LendingClub Corporation (NYSE:LC) provides a valuable service. Investors receive an alternative asset class that generally will have low correlation with stocks and returns in the 5-9% range. Borrowers receive credit at lower rates than a traditional credit card and payday lenders. This is as true today as it was before Renaud Laplanche, CEO and founder of LC, resigned on May 9th. Dozens of articles have been written on the nature of his departure and what it means for LC and its future. However, most of these articles appear to be written by folks who have never used the platform.
I am a professional in the finance industry who is an investor in both the stock and the loans of LC. My diversified loan portfolio has given me a 10.18% return by investing in primarily C Grade loans on LC's platform. This is a bit higher than the 8.47% average published on LC's website, but not uncommon. A dozen or so small businesses have grown up around LC to help investors like myself analyze the historical performance of their loans and make more educated decisions. For details go to lendacademy.com and check out the forum which lists discussions on the tools available as well as tips on how to boost returns.
What should be apparent to anyone who has reviewed the historical returns and posts from investors and borrowers alike is that the world is a better place because of LC. For decades, banks have had a monopoly on consumer credit via credit cards that charge prime borrowers around 13%. Subprime borrowers have been charged upwards of 30% if they were "lucky" enough to get credit at all. In an emergency, the rest of us had no other option than payday lenders who charge annualized rates of nearly 400%! At the same time, regular folks looking for a decent return on safe investments have been hard pressed to earn much more than the rate of inflation. With the emergence of P2P lending, I have the ability to help my fellow Americans get out of credit card debt while earning more than I expect to get from the stock market.
Those who have compared LC's business model to subprime mistakes from the Financial Crisis are mistaken. LC doesn't make subprime loans and it publishes its data so everyone can see what it is doing. All borrowers have to have a FICO of at least 660. My typical borrowers have a FICO score of 690, debt-to-income of 20% and have held their job for five-plus years. About 97% of my borrowers have not missed a payment and about 95% have improved their credit score.
Those who think that the next recession will be a disaster for LC are also mistaken. We have some insight into how well consumer loans perform through the cycle from historical annualized charge-off rates published by the Federal Reserve Bank, which got as high as 10.76% in 2010. This is bad but would in many cases be largely if not entirely offset by interest payments. In contrast, SPY dropped 50% peak-to-trough in less than a year with dividends offsetting less than 2%. The credit quality of LendingClub's borrower FICO scores and DTIs appear to be quite reasonable compared to the overall industry for consumer credit, so I see no reason to suspect that LC's borrowers would perform worse than the industry average in a recession.
The challenge for LC is how to grow this valuable service in a manner that is sustainable, grows the trust of both stockholders and loan investors, grows the trust and appreciation of borrowers, and convinces regulators and the public more generally that LendingClub is a win-win for all parties involved. In my view, LC's management should consider the following eight steps to win back the trust of both stock investors and those investing in its loans. Investors would be wise to look for these changes in future transcripts and earnings reports. In short:
How to win back the trust of stock investors
- Convince them that growth in loan originations going forward will be sustainable.
- Segregate growth in loans that are potentially in violation of state usury laws in financial statements.
- Convince them that LC's underwriting model is consistent with Fair Lending laws.
- Finally, stock investors will need to see LC win back the trust of retail investors.
How to win back the trust of retail loan investors
- Reach out directly to P2P lenders via lending blogs like lendacademy.com and address their concerns.
- Construct a Bankruptcy Remote Vehicle (BRV) for all issued notes and more robust backup servicing.
- Convince them that institutional investors and insiders will not receive preferential treatment over retail investors.
- Show how loan performance would likely be affected by a recession.
How to win back the trust of stock investors
1. Convince them that growth in loan originations going forward will be sustainable.
LC's stock price fell from $25 at IPO to $7 by May 6th in part because investors saw LC become increasingly dependent on institutional investors for growth. Institutional investors such as banks, pension funds, and hedge funds accounted for 56% of 2016Q1 originations, up from 0% in 2011. Stock investors saw these new note buyers as potentially more risky because of the added concentration. More sales were coming from fewer buyers who may not show up tomorrow. Retail investors are less likely to bolt as a group unless they lose faith in the quality of the loans on the platform and/or feel they are competing at a disadvantage with wholesale investors. While banks would need to hold reserves against potential loan losses, retail investors have no costs of capital considerations. This original advantage to retail consumers is in large part how the original P2P model justified an IPO $10B market cap for LC. Management can convince stockholders that loan origination growth is sustainable by employing tighter internal policies as well as rules to prevent evaporation in institutional investment. Tighter internal policies may include third-party audits of all management and board investments in companies purchasing LC loans. Rules preventing an evaporation of demand from wholesale investors may include lock-out periods and penalties for changing purchase agreements. Additional restrictions should also be in place to prevent any single counterparty from consuming more than around 5% of originations per quarter. Shareholder, employee, and loan investor input should be considered before establishing any of these policies.
2. Segregate growth in loans that are potentially in violation of state usury laws in financial statements.
Another reason LC's stock price fell is because investors fear the impact of loans originated at higher interest rates than state usury laws permit. Banks routinely circumvent usury laws, thanks to a 1978 court case Marquette National Bank of Minneapolis vs. First of Omaha Service Corp. This ruling essentially allows banks to issue credit cards at higher rates than the borrower's state allows as long as the bank is in a state where the interest rate is permitted. LC underwrites loans through WebBank, which is based in Utah in large part because Utah has no usury law. LC management believed its arrangement with WebBank was sufficient to avoid conflicts with usury laws in other states until the Madden vs. Midland decision, which essentially forced LC to structure its fee arrangement with WebBank, so WebBank had some "skin in the game". However, a class action lawsuit filed in April has investors questioning whether this new arrangement is sufficient. The reality is that roughly 90% of LC's business model doesn't conflict with state usury laws, and there is good reason to believe that further modifying its relationship with WebBank, if necessary, could allow the company to remain active in providing credit to the remaining 10%. Segregating out its growth and earnings statistics to illustrate this will help investors put the "Class Action Lawsuit" headlines in perspective.
3. Convince them that LC's underwriting model is consistent with Fair Lending laws.
The Treasury department came out with a report on May 10th that listed many useful suggestions for the industry. Fair Lending was listed as a top concern of regulators. Some LC investors think that because LC uses an automated underwriting model, it cannot be in violation of "The Equal Credit Opportunity Act (ECOA) of 1974", which states that "financial institutions and other firms engaged in the extension of credit" must make credit equally available to all creditworthy customers without regard to sex, marital status, race, national origin... etc. After all, how can a credit model discriminate against someone without facial recognition software. The reality is more complex. While not having any face-to-face aspect to the underwriting process helps reduce the risk of violation with the ECOA, it does not prevent the possibility. The underwriting process may inadvertently disfavor a protected class. For example, a variable indicating whether a borrower is a "renter" vs. "owner" is readily available for online retail loan investors to choose as a filter. Are protected classes more likely to be renters, and if so, are loan investors more likely to pass up borrowers who rent for those that own their own home? Perhaps, but even if they are, a careful read of the ECOA indicates that to be compliant; LC needs to only ensure that its underwriting model not inadvertently prevent protected borrower loans from entering the platform or receive a higher interest rate. The retail loan investor is not a "financial institution or other firm." However, LC would be wise to hire an external consulting firm familiar with Fair Lending practices to provide an independent review, disclose all material findings, and make any necessary changes to its underwriting model.
4. Finally, stock investors will need to see LC win back the trust of retail investors.
How to win back the trust of retail loan investors
5. Reach out directly to P2P lenders via lending blogs like lendacademy.com and address their concerns.
These more serious retail investors are the "connectors" that drive long-run sustainable growth in demand for LC loans. Malcolm Gladwell's book "Tipping Point" explains that "connectors" are the people who are willing to try products before others have even heard of them. Malcolm uses the example of Lexus to make his point. Lexus had to recall its first luxury car shortly after launching in 1990. This threatened its reputation, but management saw a silver lining. Who takes a chance on being the first to buy a product? Lexus's management understood that the people who went out on a limb to buy their first car are the kind of people that take pride in their investments and love to talk about them. So what did management do? It gave its first customers a first class experience. The company called each customer the same day the recall was announced. When the customers picked up their cars, they found that Lexus had washed them and filled up the tank. Customers that lived 100+ miles away received a knock on the door from a Lexus mechanic. This is LC's Lexus moment. So far, LC has given the impression of listening, but has not made any real progress in addressing the typical retail investors most pressing concerns. Comments from retail loan investors on lendacademy.com form the basis for the suggestions below.
6. Construct a Bankruptcy Remote Vehicle (BRV) for all issued notes and more robust backup servicing.
Prosper established a BRV in 2013. Many retail investors on the Lend Academy forum made clear indications at the time that they would switch substantial portions of their portfolio to Prosper because LC had no such BRV. What LC does have is "limited" backup servicing and unclear ownership of who has the rights to loan payments in the event of LC bankruptcy (see the prospectus - page 15). The easiest way for LC to boost sustainable growth would be to establish a BRV and provide a robust means of maintaining the servicing of loans should LC file for bankruptcy. The primary reason for the slowdown in retail investor interest since the IPO in 2014 is its "counterparty risk" or "platform risk" to LC, which threatens a total loss of their capital. LC has no debt, so the risk of bankruptcy is not immediate. However, it is possible that without the trust of retail investors, LC will not be able to cover expenses with new revenue and thus be forced to either reduce costs or take on debt. Taking on debt or using the cash to fund loans for their own balance sheet would further erode trust from retail investors, which currently see the $800M in cash on BS (as of 2015Q4), an untested backup servicing agreement, and unclear bankruptcy rights as the only thing standing between them and a material loss of capital. The upside is that if LC does establish a BRV to hold the loans on behalf of retail investors and provides more than adequate funding and procedures for backup servicing, the original peer-2-peer investors that were the bread and butter of the company until 2013 would likely grow exponentially.
7. Ensure that institutional investors and insiders will not receive preferential treatment over retail investors.
There are several reasons why retail investors have reason to suspect that they might be getting the short end of the stick. First, last month they learned that the former CEO had investments in companies that were buying LC loans wholesale. Additionally, LC manages some accounts for individual investors, which accounted for 15% of originations in 2016Q1. LC was also considering securitizations as a means of expanding its portfolio of institutional investors. All three of these practices provide incentives for LC to give institutional and wealthy investors preferential treatment. LC board members and management with stock in companies buying LC loans may be tempted to give those companies an opportunity to buy loans before they hit the retail investor loan platform.
LC may be tempted to cherry pick loans with preferential characteristics for managed accounts and securitizations to keep wealthy investors and new institutional buyers coming back for more. What is to prevent employees from taking advantage of limitations in the underwriting models or anomalies in the performance monitoring systems by tweaking investments in their private loan portfolios? No evidence has come forth showing that this has happened. However, where there are incentives there is reason to be suspicious. Retail investors are generally aware of these potential conflicts of interests, which is one reason many, such as myself, have kept investments on the platform to only a small portion of our portfolio. There are many things that LC could do to give retail investors comfort that they are competing on an even playing field. For example, employees should not be allowed to specify criteria for their own private accounts besides the subgrade. LC can turn this to its advantage by having a single employee pooled portfolio that makes investments in loans that would otherwise not be 100% funded within the required time limit. By its willingness to invest in loans retail investors passed up, LC would show it believes in its own underwriting model. Moreover, it should publish the total returns of the employee portfolio by subgrade and benchmark to those selected by retail investors to show (hopefully) that there is no material difference. This would have the added benefit of encouraging the many investors who like the idea of using LC to diversity their stock portfolio, but don't believe they would be good at picking loans.
8. Show how loan performance would likely be affected by a recession.
The LC website provides statistics of how loan vintages have performed over time. Statistics are available for loans going back as far as 2007. The 2007-2008 vintages provide insight into how well LC loans will perform if we were to experience another recession. However, this performance is an incomplete picture because only 0.14% of originations occurred during these first two years ($26M/$18B). Moreover, 5.27% of 2007-08 originations are labeled as "Does not meet the credit policy," nearly half of which defaulted. What this means is that it is unclear how well LC loans would perform in a recession. LC would be wise to publish a stress test of its portfolio each year and benchmark its performance against the industry for unsecured consumer loans. This would give retail investors some idea of how sensitive their portfolio returns will be so they don't have to make overly conservative assumptions.
I bought LC notes because they have provided a great hedge to stocks and stand a good chance of outperforming them given the exceedingly high price of SPY and strong credit quality.
I bought LC stock because, so many of the negative articles out there showed a panic that simply wasn't justified by the underlying business model and failed to recognize the moat of a company that owns rights to underwrite and service the largest and most liquid market for #P2P consumer loans in the country.
I'll buy more of both if LC's management takes serious steps toward the above... and I'll tell all my family, friends and SA followers to do the same.
Disclosure: I am/we are long LC, SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.