Acknowledging the Value of Lending Club, Even as It Stumbles

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The New York Times - Deal B%K | | May 17, 2016

Lending ClubLending Club’s implosion is a tale of two Silicon Valleys. The first story is about yet another Internet unicorn — valued at more than $8 billion at its initial public offering in 2014 — grasping for growth and cutting corners. But the second is about the good that an online lender can do, by disrupting technology and opening new avenues of credit for consumers. As the herd lashes the now-fallen Lending Club, let us not forget this second story.

Lending Club, which connects small borrowers with individual and institutional investors, hit a wall last week when it disclosed that it had fired its founder and chief executive, Renaud Laplanche. Mr. Laplanche’s primary fault was to have failed to properly address $22 million in loans that were sold under false credentials to the investment bank Jefferies. To me, there’s a word for this kind of conduct: fraud.

The loans were subsequently bought back by Lending Club, but the company was forced by its auditor to disclose that it had a “material weakness” in its reporting. To make matters worse, Lending Club also disclosed that Mr. Laplanche may have secretly been investing in a fund that Lending Club also had a position in.

Mr. Laplanche is history, but the news led to a sky-dive in Lending Club stock. The stock fell by almost half, losing more than $1 billion in value. While Wall Street tends to overreact, it’s not hard to see why the panic occurred: In the age of Theranos and Zenefits — two high-flying companies that have come under scrutiny for alleged transgressions — Wall Street is quite nervous that its darlings may not have all the panache advertised.

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For one thing, there is Lending Club’s democratic business model: as a peer-to-peer lending site, the company offers an alternative for borrowers who might be turned away by a big bank or find the interest rates at those banks prohibitive. The site was successful, and last quarter originated over $2 billion in loans; it is in the vanguard of an emerging industry.

But that business model is also changing and hitting some unexpected snags.

Lenders have turned out not to be average Joes, but mainly hedge funds and other sophisticated parties who aim specifically to extend credit to this category of borrowers. And so what is called a peer-to-peer site is really all about business-to-people. This is why Lending Club’s disclosures have been so devastating. Not only will there be a criminal inquiry — the company revealed Monday that it had been subpoenaed by the Justice Department — but Lending Club’s lenders may back away from dealing with the site because of a lack of trust.

But the growth has been choppy, and investors have raised concerns about the algorithm Lending Club uses to assess its borrowers — concerns that had previously dragged down the company’s stock price.

A new study provides valuable insight into the Lending Club business model. Three professors — Colleen Honigsberg and Robert J. Jackson Jr. from Columbia University, and Richard Squire from Fordham — were able to obtain a huge amount of data from a number of peer-to-peer lenders on their borrowers and loans. Their study primarily examines the effect on an arcane opinion issued last year by the Second Circuit, which called into question whether loans originated by Lending Club violated the usury laws.

Most states have usury laws, which cap the rate of interest that can be charged. Loans above that interest rate are considered void. But some states are not so concerned. South Dakota and Utah, among others, have no cap on interest rates. That is why your credit card is issued from those states. And under a statute enacted during the Civil War, the state where the loan originates is where the applicable usury law holds sway.

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This was the way it was until the Second Circuit ruled that when a loan was issued in one state but sold in another state to someone other than a bank, the second state’s usury law holds sway. That was a shock, since it meant that high interest rate loans might be illegal.

Under this ruling, it was easy to predict that the worst borrowers would no longer get loan offers on the peer-to-peer sites, because lenders would be concerned that they could not resell the loans.

And that is what the study found. The authors analyzed peer-to-peer lending data after this decision and found that the bottom fell out of the subprime market at peer-to-peer lenders. Lending to this particularly vulnerable class of borrowers simply stopped.

The case is on appeal to the Supreme Court, and no doubt this study will be influential in the court’s decision. The central question is: When you cap interest rates, do you tend to shut off credit to the people who perhaps need it most?

In analyzing the data and the Second Circuit opinion, the authors concluded that peer-to-peer lenders provide an extremely valuable service. Instead of getting a credit card loan that charges 20 percent interest, low-income borrowers are paying lower rates thanks to the availability of this credit — credit which in part was denied by the Second Circuit decision.

“The most common use of these platforms has been to consolidate higher-cost credit card debt with a lower-cost loan from a marketplace,” said one of the authors, Professor Jackson of Columbia Law School, in an email. “If the platforms disappear, are regulated out of existence, or are put in a situation where lending to higher-risk, lower-income individuals is no longer profitable, you can expect the kind of result we found in our paper: that marketplaces will stop doing that lending. The result will be that these consumers will have to turn elsewhere for credit — likely to higher-cost credit card companies.”

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