I have to admit: investing in peer to peer loans didn’t initially appeal to me.
I thought it would be hard to assess the risk in lending to individuals — after all, that’s what banks get paid the big bucks for, right?
Founder Renaud Laplanche joins me on Tradestreaming Radio to talk about how the p2p loan industry cures some major inefficiencies in the market for capital, does a better job sizing up and personalizing risk, and how his firm and industry might just eat the banking system’s future lunch.
Announcer: You’re listening to Tradestreaming Radio with your host, Zach Miller. Expand your mind. Become a better investor with tools, tips and technology from the smartest investors on the planet.
Zach: Hey, Zach Miller here and you’re listening to Tradestreaming Radio. Thanks for checking us out. This is the place you come to for tools, tips and technology to help you make better, smarter investment decisions. Today’s guest on the program is Renaud Laplanche, who is the founder and CEO of Lending Club, the largest peer-to-peer lender.
I’ve written on the blog recently, and have mentioned on this podcast as well, that I’m a convert to peer-to-peer lending. It started as sort of an adjunct, sort of fringe type of investing. I think, this type of product, thanks to Renaud, and to Lending Club, and all the competition going on there, will become, eventually, a core holding in many investors’
portfolios. You can get much better yields than you can find in money markets at this point. Obviously, there’s a risk there, and Renaud will talk about some of the work that they’re doing in terms of risk assessment, and ratings there, which could be actually much better than our own rating agencies.
So thank you for joining us. I think you’ll find this podcast very interesting to hear about Lending Club, and the whole peer-to-peer lending market. You can find this podcast as well as my archives on my website, Tradestreaming.com. You can also find the archives on iTunes, as well as on Stitcher Radio, by the way. So, catch us wherever you are, and feel free to drop us a line, and let us know how we’re doing. If there’s some things you’d like to learn more about, like to hear more about, we’re here to help you. So thanks again for listening and we’ll catch you back next week.
Zach: Great, so, can you introduce yourself?
Renaud: My name is Renaud Laplanche. I am the Founder and CEO of Lending Club.
Zach: So, how long has Lending Club been in existence?
Renaud: So, I started Lending Club in 2006. And we really started operating and making loans in 2007. We launched our website in September 2007, so we are soon going to celebrate our fifth anniversary.
Zach: And where did the idea come? I guess, there had been peer-to-peer lending sites in the non-profit world, up to that point?
Renaud: That’s right. And Lending Club is using many of the mechanisms that you would see in other non-profit peer-to-peer lending websites.
Renaud: And even micro lending sites, like Kiva.
Renaud: But really where the idea came from, was in the summer of 2006. I had just sold my previous company to the software company acquired by Oracle.
Zach: What company was it?
Renaud: The company was called Match Point.
Renaud: You might have heard of it.
Renaud: And so, it was really for the first time I had the time to look at the credit card statement, which I usually don’t do, like most people.
Renaud: And I was going through it, and I realized that if I were to carry over the balance on my credit card instead of paying at the end of the month, I would be paying 18% interest rate on that credit card, which I thought was a very high interest rate. And I started to try to understand why the rate was so high. I didn’t feel it was a fair interest rate compared to the risk that I represented for the credit card company. And I started talking to a number of close friends in the credit card industry, and at banks, and realized all the inefficiencies and mis-pricing, and how much cost was factored into that rate of 18%, that there would be a way, a very simple way, for capital to flow more directly to borrowers. And that would take that interest rate down for borrowers, but also give access to investors to enter that consumer credit as an asset class, and get an opportunity to earn, maybe not 18%, but some rate of return that would be lower than 18% but higher than most fixed income investments.
Zach: Makes a ton of sense. Did you do any market research at that point to substantiate that feeling?
Renaud: Yes, so I started doing a lot of work and the starting point was Pete Hobbs, who was the CEO at MasterCard, and has become a friend and an advisor to the company. And Pete introduced me to a number of folks at MasterCard, and through a number of conversations at MasterCard and then at Wells, I really came to understand the value chain in banking and in consumer credit, in particular, and specifically on credit card issuances. And really two things that became clear, and where I thought a platform, a credit platform could really create some efficiencies, was one, the amount of infrastructure cost that the banks have to face.
Renaud: In terms of the branches, and the thousands of employees that are involved in the process of taking deposits on one side and then turning around and making loans on the other side. And that a technology enabled web-based platform could do that same thing at a much lower cost by establishing a direct path of capital between the investors and the borrowers. So that was really the number one finding. So number two finding was the fact that most credit card issuers don’t apply a lot of risk-based pricing. And that’s what really happened in my personal view, at my initial reaction when I saw that 18% interest rate. Most credit card issuers charge 18% across the board, and essentially use extra spread on the most credit worthy borrowers to subsidize some of the losses and the volatility in the lower credit card [inaudible 06:42].
Zach: Kind of a free rider problem.
Renaud: Exactly, and I thought we could make the process more efficient, by focusing on the top 10 to 20% of the U. S. population by credit quality and income, and payment capacity, and offer that population a lower interest rate than they’re paying on their credit card. And that’s really what we’ve done at Lending Club over the last five years. We’re focused primarily on helping people with good credit pay off credit card balances and transfer that balance onto a Lending Club loan at a lower interest rate.
Zach: So Tradestreaming is an audience, a community, of forward-thinking investors looking for new products, technologies. Is there a persona of the average, I’m less in interested in the borrower and more in the lender, in the average lender? Can you talk about what that person’s make up is like?
Why he’s coming to a peer-to-peer lending site? What he hopes to get out of it? Maybe, some of the other activities he’s doing?
Renaud: We have a lot of investors who are not particularly high net worth. I mean, we have some of those members as well. But most of our 50,000 investors are what we would describe as mass aspirants. They have some savings, some investments. They don’t like the volatility on the stock market.
Renaud: They are earning no yield on their money market funds or CDs or savings accounts. And they’re interested in earning income and yield on an investment that is more predictable than equity and not correlated to most other investments out there. They really come to Lending Club for that purpose. Another, that’s our retail base. We also have direct investing through the platform online. We also have funds, private funds, that we distribute for private placements, where they’re available to high net worth individuals and qualified purchasers, including family offices and larger institutions, where we get investments of 5 to 25 million dollars from single investors. So that’s a different product, and obviously a different demographic. But the retail platform is really mostly individual investors.
Zach: So you talked about the inefficiencies in the credit markets in general, and how sites like yours are addressing that. You issue you own credit ratings. How far do those diverge from traditional credit ratings?
Do you feel like you’ve done a better job? Can you talk a little bit about that?
Renaud: Mm-hmm. Yeah. So our grading system, our risk ranking algorithm, evolves constantly. What makes us say we are doing a good job at risk ranking borrowers, that if you look at returns by grade, let me take a step back. We decline roughly 90% of all the applicants.
Renaud: All the borrowers who come to us, apply for a loan, we’re going to decline 90% of them, and really focus on the top 10%. So that top 10% then got risk rank across seven loan grades from A through G.
Renaud: And assigned an interest rate that’s really commensurate with the risk that this person represents. And so rates start at 7% on the A grade, and goes all the way to18 or 20% on G grades. And so really a measure of how good we are at ranking risk is in net return on any single grade, and as you can see on our website, we publish returns by grade. And generally, you pick up additional return when you pick up additional risk. So when A grade would return five and a half or six percent net return after credit losses, than you got all the way to F and G, where you get 12% net return after credit losses. So there’s actually one grade where you don’t pick up, historically you haven’t been rewarded for additional risk, which is a G grade. So actually F grade has returned better returns than G. [laughs]. So there’s a little bit of a improvement potential there. But, generally, we’ve taken care of it. But generally, you can see the historical returns and that give you a sense of the power of our risk ranking algorithm. But again, it’s evolving and we’re always improving it.
Zach: The company’s been around during sort of a declining interest rate environment. If we start to see rates start to creep up again, do you imagine that the interest rates you’re going to pay borrowers are going to rise as well, or do you see those as sort of fixed returns?
Renaud: No. So, what happens in an increasing rate environment is most rates move in parallel.
Renaud: Right. So when the Fed raises interest rates, auto loan rates go up. Mortgage rates go up. Credit card rates go up. Most credit cards are priced as liable plus, so it could be liable plus 14 or 15.
Renaud: But it’s still a liable plus rate. So what you would see is if the risk free rate goes up to 2 or 3%, you see most rates go up, and our interest rates would go up as well. Really, our bench mark is credit cards. We offer people with good credit again a chance to lower the cost of credit compared with credit cards, and with credit card rates at 18, we have plenty of room to operate. But when rates will go up, credit card rates will go up as well. And the other thing that’s interesting about credit card rates, is that they’ve been pushed even higher by some of the regulations, like the Card Act of ’09 and Dodd-Frank, that were designed to protect consumers against some of the practices of credit card issuers. But unfortunately, it backfired to some extent because credit card issuers have increased rates to offset some of the lost revenue on some the fees that they used to charge, and that became illegal under Dodd-Frank. So credit card rates have actually shot up in 2008 to offset higher charge-offs, and then stayed up and have been pushed even higher by the new regulations.
Zach: Wow. I didn’t even realize that. So under regulatory regime, you fall under SEC regulation. Each one of these notes is actually registered as some type of investment with SEC. Is that how it works?
Renaud: That’s right. So on the retail platform, investors buy notes that are registered securities. So we have a shelf registration and we draw down from that shelf every day as notes get issued. We had an initial 600 million registration that we fully drew upon. And we find a couple of months ago for an additional one billion dollars, S1, that we’re going to draw, fully draw, in the next year, year and a half [inaudible 15:06] for an investigator in the [inaudible 15:09] it’s a different type of security, but it’s also supervised by the SEC.
Zach: Is there a secondary market for these? If somebody buys one and they want to unload it, or they’re looking to buy some that other people are selling, is there a vibrant secondary market?
Renaud: Yes. Secondary markets, there are two ways to get liquidity. One is if you’re an investor on the retail platforms, on the self-directed platform. There is a secondary market operated by [inaudible 15:43] called Folio, folio investing, where you can put your notes up for sale on that platform. So that’s one way and obviously in the [inaudible 15:59] it’s different. There are some redemption mechanisms for some investors.
Zach: Interesting. Obviously, the growth in industry lead by you and your firm has been really interesting to watch as an outsider. And I see the product and the platform making its way into the mainstream. What do you think it will take for this to be sort of an everyday product that your average investor would invest in?
Renaud: It’s really going into that direction, where we’re seeing more and more mainstream adoption. We’re growing eight to ten percent a month. And we sort of capped the growth rate at that eight to ten percent a month.
Zach: That means you’re issuing eight percent more from the month previous?
Renaud: Yeah. That’s exactly right. For example, we issued $42 million in loans in April, and $45 million in May, and we’ll probably going to do between 48 and $50 million in June. And so at that growth rate, we’re soon going to be, so we’re going to pass a billion dollars in total originations by the end of this year and are planning to issue another billion next year. So that’s quickly becoming a mainstream investment.
Zach: So I’m interested also in learning a little bit more about the dynamics of the industry. If competition is increased, if your issuing more loans, are there any constraints in your business? And is there downward pressure on the returns an investor would see as the industry becomes more popular and more mainstream?
Renaud: So, an interesting characteristic of U. S. consumer credit is that it’s a very large market [laughs].
Renaud: There’s a $2.4 trillion consumer credit market out there. Eight hundred fifty billion of that is credit card receivables priced at 15 to 18%, so we don’t feel that either the size of the market or competition on that market would ever be a limiting factor to our growth. And we can continue to double each year for the next five to ten years, without capturing any significant part of the consumer credit market.
Zach: And similarly with interest rates, you don’t see those necessarily impacted by the volume of loans or the competition?
Renaud: No. We’re very focused on creating value for our customers, and so, we’re really here to compress the spread between the risk free interest rate and the lending grades on credit cards. And that spread, again, is at 14 to 15%, and it stays pretty much constant in every interest rate environment. So as long as we can continue to lower the cost of credit by three to four hundred basis points for prime consumers and continue to return nine to ten percent net return to investors, we’ll keep doing what we’re doing.
Zach: That’s great. What’s your impression of the future of your company?
Are you going to expand into new types of products, other types of lending?
Just continue to block and tackle, do what you guys are doing really well?
And I’m also kind of curious what this presages for the future of banking, or I call it the incumbent banks. Are you in some sense, dis-intermediating them, or providing just, just capturing those inefficiencies in the credit markets?
Renaud: Clearly, Lending Club is a dis-intermediation play.
Renaud: We feel we’re making a very large industry more efficient. And so, certainly the current opportunity of providing unsecured consumer loans is large enough that we wouldn’t need to necessarily expand beyond that. However, we feel we can do the same thing we are currently doing but be more helpful to more customers, or to our existing customers at a different time in their life. So, we’re helping them get a lower cost of credit on their credit card. We can also help our customers with car loans and small business financing and at some point mortgages. So we don’t feel there’s a limit as to what the platform can handle in terms of consumer credit. So we intend to tackle all of these markets at the right time. And then, we do believe that we are creating a mainstream alternative to banking, and we’re the new form of consumer lending.
Zach: It’s so interesting because what you’re describing is almost a life cycle of credit. If you guys get to know your borrowers really well, you’re in a perfect position to continue servicing them throughout their lives. I ask that question because I wrote a book in 2010 called “Trade Stream Your Way to Profits: Building a Portfolio in the Age of Social Media.” And one of the people I interviewed was a partner at Benchmark Capital, Michael Eisenberg, and one of the quotes I got from him was that he envisioned a day where he talked a little bit about peer-to-peer lending, but almost like, the need for banks went away. Large corporation like Google and Apple have pristine balance sheets, and they’d be lending off of their balance sheets.
Renaud: Mm-hmm. Mm-hmm..
Zach: He really saw the end of banking as we know it. I don’t know if what you’re saying goes to that extent, but you’re really talking about a really different model going forward.
Renaud: Right. I think it does. I think banks came around as a very useful way to centralize capital, to aggregate a large amount of capital, and redistribute it. Now, technology and the Internet make that function unnecessary. And I think we can make capital flow more efficiently and more directly between the source of capital and the use of capital. So the use of capital is people who need credit. The source of capital right now is individual investors, family offices, and small firms, but you’re right, there’s no reason why it wouldn’t be the treasury department of a large corporation that has excess cash and is not getting any yield on their fixed income investments right now. There’s no reason it wouldn’t be an insurance company, putting their premiums to work with a credit platform like Lending Club. In fact, we have a couple of insurance companies that are testing the platform right now.
Renaud: So we do think we are changing a lot of things here. And it’s going to take time, but it’s exciting.
Zach: I have one last question for you. There was news recently of a company, a competitor launching in Europe that was using meta information in the social networkto try to gauge credit quality. Can you talk a little bit about what the inputs are that go into your own internal credit ratings?
Renaud: Our current underwriting is pretty traditional. When you focus on prime consumers, there’s generally good, readily available information that helps you underwrite these people, these customers in a fairly predictable way. It goes beyond the FICO score, or the credit attributes that you can find in a credit report as well as transactional data from the person’s bank account activity, as well as income, employment, and demographics data. So all that really creates a fairly good picture of prime consumers. I think you need a lot more data and there’s more benefit in going into, for example, social type of data, and other alternative sets of data, for sub prime customers, where you get a thinner credit file. There’s not as much payment history, not as much credit history. If you’re the first entity making a loan to a person, obviously you need to find that underwriting better elsewhere. So there are a lot of companies doing some very interesting thing in that segment. We’re not necessarily at the forefront of that effort, but we’re watching what’s happening and constantly looking at what could be applicable to us and if there’s any part of these experiments that we can use.
Zach: Renaud, that’s so much for coming on Tradestreaming Radio.
Renaud: Sure. My pleasure. Thank you for having me.