well employed, have free cash flow, and are well educated. If there’s a downturn, they’re in good relative position to get through it.
People see this entire demographic of recent college graduates as risky. But we can actually understand the differences in risk among people in that demographic.
Xconomy: Lending Club recently completed an IPO at a favorable price per share, and has since seen its share price rise significantly. How will that event affect the online lending industry?
Dave Girouard: It certainly legitimizes the space. A few years ago, you’d see articles basically saying, “Who is this Lending Club in California? Is it shady?” But the investment community is beginning to say, “Wow, this isn’t just a fluke.” The IPO of Lending Club is kind of like the starting pistol.
Right now, if you put together Lending Club and all other online lending marketplaces, they probably account for less than $10 billion in loan originations. But I think it’s a much bigger opportunity.
There’s more awareness now that this is an option for consumers, and consumer awareness is key. The IPO was a great marketing event for Lending Club.
Xconomy: You had mentioned that traditional banks may get involved in this industry, or may be disrupted by it. Tell me more about that.
Dave Girouard: For the banks, the online marketplaces had been seen as a bit of a curiosity, nothing to be concerned about. But now, all flavors of credit are being challenged— consumer loans, business loans, real estate, and even revolving credit. Lending is a cornerstone of banking, and now there are startups that are attacking every part of it.
Smaller banks have developed partnerships with some of the online platforms. They send potential borrowers to them. Other banks may take the “compete route.” There’s no reason why they can’t build platforms to compete in the market.
Xconomy: As more players pile into the space, will they all end up competing for a limited pool of creditworthy borrowers? Could the returns for each platform decline?
Dave Girouard: There is, and will be, more competition for the right kinds of borrowers. But it’s not a monolithic industry. There are many segments. For example, some platforms focus on real estate loans, others focus on funding for franchise businesses.
However, I do think there will be a thinning of the herd. By the end of 2015, I think there will be fewer people in the market than there are now. Those who stay will have been able to operate more efficiently, at lower cost, and be better for both borrowers and investors. There will be eight to 10 large public companies created out of this in the next five years.
Xconomy: How has the role of institutional investors changed in the online lending marketplace?
Dave Girouard: A few years ago, most of the money for loans at online marketplaces was coming from individuals. That’s why it was referred to as peer-to-peer lending. About two years ago, institutional investors began to take note, and hedge funds were formed specifically to invest in marketplace lending. In a very low-yield environment, online lending has offered a 7 to 12 percent return on investment.
Large funds that have been around for decades are beginning to participate. In 2015 what we’re going to see is a broadening of that.
Xconomy: When individual investors provide loan capital on sites such as Lending Club, Prosper, and Upstart, they don’t receive in return an IOU from the borrower, but a type of note or security from the lending middleman that gives them rights to a share in the loan repayments. The individual may have funded only a fraction of the entire loan amount. How is the transaction different when institutional investors supply capital for loans?
Dave Girouard: Institutions don’t go online to select loans to fund, as individuals do. And most institutional investors buy an entire loan as opposed to a fraction of a loan. They have a more direct ownership of the loan asset. To comply with current regulations, their loans are usually held in a trust, and they hold an interest in that trust.
Upstart has $500 million in capital from institutions that want to fund our loans over the next two to three years. They have vetted us, and signed agreements to invest on our platform. We also service the loans on their behalf.
Xconomy: The institutional investors seem to have a protected right to the loan repayments, even if their loan comes from a lending company that is one of those that will fail in the next few years, as you have predicted. Are the rights of individual investors as well protected if they hold a note from an online lending marketplace that enters bankruptcy? Would individuals be in danger of having to vie with the company’s other creditors for their share of loan proceeds?
Dave Girouard: To be a credible platform for retail investors, loans need to be held in a trust, which separates interest in the loans from risk in the platforms themselves. This is referred to as a bankruptcy remote structure. Upstart has this mechanism in place. If we went out of business, our creditors wouldn’t have access to the loan repayment streams. We also have a backup processor that would service the loans and repay the investors in the event of our demise.
Xconomy: You’ve said that investors are attracted to lending marketplaces because they offer the potential for higher returns in a low-interest environment. How would the online marketplaces fare if interest rates go up?
Dave Girouard: The marketplaces will adjust rates as the economy changes. If the prime rate goes up, lending platforms are going to adjust. But it’s also true that as the cost of money goes up, the amount of borrowing goes down. Successful lending platforms have to be designed to withstand any series of shocks to the economy. They’re inevitable.
Xconomy: How has computing power changed the lending industry?
Dave Girouard: One area—one in which we play—is the use of big data. For the most part, consumer credit modeling hadn’t changed in decades. But now there’s a lot more data available that allows for better and faster credit decisions. Underwriting models can now consider the performance of millions of borrowers over history. In a few seconds, these models can run thousands of simulations to better predict what might happen if a particular applicant gets a loan.
Because of this, credit decisions can now be made in seconds. That would have been unheard of five or 10 years ago.
