Wednesday, January 22, 2014

Lending Club and Crowd Funding

Are crowd funding sites like Lending Club a good deal?  That depends.

Crowd Funding is all the rage right now - and that right off the bat turns me off.   When the media hypes something, it usually is a raw deal.  And fads and crazes - also the darling of the media - are not worth investing in.

Crowd Funding allows individual people to contribute small amounts of money, individually, to a start-up, a political campaign, or a cause, and create huge amounts of capital as a result.   It has been used by the Obama Campaign (which out-raised the GOP with $10 contributions from millions of people), the Jamaican Bobsledding team, and even a start-up company making a Grilled Cheesus sandwich maker.

Crowd Funding can also be used to fund consumer loans, and I first heard about this on the GetOutOfDebt guy site (which has been re-designed recently, for the better).   I was a bit concerned as the man who operates that site was answering "questions" from readers, and as of late, a lot of his "answers" were to go to a crowdfunding debt site, where he would sponsor their loan.   It is one thing to give financial advice, another to loan out money.

I heard about Lending Club a second time from a neighbor.  She was alarmed about it, as her husband, who had all his money invested in 8% CDs was looking for a new place to invest, once the CDs matured (and the new rates dropped to 0.5%).  He was pouring money into Lending Club and she was concerned.  The rates of return were high, but the risk?   My two cents was the old saw - never put all your eggs in one basket.  (Wow, three cliches in one sentence.  A new personal record).

You may have also read about Lending Club as "one of the best 100 companies to work for" on CNN or NBC (I forget which).  Such lists are poor journalism, IMHO, and based on specious criteria.  But I am sure it is a pleasant place to work.

How does Lending Club work?   Well, instead of the traditional model, where people deposit money into their savings account, earn nothing in interest, while the bank lends out money at 22% (via credit cards) and rakes in the profits, with Lending Club, people basically lend money directly to others who want to borrow.

That is an oversimplification of the process.   When someone applies for a loan, people review their particulars and then pledge amounts toward the loan.   Each person might be pledging only a few hundred to a few thousand for a particular loan, and you may have your pledges spread out among a number of loans.  So the risk of a single default "taking you out" is diminished.

It is a startling theory of lending!

For the borrowers, Lending Club is a low-interest alternative to credit card or other high-interest debts.   A typical borrower, for example, might have gotten themselves into intractable credit card debt.  Once they miss a payment on their 14% "rewards" card, they are assigned the "punishment" interest rate of 25-30% or more, which effectively means any subsequent payments are almost pure interest and the borrower will never climb out of that debt (unless they can pay it off all at once, which is unlikely).

Think this can't happen to you?  Think again.   Rewards cards with high "default" interest rates are like a loaded handgun waiting to go off.   I learned my lesson, and have a credit card at 7%.   If I carry a balance, I can pay it off.  And the minimum payment is set up to be made automatically, if I forget to pay.

But getting back to Lending Club, these sort of consolidation loans can be a lifeline for someone trying to climb out of credit card debt.    A loan at even 10% is far more attractive than 25% and actually has a possibility of being paid off.

Rates are determined by risk, and Lending Club claims that the average borrower has pretty decent credit:

As of December 9, 2013, the average Lending Club borrower shows the following characteristics:
  • 702 FICO score
  • 16.3% debt-to-income ratio (excluding mortgage)
  • 15.1 years of credit history
  • $71,377 personal income (top 10% of US population) 1
  • Average Loan Size: $13,625
I don't think this is because Lending Club is necessarily cherry-picking the best borrowers, but only that your average debtor is actually pretty well off and capable of paying back their loans.   A dirty little secret of the Credit Card industry is that most people who end up over a barrel with Credit Card debt are not poor people living in trailers, but middle class people who just have bad spending habits - like the former Governor of Virginia, who was elected on a platform of fiscal responsibility, but was maxed out on his credit cards and upside-down on a vacation home.   In other words, the struggling middle-class who have brought all their woes upon themselves, are the typical borrowers.

OK, so this Lending Club concept cuts out the middle-man (the banks) and gives investors better rates of return on their money and borrowers lower interest on their loans.  Is there a downside for either party?  Perhaps.

First of all, Lending Club doesn't really eliminate the middleman.  Lending Club IS the middleman in these transactions.  Like a bank, they actually issue the loans, pay the depositors interest, and then collect on the loans (turning bad debts over to collection agencies if the borrower defaults).  How Lending Club can do all of this, and not charge the high interest to borrowers and low interest to depositors charged by banks, is a mystery to me.   Are banks wildly profitable and Lending Club has found a loophole?

Perhaps.  Banks do make a lot of money on credit card interest.  And if you go to a bank and say, "Gee, my credit card is at 25% and I want to get a debt consolidation loan at a lower rate" chances are, they will laugh in your face - or offer you a home equity loan with $5000 in closing fees.

So, somehow, Lending Club has found a way to do this, in a way that banks can't, and still be pretty profitable in the process.  Sounds like magic to me.  And maybe it is.  As late as 2012, Lending Club, like most Internet start-ups, was burning through $1M of cash a month.  So maybe Lending Club hasn't found a way to transmute tin into gold.  We'll see if they can start being profitable down the road - or start raising interest to borrowers and lowering payout to depositors, like a regular bank.  According to this Wall Street Journal article, in May of 2013, Lending Club "just turned profitable" and the company is acquiring a lot of big-name investors, including Google.  Maybe they can make money from sidebar ads.

But what about the customers?   For the borrowers, I suppose it is a no-brainer, if you have high-interest debts and no way to get out from under them.   But, as I have noted before, when you are in debt, borrowing more money can be like throwing gasoline on the fire.   A low-interest card rollover or a consolidation loan might work in theory, provided you cut up your paid-off credit cards and close the accounts.   If you just rack up more credit card debt (which I suspect 70% of people do - I did it at least once) you are just digging yourself in deeper and deeper.

For the depositors (lenders) the rate of return is attractive.   But unlike a CD or bank deposit, it is not FDIC insured and your loan money is at the mercy of the borrowers.   Sure, if you spread out your money to a number of loans, you might ameliorate risk.   On the other hand, maybe you'll be the poor sap who ends up funding all the bad loans, and you lose half your investment.   It is an risk-based investment, and if 10% of your loans go bad, well, you've wiped out that 10% in interest you might have been earning.  As the link above notes, some borrowers make one or two payments and then disappear - leaving you with pennies on the dollar, if that.   One loan like that can wipe out a year's interest on the others - or more.

I am not sure Lending Club is a great investment, compared to others.   It really sounds like a better deal for the borrowers.  But even then, only for borrowers who are looking for a lender of last resort.   The chart below shows their average interest rates among different borrowers.   At the present time, their "best" rate is higher than my credit cards.   If I wanted to borrow $30,000 to buy a car, for example, I could get a better rate (about 5%) at the dealer or my Credit Union, than I could at Lending Club.   So for folks with good credit, Lending Club isn't really a bargain.   Which means Lending Club is attracting people who don't really have good credit (as reflected by the average 702 FICO score). 

These are not really attractive rates.

For investors, Lending Club is a high-risk investment, despite what some folks say.   Yes, stocks and bonds are also risky.   And usually, rates of return reflect the amount of risk involved.   There is no way to get a 10% rate of return on your money (these days) without putting your money at risk.   And safe investments are going to have very low rates of return.  While this may not be a bad investment, it ain't a stellar one, either.  I would not put too much money into Lending Club, and what you do put in, be prepared to lose, if necessary.

In other words, There Ain't No Such Thing As A Free Lunch.**

See also:  - a reviewer notes that his annualized rate of return of 11% was wiped out when two notes defaulted.
"What I suspect was happening here, was that Lending Club was not marking down delinquent notes, recognizing that the value was impaired. Sound familiar?  It ought to, since it was the same failure to "mark to market" that the big banks were doing on their real estate loans until the near financial collapse in 2008."
Interesting...  As the company is growing rapidly, they are signing up a lot of "new" loans.  There are not a lot of older loans in the portfolio - the type of loans more likely to go into default, according to one analyst.   So, on paper, they have all these new loans paying high interest.  And since they show interest payments from delinquent loans on your "profits", it makes the rate of return appear higher.   If a lot of loans default, down the road, it could spell trouble - unless of course, they keep taking in more and more money and loaning out more and more money (which would mean chasing worse and worse credit risks - already average FICO score has dropped from 706 in one article to the 702 shown here).

In other words, it is, in a way, a pyramid scheme - so long as they can keep the ratio of "new" loans higher than older ones, it will show spectacular growth.   But if growth plateaus (which it will, as they run out of borrowers, eventually) the rates of return could plummet, as older, more deliquent loans load up the portfolio.   Interesting perspective.

This article notes (in addition to the markdown issue) that the number of lenders already outnumbers borrowers - in other words, they have a borrower shortage.   Yet many are complaining about being denied loans (usually due to income/debt ratio).   It is not hard to find borrowers - but it is hard to find GOOD borrowers.   And maybe Lending Club maybe running out of those.   Who knows?

ONE FINAL NOTE ON LENDING CLUB:   When you Google "Lending Club Sucks" or "Lending Club Complaints" you come up with these weird cheerleading sites which appear to have no other function than to groom the image of Lending Club.   Pay no attention to the man behind the curtain, Dorthy!  These are legitimate, impartial websites and blogs!  For Sure!  For example, this blog-like site concludes with the comment, "Lending Club Rocks!" (note: since removed) which is sort of embarrassing.  No one talks that way anymore.  Not since 1989 anyway.

Over-grooming your image on the Internet has a backfiring effect.  It comes across as too Stepford-Wife creepy, mind-control, Socialist State weirdness.   I mean, you have to see some real complaints and critical analysis out there to make something "real".   When all you see are rah-rah postings, beware!

* * *

**Well, there may be a free lunch - for people who use kickstarter to raise funds.

According to a recent article on NBC News, a movie that was funded in large part by kickstarter contributors, is now making millions for its producer.   What do the "backers" get?  A free ticket to the movie or other such nonsense.   Turns out, Kickstarter won't let backers profit from anything they back:
"Because Kickstarter and other crowdfunding sites do not allow investors to earn profits, project leaders offer rewards as incentives for contributions. Braff essentially offered his investors behind-the-scenes or VIP access, including personal copies of the script, roles as unpaid extras, screenings in 11 cities with Q&As with Braff, and on-screen credits. "
So what is the point of giving your money to a commercial enterprise like a movie?  It would be like giving money to GM or Exxon.

People are idiots, I'll say it again and again.  Note the comment from one LOSER who can't remember how much he donated ("20 or 30 dollars, I can't remember).   Gee, if you have $20 to just throw away, I hope you're fully funding your 401(k)!

Or is there a kickstarter for that?