I receive many emails from readers each week and I read and respond to every one. I thought this email that I received recently would be interesting for all readers. So rather than respond in private I am doing so here.
Here is what this reader asked:
If this (p2p lending) is so great and a threat to banks, why aren’t banks offering this? Seems inefficient for these companies to contract with Web Bank (what is the stability of this bank???). I’m always a little wary of things that aren’t institutionalized yet – especially when some of the return stories seem too good to be true.
So there are really three questions here and I will deal with each one in turn.
1. Why Aren’t Banks Offering P2P Lending?
The most obvious answer is that they don’t have to. Right now banks can borrow money at extremely low interest rates and then lend this money out at a much high interest rate (particularly in the case of credit cards). Their cost of capital would be much higher if they offered p2p lending because investors would demand more than a 1% or 2% return.
P2P lending is a tiny industry right now – the total amount of revolving consumer credit in this country is around $800 billion and the total outstanding loans at Lending Club and Prosper is around $600 million. So p2p lending makes up less than 0.1% of the unsecured consumer lending market. Why would a bank that is issuing billions of dollars in loans every month worry about an industry that has not even issued $100 million in a month? In the short term they really have nothing to worry about. But if p2p lending keeps doubling in size every year then within five years there will be $20 billion in loans outstanding with $2 billion in loans being issued every month. By this stage it will be clearly starting to impact the banking industry.
I don’t expect banks to embrace p2p lending any time soon. Most of them probably dismiss it as irrelevant and for a while it will be. They can ignore p2p lending for now but just as the newspaper, photography and music industries have been impacted by rapid changes these changes are also coming to banking.
2. Why Do Prosper and Lending Club Contract with WebBank?
Prosper and Lending Club do not have a banking license so they cannot issue personal loans themselves – they need to rely on a bank to do that. Here is the wording from the Lending Club prospectus (Prosper has almost identical wording) that explains the process:
Each member loan is originated through our website and funded by WebBank at closing. WebBank is an FDIC-insured, Utah-chartered industrial bank that serves as the lender for all member loans originated through our platform. Immediately upon closing of a member loan, WebBank assigns the member loan (and all rights related thereto including any security interest) to LendingClub, without recourse to WebBank…
All WebBank does is fund the loans that are then immediately assigns them to Lending Club or Prosper. It is just a technicality so the p2p lenders don’t have to apply for a banking license. WebBank is an FDIC-insured bank so the money is safe, but if they were to go under Lending Club and Prosper would need to find a replacement bank or fund the loans themselves which I believe will create all sorts of regulatory challenges.
3. I am a Little Wary When Returns Seem too Good to be True
I think it is prudent to be wary when returns sound too good to be true because most of the time that is the case. Even in p2p lending returns are not always as they seem. I recently helped my father-in-law open a new account at Lending Club and his current Net Annualized Return there states 13.3%. I have told him to expect returns in the 8-10% range but it would be easy for him to believe that this 13.3% was sustainable long term. I have written before about the difference between stated and actual returns.
If you do some research you will see screenshots of Lending Club and Prosper accounts from other bloggers showing these excellent double digit returns. While 10% returns are indeed possible if investors do their research and are well diversified the real world return of most investors is likely to be 1-3 percentage points (and possibly more) lower than the returns stated at Lending Club and Prosper.
Having said that, something that should provide comfort to this reader is the growing interest in p2p lending by institutional investors. Some of the most sophisticated Wall Street investors have taken a look at p2p lending and are moving money into this asset class. They have done detailed analysis on the loan history (which is all public) and decided that it is a worthwhile investment.
So, yes p2p lending offers really good returns. My goal is to produce returns greater than 10% annually long term. But if you look at the returns for all notes on Lendstats.com you will see that at both Prosper and Lending Club the average real return to investors is less than 10%. But even 7% is a good return in today’s investing environment and p2p lending certainly offers the potential to earn this and, if you do your homework, even more.