Today’s post is the second-part of an interview about the future of peer loans with Ron Suber, President of Prosper Marketplace. Ron joined Prosper in 2013 to develop and execute on the company’s business development strategy. He previously served as a Managing Director at Wells Fargo Securities and as a senior partner at Merlin Securities.
Please click through here for the first half of the interview.
I have included my own comments in italics so as not to be confused with Ron’s.
Now, shifting gears to the investor side. What three things should investors know about peer loans?
It’s been written by almost every platform that one critical components of being an investor in a marketplace lending platform and a peer-to-peer platform is investment diversification. Ensuring that you have at least a hundred loans and, also preferable, more than two hundred loans spread across different loan grades and different time periods and vintages, to ensure diversification. And another key is to not just to be on one platform but to have the opportunity to invest in more than one platform to continue the diversity of their investment.
And the third thing I would encourage investors is to look at the IRA account. The tax deferred account, as a vehicle when investing in these loans given the high interest and the ability in tax deferred accounts to defer the interest in the IRA account. Those are three points I encourage the investors to consider.
I have talked about investment diversification in peer loans on the blog as being a double-edged sword. It is absolutely critical, as with all investments, that you invest in enough loans so a few defaults do not significantly affect your portfolio return. On the other hand, a lot of sites recommend investing in thousands of loans which means you’ll need to relax your loan criteria and basically invest in any loan that comes down the pike.
That kind of ‘dartboard’ investing is similar to index investing in stocks. You may earn the market return or a little worse but you’ve diversified away any chance at better returns. A chart of portfolio returns by the number of loans held, based on Lending Club data, shows that diversification benefits level off quickly around 150 to 200 loans.
peer loans investment diversificationI normally recommend investors aim for between 150 and 200 loans in their portfolio but you could go up to 250 loans if you are able to find them within your loan criteria. If you find you are relaxing your loan criteria just to get more loans, you put yourself at risk of lower returns.
The Individual Retirement Account (IRA) option is a great choice for investors. Interest from loans is taxed at the same rate as your income so can be pretty high for those in the top tax brackets. Putting your money in an IRA account means you won’t pay any taxes until you withdraw the money. You will also be able to deduct the money you put into the account from the income you earn each year. There is a limit to how much you can put in an IRA account each year and you cannot withdraw it until you are 59 years old, so there are some limitations.
The money you lose on charged-off loans can be deducted from your other investment gains, if you hold your peer loans in a regular, taxable account. This can help to offset gains in other investments like stocks but the taxes you pay on peer loans interest may make it a better choice to put your peer loans in an IRA account.
That brings us to the growth in the investor base. It’s really taking off, especially on the institutional side. I’ve heard a lot about the interest from family offices and advisors and it seems like it’s making it difficult to find peer loans to fund for retail investors. Does Prosper have a plan for attracting more borrowers to fill this demand? How could they do that?
Prosper is very committed to the balance between retail and institutional investors. To do that we are very focused on borrowers. We’re using many new avenues to find borrowers that fit. Traditionally, these platforms use a lot of direct mail to find borrowers, and to educate borrowers and to pre-screen offers. Now, we’re using digital marketing and social media and partnerships and affiliates and lots of new ways to find new borrowers and educate them about the opportunity to borrow for less, easily and quickly, with a fixed rate and a fixed term to get out of debt and improve their credit.
The fact that Prosper doubled loan originations though the platform to $2 billion in just six months this year speaks to the growth in the industry. There will be some growing pains, as we’ve seen in the faster growth of investor loan demand, but I think the issue gets worked out in the coming year. As more borrowers begin to see peer loans as an alternative to traditional bank financing, the increase in loans will help clear the market for investors.
The Lending Club IPO looks to raise about five hundred million going public, possibly as soon as this month. Any ideas on how they might use that money? What, maybe, Prosper would use the money for?
We’re very excited and happy for Lending Club and their pending IPO, and we hope it’s a very successful event. We are now roughly 42% of Lending Club’s size, if you look at the third quarter information posted by both firms to the SEC website. And we think there is plenty of opportunity for both firms, as shown by the growth.
Ron wouldn’t speculate on what Lending Club might do with its new funding. I wasn’t really expecting him to comment but had to ask as a way of maybe getting some inside scoop on where growth is going in the industry. On a side note – Lending Club has recently said they would increase the offering to $650 million, which would set a valuation for the company above $4 billion. This is a great sign for the industry. It likely means that the company, in its talks with investment banks like Morgan Stanley and Goldman Sachs selling the deal, is seeing a lot of interest in the peer lender.
It will be interesting to see what Lending Club does with the money and how other lending platforms react to the competition. While being completely online has been the distinguishing feature of the industry, I could see the benefit to having some form of storefront outreach for the platforms. It would likely include a lot of regulatory work but it would also be interesting to see Lending Club acquire one of the foreign peer lending platforms to expand globally.
How about the future of the industry? Where do you see peer loans in, let’s say, three years? Maybe even in five years?
I see peer lending really integrating itself with the banking industry. There are initiatives happening today where banks are introducing their borrowers to us, the peer-to-peer marketplace lending platform. At the same time, as we are able to help their borrowers get a loan, those banks are buying those loans from us.
We’re starting to see the banks realize that we are part of the solution to help them take care of their clients, to improve customers’ satisfaction, to get loans to their clients, and at the same time, own customer credit without having to do the loan. I think that a critical piece for people to understand today is that the banking community is really embracing what we’re doing and seeing as how we can help the banks and their clients.
The second thing I think that’s going to happen is a continued integration of these peer-to-peer platforms into the social network and the social community. If you look at Facebook today and go to the Prosper page on Facebook, you see thousands, tens of thousands of people telling their stories, sending in videos about how we helped them, and sending in photographs about the benefits of using Prosper. And you’ll start to see more and more of these technology firms embracing peer to peer finance and payment. I think that will be a major driver in the next year or two ahead.
Integration with the traditional banking industry will be very interesting over the next few years, especially as more regulation from Dodd-Frank comes into effect. These, and other banking rules, have increased capital requirements and regulatory fees on banks and limited the ability of smaller banks to profitably survive. The fact that banks are choosing to be an investor in peer loans rather than originate themselves give you a clue to the difficulty in their industry.
It’s interesting that you brought up Facebook. You probably heard the rumors that Facebook wants to be more involved in peer loans. Everyone is curious whether that means its own platform or maybe a platform on the site run by another company. Any idea where Facebook might want to be involved in peer loans?
No, I wouldn’t want to speculate about that.
Another question that I really didn’t expect Ron to be able to answer but it was worth a try. The social network reaches more than a billion people and would bring a huge global reach to peer loans. While the Lending Club IPO is a positive for the industry, investors in Lending Club shares should be worried that Facebook could enter the market in some way as a competitor.
What speed bumps do you see for peer lending companies, whether government regulations or economic that could come into play?
The things that we think about at Prosper include the risk-free rate of returns and the Fed funds rate and what are the investment alternatives that retail and institutions have to ensure that we become an attractive place for people to invest in a loan. We also think a lot about the economy and unemployment to make sure that our pricing, credit and risk continues to iterate and stay very up to speed on what’s happening with consumers.
And the other thing we think about is the institutionalization of these platforms as they grow. We need to continue to invest in infrastructure, people, mobile and new products to make sure that we can continue to be able to grow with quality and with the great service our borrowers and investors are used to and require.
The risk-free rate is the interest rate paid on U.S. government treasuries, usually the 10-year bond. It is called the ‘risk-free rate’ because payments are backed by the full faith and credit of the United States. It is on this interest rate that all other bonds and loans trade because all of these have marginally higher risks than the treasury bond. They have to do this to attract investors to buy the debt.
The highest-rated bonds of corporations might pay rates just a little above treasuries, after all you wouldn’t expect Disney to ever default on its loans. At the other end of the spectrum is bonds of risky companies and unsecured loans to individuals, i.e. peer loans, that would need to offer higher rates of return to investors.
The Federal Reserve, which sets the rate on government bonds through its federal funds rate, has given clues that it will start raising rates in 2015. While it will mean different things for different types of loans, I think it is going to be a good thing for peer loans. Rates on peer loans may increase a little as the interest rate increases while defaults will probably not increase since missed payments are more closely tied with employment and the economy. Even if there is higher competition from other bond investments from an increase in interest rates, peer loans offer extremely high returns compared to even junk-rated debt and I still see a lot of investor interest in the year ahead.
You gave a great presentation about the Necessary Nine for Global Success of the Marketplace Lending Industry (Youtube) at the Alternative Finance Conference in November. What does peer lending need to do to stop being an alternative form of finance and become really mainstream?
I think in 2015 peer-to-peer lending will become the best way, the most efficient way to borrow money. It won’t be something that’s new and it won’t be that only just a few people use it. I think it will eventually become an application and use in people’s daily life and not just for a first loan, but for a second and third loan and a place that the millennials and Gen X use as a solution for their personal financial needs, both for investment and for borrowing.
At present twenty-three states prohibit investing on Prosper, similar numbers prohibit investing on Lending Club. I think there are three states prohibiting borrowing on Prosper and five that prohibit borrowing on Lending Club. Can you talk a little bit about why that is? And how Prosper or the industry in general can go towards making it a more democratized system across the country?
Absolutely. We are working very closely with the regulators, both on a federal level and state level, to educate them on the benefits, to the investors and the borrowers of the transparency of the platform. And how we’re really helping people and how the industry has grown and changed since perhaps their earlier introduction to it over the last eight years.
Many of these states are starting to realize that these platforms are extremely well capitalized. Run by experienced professionals with pricing and credit and risk models that are very different than the earlier days of peer loans. And that these platforms are going to be accepted by many more states. We’re hoping to have more states looking to approve us going forward especially in 2015.
I think, as the Lending Club IPO starts to gain media attention, the pressure is really going to be on states to open their regulation to investing and borrowing in peer loans. After nearly a decade of lending in the industry with no real smoking gun or fraud, there is little reason to keep half the country from being able to invest in peer loans.
What are the three biggest area of growth? I know you mentioned that you’re focusing on personal lines for borrowers, are there other areas, whether demographic, geographic, anything in specific that Prosper is looking at?
I think for growth, Prosper is looking to grow its employee base. We are hiring people every week and we are expanding in California and Arizona. In 2015, we are focused on our products – rolling out new features and functionality that attract more borrowers, including a major focus on mobile. We’re also focused on partnerships that help us reach new borrowers.
Growth has just been amazing in the peer lending space and there is still a ton of room to go before the platforms have to really start thinking about competition. I think it will be interesting to see how that competition evolves in the online lending space, whether through financial institutions moving online or through social networks developing lending platforms. Growth in other loan types is probably the biggest opportunity in the near-term as people go to the platforms to fund their large purchases instead of just for debt consolidation.
Thank you Ron Suber and I want to thank you, the reader, for joining us. I hope you will join us for more interviews and follow the blog on Facebook and Twitter. Please consider sharing this article with your friends using the social share buttons on the left.