was a quarterly high for the industry. PeerIQ estimates that peer-to-peer ABS securitization will hit $18 billion this year, up from $14 billion in 2017.

Peer-to-Peer Lending’s New Ways Look a Lot Like the Old Ones

Analysts at Morningstar Credit Ratings, a division of the mutual fund research firm, which has been building up its bond-rating business, contends it has been consistently cut out of peer-to-peer lending deals because it has generally been more negative on the sector than other rating firms.

“We have no insight into the rating agency selection process," said Rohit Bharill, who heads Morningstar's asset-backed securities credit-ratings effort. "But we have been asked to evaluate many of the marketplace lending deals, and we have heard that our cumulative expected default rates are generally higher than other rating agencies in this sector, and we have not gotten a mandate to rate a single deal.”

More than once, Moody’s Investors Service, which has a rated a number of peer-to-peer deals, has had to revise its initial loss projections for the deals. In early 2016, Moody’s increased its loss estimate on two deals it had rated for LendingClub rival Prosper to 12 percent from an initial 8 percent. In December, it warned about more problems for deals backed by online lenders, seemingly acknowledging that its projections and those of other ratings firms have continued to be too rosy. Moody’s said that it expected poor performance of deals with “recent vintages” to boost expected default rates. 

Peer-to-Peer Lending’s New Ways Look a Lot Like the Old Ones

Moody’s declined to comment. Kroll Bond Rating Agency, S&P Global Ratings and DBRS, which have also rated a number of peer-to-peer deals, did not return requests for comment. A spokesperson for Fitch, another ratings firm, said, “We’ve been historically more bearish on marketplace/P2P deals, which is why we’ve only rated the Prosper platform.”

It’s possible that Morningstar’s expected default rate is higher than rivals because it has seen only the riskier deals. It’s also possible that lenders improved the loan pools that Morningstar examined before showing them to other ratings firms. Bharill says he and his team have never looked at any final deals to see whether changes had been made.

“We do not have a negative view on the sector, but we do believe that it will be more volatile than the market thinks if there is an economic correction,” said Bharill, who added that protections in the deals, like overcollaterlaztion and the spread between what borrowers pay and what investors are promised, have largely insulated investors from losses. 

LendingClub and Prosper both report overall loss rates for loans, both those funded by ABS deals and direct investors -- the so-called peer lenders -- originated through their systems. Those loss rates averaged 8.3 percent and 8 percent respectively for LendingClub and Prosper from 2014 to 2016, according to NSRInvest. But some have questioned whether those loss rates reflect all of the lenders’ loans or just a subset of the better-performing ones. 

Elena Loutskina, a University of Virginia professor who has studied the industry, said upstart online and peer-to-peer lenders faced a problem because there is a limited number of high-quality borrowers they can steal from the banks. “But you can go down as much as you want,” she said.

Just as in traditional banking, that way lies trouble. On one end, it can mean hiding fees from borrowers, and on the other, it can mean masking potential losses from investors. The friendly peer-based lending environment LendingClub and others promised just a few years ago, where everyone wins, is turning out to be more like the traditional finance business, where too often there are unsuspecting losers. 

To contact the author of this story: Stephen Gandel in New York at sgandel2@bloomberg.net.

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