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By Alistair Barr
SAN FRANCISCO, July 3 (Reuters) - Institutional investorsare tripping over themselves to buy so-called peer-to-peer loansoffered by a new breed of Internet lending companies, adevelopment that could transform the nascent sector intosignificant player in the credit markets.
P2P lending, as it is known, started in 2006 with thefounding of Lending Club and Prosper Marketplace. Back then, theidea was to match individual borrowers with small investorslooking to lend as little as $25.
The loans often have interest rates low enough to make thema feasible way for individuals to pay off high-cost credit carddebt, yet the returns to investors are attractive compared tomany other fixed-income assets.
These developments have caught the eye of hedge funds,endowments, pension funds and even banks and insurers who wantto put hundreds of millions of dollars to work.
The influx of institutional money is enabling onlinelenders, led by Lending Club and Prosper, to offer far moreloans and compete more directly with traditional banks. Loanoriginations are growing at about 300 percent a year, accordingto the two market leaders.
But the arrival of Wall Street investors also brings newrisks for the sector. Sharp changes in interest rates or anothereconomic slump could prompt the new money to depart as quicklyas it arrived. And questions remain about the way thepeer-to-peer lending industry vets borrowers and whetherinterest rates on the loans properly reflect the risk.
"The industry says it's more efficient and it usestechnology to underwrite better. That's all a bunch of crap,"said Mike Cagney, a credit market veteran and founder of SoFi,an Internet lending platform focused on student loans."Peer-to-peer lending in its current form hasn't really gonethrough a full credit crisis."
Lending Club and Prosper do not lend money directly.Instead, borrowers fill out loan applications and post requestson their websites. Investors commit to fund the loans, thenUtah-based bank WebBank makes the loans, sells themto Lending Club and Prosper, which in turn sell them on to theinvestors in the form of a note. The companies make money fromservicing and origination fees.
The industry is on course to make about $3 billion in loansthis year. But the market opportunity is about $85 billion,based on the most creditworthy borrowers currently served by thecredit card industry, Prosper executive Ron Suber told a packedcrowd at the industry's first conference, LendIt, last month.
Google Inc took a $125 million stake in LendingClub in May, valuing the company at more than $1.5 billion. Aninitial public offering is planned next year, according toLending Club Chief Executive Renaud Laplanche.
'ATTRACTIVE YIELD'
P2P loans have annual interest rates ranging from 6 percentto as much as 30 percent, higher than many other fixed-incomeassets. The loans are typically repaid after just over a year.
"Attractive yield and short duration. In a yield-starvedworld, it's very interesting," said Jason Jones of privateinvestment firm Disruption Credit, which is starting a fund tobuy and possibly securitize P2P loans.
Other investment funds that are jumping into the businessinclude HCG Funds, which recently launched a $10 million fundfor Lending Club loans; Colchis Capital, which has more than$200 million allocated to P2P loan investing; and EaglewoodCapital Management and Arcadia Funds.
A new Internet lending site, CircleBack Lending, will launchthis month with an exclusive focus on institutions andultra-wealthy investors, according to co-founder MichaelSolomon.
Some institutional loan buyers employ leverage - borrowingmoney at a lower interest rate and then re-lending it to theonline borrowers.
Disruption Credit, according to Jones, is planning to raisea $75 million fund to invest in P2P loans, and will then borrowanother $425 million so it can buy $500 million worth of loans.
Eaglewood, which has put about $80 million to work in P2Plending so far, can leverage its fund 3 to 1, depending on therisk of the loans and other criteria.
But counting on money from leveraged hedge funds could leavethe industry suddenly starved of funds to lend in the event thatrising interest rates, a slumping economy or unexpectedly highrates of default were to suddenly send that money elsewhere.
The credit risk is hardly academic: loans originated byProsper from November 2005 to June 2009 had a yield of just over12 percent through the end of 2012. But losses from loandefaults reached almost 18 percent, leaving investors down 5.36percent overall.
Prosper now sets interest rates on loans itself, based onthe creditworthiness of borrowers, a big change from lettingborrowers and lenders negotiate rates and an approach it saysthat has helped the company attract institutional investors.
Still, the challenges of relying on leveraged investorsremain for Lending Club, Prosper and new rivals like CircleBack.
"If any P2P platform becomes overly reliant on hedge fundsor similar capital that is sensitive to markets and could bequickly removed, a major market shakeout could cut demand fortheir loans," said Jose Penabad of HCG Funds.
Hedge funds represent less than 10 percent of funding forloans on Lending Club and only half of them use leverage,according to CEO Laplanche. Lending Club has been working toattract more stable sources of institutional funding such ascorporate pension plans and community banks, he said.
And Lending Club has sought to prevent too much hedge fundmoney from flooding the market.
Colchis tried to launch a leveraged P2P loan fund earlierthis year, but Lending Club did not allow it because theplatform is not originating enough loans to meet the demand thatwould have been created by such an investment vehicle, accordingto a Colchis investor who did not want to be identified.
A Colchis representative declined to comment. Lending Club'sLaplanche confirmed that there is no leveraged Colchis fund butdeclined further comment.
SECURITIZATION LOOMS
Some of the new P2P investors hope to employ yet anotherWall Street tactic to boost returns: securitizing the loans byslicing them up into pieces for sale.
Disruption Credit, for one, plans to securitize its loan assets in the future, dividing them into different tranches thatcan be bought and possibly traded by institutions such aspension funds and insurers.
Cagney said SoFi is planning the first securitization of itsP2P student loans in September, with ratings from the creditrating agency DBRS and underwriting by banks including Barclays.
Securitization will provide another source of capital tofuel further growth in originations. But it also exposes theindustry to even greater interest rate risk.
If yields on other types of debt jump as firms are preparingto securitize a pool of P2P loans, that could imperil the effortby making the offering less attractive to investors.
Junk bond yields have surged from less than 5 percent toalmost 7 percent in recent months. That makes P2P loansrelatively less attractive to investors, said Cagney.
If rates keep climbing, SoFi may have to wait to do itssecuritization, he added.
Meanwhile, SoFi's loans are being financed by banksincluding Morgan Stanley.
"We could afford to wait a few months," Cagney added.
