EBay-Style Lender Has Better Way of Keeping Books
LendingClub Corp., a so-called peer-to-peer lender with a star-studded board that's getting a lot of interest from Wall Street, is unusual in a number of ways.
Its stock isn't publicly held, but the San Francisco-based company does file financial statements with securities regulators. The company matches individual borrowers with money from outside investors -- hence, the terms "peer to peer" or "EBay-style loans." The loans go on the company's books as assets, while the notes and similar instruments that it sells to investors are recorded as liabilities.
And perhaps the most intriguing aspect of the company's financial reporting is that, unlike the vast majority of financial-services companies, LendingClub shows the loans on its balance sheet at their fair market values, defined as the price that would be received for an asset or paid to transfer a liability.
Recall that a few years ago, the U.S. Financial Accounting Standards Board issued a proposal to require fair-value accounting for loans on corporate balance sheets. The banking industry howled that it was too difficult to come up with market values for loans, that the numbers wouldn't be reliable and that doing so would lead to needless volatility in companies' financial results. The FASB backed down, and has since issued a new plan that requires lenders to recognize loan losses more quickly but still allows historical-cost accounting for loans.
Yet here's an upstart lender that voluntarily elected fair-value accounting for its loans. The company's board includes former Treasury Secretary Larry Summers, who could become the next Federal Reserve Board chairman, as well as John Mack, the former head of Morgan Stanley. And LendingClub, which began operations in 2007, seems to be progressing fine.
Here are the numbers: LendingClub had $1.07 billion of total assets as of March 31, which included $996 billion of loans shown at fair value. By comparison, it had $1.02 billion of total liabilities, $1 billion of which were "notes and certificates, at fair value."
Why did LendingClub elect fair-value accounting for its loans? In short, it reflects the economics of its transactions better than using historical cost would. Choosing fair value for both the loans and the corresponding liabilities "allows symmetrical accounting for the timing and amounts recognized for both expected unrealized losses and realized losses on the member loans and the related notes and certificates," the company said in its annual report.
In other words, the economic values of the loans and related liabilities move in tandem, and fair-value accounting reflects that. Although loans to customers are unsecured, the company's potential credit risk is mitigated because credit losses get absorbed by holders of the notes and certificates.
The fair-value numbers aren't infallible, of course. As with most figures on corporate financial statements, they are only estimates. There could be significant problems with the company's reported profits if the estimates are wrong, because changes in the fair-value figures are included in earnings each quarter. (For what it's worth, LendingClub reported a tiny profit during the first quarter.)
LendingClub in its footnotes classifies the loans as "Level 3" assets. The related liabilities also are labeled as Level 3. That means they're illiquid, difficult to value and that the company uses "unobservable inputs" in its valuation models. By comparison, Level 1 items are those for which there are readily available market quotes, while Level 2 items rely on valuation models but all of the inputs for the models are observable.
Sure, an investor might look at those Level 3 disclosures and say yuck. But that's the point: Investors can see them and make up their own minds. The reality is that the historical-cost numbers on others lenders' books are problematic, too. It's just as difficult to come up with estimates for future loan losses and reserves as it is to gauge market values for loans.
The fair-value numbers are supposed to be an attempt at reality. LendingClub at least shows that it can be tried.
(Jonathan Weil is a Bloomberg View columnist. Follow him on Twitter.)