Loans Made in Blink as Investors Vie for LendingClub ClientsNoah Buhayar
For most of its 107 years, Titan Bank has relied on loan officers to vet borrowers. These days, the Texas bank’s computers make some decisions as fast as employees blink.
Four times daily, Titan’s software pings servers at LendingClub Corp., vying alongside other investors to get a first look as hundreds of online loan applications are posted. That’s when Titan’s algorithm takes off, speeding through dozens of variables -- from FICO credit scores to income and debts -- to pick candidates it will fund.
“We don’t have 20 minutes to read each loan file, or that loan is going to be gone,” said Jonathan Morris, a director at the community bank, which has two branches in Palo Pinto County, west of Fort Worth.
LendingClub and smaller competitor Prosper Marketplace Inc. are leading a technology-driven push to lower borrowing costs by matching people who need a loan with investors who want to fund them. Less than a decade after bad lending decisions led to a global credit crisis, the two firms are advertising returns between 4 percent and 11 percent to banks, individuals and asset managers such as BlackRock Inc. that are willing to forgo old-fashioned due diligence on borrowers.
LendingClub Chief Executive Officer Renaud Laplanche, 44, is counting this month on surging originations and revenue at his company as it becomes the first peer-to-peer lender to go public. While the offering is raising that industry’s profile, it’s prompting questions about the use of algorithms, rather than human interaction, to dole out money.
At some point, we could see “an explosion of credit losses that will be due in part because the nature of the screening is such that it’s basically computerized,” said Bert Ely, an independent banking consultant in Alexandria, Virginia. “The big question is: Are these lenders, the funders of these loans, getting compensated enough?”
LendingClub and Prosper mainly help originate unsecured consumer loans of as much as $35,000. The San Francisco-based firms, both less than a decade old, arranged funding for $4 billion of debt during this year’s first nine months.
It’s hard to tell whether their underwriting process is sound, because originations are ballooning at a particularly good time in the credit cycle, said Brendan Sheehy, director of financial institutions at Fitch Ratings Inc.
“Over the last couple of years, every consumer asset class has been performing very well,” he said.
U.S. banks’ quarterly write-offs on credit cards slid to less than 3 percent this year, the lowest in almost three decades, from almost 11 percent in 2010, according to the Federal Reserve. At LendingClub, about 6 percent of three-year loans issued in 2010 had to be written off, down from about 9 percent in 2009, according to a chart in the prospectus for its stock sale. Subsequent vintages have performed around the lower level or better.
Big names have lined up behind peer-to-peer lenders: Google Inc. and funds run by BlackRock and T. Rowe Price Group Inc. hold stakes in LendingClub, and board members include former Morgan Stanley CEO John Mack and former U.S. Treasury Secretary Lawrence Summers. Raj Date, a former official at the Consumer Financial Protection Bureau, is a director at Prosper.
LendingClub was valued at almost $3.8 billion in April in a $65 million funding round. The company said in a filing today it planned to sell 57.7 million shares for $10 to $12 each. At the top end of the range, LendingClub would be valued at about $4.3 billion, based on 361.1 million shares outstanding. That share count excludes certain stock options and shares reserved for employee compensation plans, the filing shows.
To get a loan, applicants submit their information online and explain why they need money, usually for terms of three or five years. LendingClub and Prosper check credit reports, then assign a grade and fixed interest rate. The companies’ automated lending processes allow them to provide cash at prices that can be cheaper than carrying a credit-card balance.
Both firms say customers have average FICO credit scores of about 700, better than subprime. Annual percentage rates at LendingClub range from 6.78 percent to almost 30 percent on three-year loans.
Investors can buy debts fractionally in increments of $25 - - the favored method for people seeking to diversify holdings across a swath of borrowers. It’s also possible to purchase whole loans.
Institutions like Titan write software to cherry-pick files. A growing number, including at least one investment fund run by New York-based BlackRock, are choosing a more passive strategy, buying loans that meet preset criteria. Enthusiasm is so high that investors have used leverage to boost holdings. They’re even packaging them into securities.
LendingClub makes much of its money by charging borrowers 1.11 percent to 5 percent of the loan, with higher rates for people with weaker credit or seeking longer loans, according to its website. The firm also imposes a servicing fee on investors. Its operating revenue more than doubled to $144 million in the year’s first nine months. Prosper’s jumped fivefold to $52 million.
Both firms say they take steps to prevent fraud and ensure interest rates reflect loan risks. Still, LendingClub lists the effectiveness of its procedures among potential threats in the prospectus. Failing to sort borrowers correctly could lead buyers “to rescind their affected investments or decide not to invest,” the firm wrote.
Prosper CEO Aaron Vermut is blunter: “If you do it wrong, you’re dead,” he said in an interview. “If time goes by and those estimates of losses and returns don’t bear fruit, your investors are gone and they’ll never come back.”
Beth Haiken, a spokeswoman for LendingClub, said the company can’t comment for this article because of restrictions ahead of its initial public offering.
Ranger Capital Group raised a fund last year to tap into peer-to-peer lenders, and snapped up about $25 million of loans with software designed by a partner with a background in artificial intelligence. The Dallas-based asset manager is exploring other online platforms to deploy more money.
Institutional investors are asking, “If I give you $100 million, how fast can you put it to work?” said Bill Kassul, a partner with the Ranger Specialty Income Fund.
Don Davis, president of Prime Meridian Capital Management, started a fund in April 2012 that buys loans using an algorithm. While competition is mounting, worries about automation are overblown, he said. In the worst-case, the software would just fail to grab the best loans available.
“We’ve got two IT guys who are watching this stuff every day,” he said.
Titan, whose loan officers mostly focus on small businesses, uses LendingClub and Prosper to reach consumers who might otherwise be swept up by larger branch networks run by regional and national banks.
Still, with only about $80 million in assets, the bank has to be careful, Titan’s Morris said. Soon after it buys a loan, employees seek to validate information borrowers provided, asking questions like: “If the person’s a janitor, do we think they’re actually making $200,000?” So far, that’s been enough.
“We’ve just never had an issue,” Morris said. “The paper has been very clean.”
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