Your guide to peer to peer lending

LendStreet Takes an Innovative Approach to P2P Lending

by Peter Renton on May 18, 2011

There is a new startup getting ready to join the peer to peer lending party. But Lendstreet is taking a fundamentally different approach to Lending Club and Prosper.

Jerry Nemorin, founder and CEO of Lendstreet, had a first hand look at the credit crisis while working in investment banking at Bank of America. He saw the devastation that occurred when companies and individuals get in over their head.

He also saw companies buying bad credit card debt at 10 cents on the dollar or less. When credit card defaults went north of 10% in 2009 he sensed an opportunity. One that could provide a win for the borrower, the credit card company and the investor. He had been a Prosper investor for some time and he loved the p2p lending model, so all these factors combined to form LendStreet, which Nemorin founded in June of last year.

Lendstreet combines debt restructuring, financial literacy counseling and peer to peer lending. It is targeted at those borrowers who Lending Club and Prosper reject. These are sub-prime borrowers with FICO scores under 640. To explain how it works it is best to provide an example.

Debt Restructuring With a Twist

A borrower (we’ll call him Bill) is struggling with a $15,000 credit card debt across three different credit cards, each with an interest rate over 20%. He has missed a couple of payments and is seeking debt relief, so he sends an application to Lendstreet. Lendstreet helps Bill get debt relief by restructuring his debt and setting him up in a payment plan that is within Bill’s budget. Here is what Lendstreet does to achieve this:

  1. They settle the $15,000 credit card debt with the three credit card companies for $8,250.
  2. Peer to peer investors fund this $8,250 settlement.
  3. Lendstreet creates a new loan for Bill at $12,000 at a more manageable 9.5% interest rate.
  4. Each investor receives a share of this $12,000 plus interest over the life of the loan.

The credit card companies are happy because they are getting 60 cents on the dollar for their asset that is about to go bad. Bill is happy because he has lowered his payments and has the credit card companies off his back. Peer to peer investors are happy because they have the opportunity to earn a great return that combines capitalized interest as well as cash interest.

Here is the catch for the borrower that will reduce the number of people looking to game the system. The borrower never sees the money, the payoff goes straight to the credit card companies. During the duration of the loan they are contractually obligated to not open another revolving credit line; if they do, it will be considered a default and their interest rate will go back up over 20%. The borrower can also gain credits for passing financial literacy tests and other milestones which can go towards reducing the principal balance. A studious borrower could see their $12,000 loan reduced to $11,500 with some of these initiatives.

Default Rates Expected to be Higher

Having said all that, Nemorin acknowledges that these are high risk borrowers and defaults will be significant. While it is difficult to estimate exactly what default rates will be, it will most likely be higher than current default rates at Lending Club and Prosper. But investors will be buffered from the impact of these defaults by the extra principal that is made part of their investment.

Lendstreet is expected to launch later this year. It will initially be open to accredited investors only in all 50 states. The plan is to also bring in institutional investors early, primarily those institutions accustomed to buying credit card debt on the secondary market. In 2013, once the business is well established they will seek SEC registration for their securities and start offering their investments to retail peer to peer investors.

It is difficult to say whether LendStreet’s model is going to be a successful one. It certainly is an innovative approach but the key as I see it will be risk management. If they can attract a pool of motivated borrowers with relatively low default rates then it could be a big win for all parties.

Hat tip to Matthew from P2P Lending News who covered LendStreet last week.

{ 28 comments… read them below or add one }

Dan B May 18, 2011 at 4:19 pm

Hmm? I’m thinking that one would have a real tough time settling for 60 or even 70 cents on the dollar unless the debtor is at least 3-4 months delinquent on the accounts in question. …………… especially with small dollar value accounts.

But putting the above argument aside, & using the example given, what is the return to the investor? I’m assuming that we would need to know the term of the “new” $12k loan to figure this out?

R. Jerry Nemorin May 18, 2011 at 5:24 pm

Dan,
Thanks for commenting on article. The example above was more high level to give a sense for the process. We will structure the loan to provide a return that is commensurate with the risk being underwritten. We do realize that it will be perceived as a “riskier” proposition at first but with proper restructuring we can mitigate a lot of the risk for the investors on the site. The terms will be based largely on the borrowers capacity to service the debt and that which provides a fair return for investors.

Mikael Rapaport May 18, 2011 at 6:42 pm

Very interesting new venture. It seems that you will be focusing mainly on the “Super Junior” Equity Tranche”of the capital structure. A little question/concern: With interest rates over 20%, how will investors diversify their investment portfolio? How many notes do you suggest investors to invest in to keep defaults low? I would be surprised to see a ROI at LendStreet higher than other p2p lending shops who use a more conservative credit risk approach like Lending Club, Prosper and Peerform. I believe that investing in the most “senior tranches” (Credit score > 660) is still the most interesting approach for investors, unless they are able to diversify into thousands of borrowers.

Good Luck,

Mikael

Matthew Paulson (P2P Lending News) May 18, 2011 at 8:02 pm

It’ll be interesting to see how LendStreet turns out. I’m excited to see them, peerform, and others launch new takes on peer-to-peer lending.

Dan B May 18, 2011 at 10:25 pm

Wow. Gee thanks Jerry for providing a plethora of details in your response. It’s nice to hear that your goal is to “provide a fair return for investors”. I’m especially relieved to hear that you intend to “structure the loan(s) to provide a return that is commensurate with the risk being underwritten”, as opposed to the obvious alternative, of course.
Thanks for also clarifying & letting us all know that “the terms (of each loan) will be based largely on the borrowers capacity to service the debt”. You see I was going to guess that they’d be structured beyond the borrowers capacity,………………….. so thanks for clearing that up. :)

R. Jerry Nemorin May 18, 2011 at 11:44 pm

Dan,
I’m not trying to be vague but for obvious reasons I can’t go into too much details. I can assure you the returns will be significantly higher than the existing platforms (as they should be since it is a “higher risk” segment). As discussed in the article, the returns are a mix between the interest rate charged to the borrowers and the capitalized interest, so that gives us a lot more leeway to structure the debt to make the economics work without impacting the debtors ability to service it. Though, you may find the comment structuring the loan to “meet borrowers’ capacity to service” to be trivial…the events of the past several years have taught us otherwise. Also, credit granted based on a borrower’s credit score is not necessarily structured to meet “borrowers capacity to service the debt”.

R. Jerry Nemorin May 19, 2011 at 12:10 am

Mikael,
Thanks for the comment. My view, to use your analogy, is that an unsecured loan to a consumer is essentially an “equity tranche” trade so whether you’re investing in borrowers with “720″ or “620″, you are “super junior in the capital structure”. I am not sure about the 20% interest rate reference and how that relates to diversification. Diversification can be done in many ways, whether it’s investing across the various loans on our platform with different default projections, or across the various P2P platforms, or mixing in traditional investments. We will not only encourage investors to diversify their portfolio but will also incorporate measures to facilitate such. We’re not saying there’s anything wrong with the existing platforms, just creating a new asset class within the industry. We’re taking a different approach to make P2P more accessible to the people who need the help the most while providing fair returns for investors and mitigating their risks. Good luck with your venture.

Dan B May 19, 2011 at 5:00 am

Jerry………….I’m assuming that you know what you’re doing & that you’ve worked out how to automate, expedite & simplify this process given the scale that it needs to be to become a viable business………….though I can’t off hand imagine how you’d do that.
But in any case, wouldn’t it be simpler & potentially more financially rewarding to just start a kind of “p2p credit card” thing? Like a p2p Capital One or Orchard Bank? I’m sure there’s a better term for this, but I’m assuming you get my point. Or are there legal obstacles to such an idea?

Peter Renton May 19, 2011 at 9:57 am

@Dan, While I can’t comment on Jerry’s plans for Lendstreet I do think there are some interesting differences between them and other p2p lenders. The thing that makes Lendstreet unique in my opinion is that they are focused on the borrowers capacity to service the debt, something that Lending Club and Prosper have no interest in.

Obviously, for something like this to scale Lendstreet is not going to have a person look at every individual loan and make a decision as to what is best. There will be a detailed application process and I imagine an automated process that determines what lending variables would be appropriate based on those inputs. While not trivial, this would be a relatively easy thing to automate.

@Mikael, Thanks for introducing me to a new word – tranche. I had to look that one up. The question of diversification is one that comes up a lot in the comments of the blog. In my analysis of the top 50 lenders on Prosper (with more than 200 notes and an average loan age of at least 9 months) the median number of loans for these top investors was around 320. I really don’t think an investor needs thousands of notes to be fully diversified. In fact, I would argue that too many notes works against the investor looking for above average returns.

As Jerry mentioned, this could be seen as a complementary investment with the mainstream p2p lending platforms and not necessarily a competitive one. It provides exposure to a class of consumer credit that is not available elsewhere.

@Matthew, Ditto. I think the more new players come in, the better. I know of three or four more concepts that are under development so the rest of this year will be very interesting.

@Jerry, Thanks for being so proactive on your responses. As I said I thought this might provoke some lively discussion.

R. Jerry Nemorin May 19, 2011 at 10:07 am

@Peter – thanks for the comments and for highlighting our approach to the P2P space with this article

@Dan – the credit card concept is probably a more gargantuan task than what we’re trying to do. Also, it would be extremely difficult to provide a true return for investors given the fluctuation and the short term on the revolving credit.

Dan B May 19, 2011 at 10:57 am

I see, so you’re thinking of a p2p investment with a fixed rate of return for investors, am I right?

R. Jerry Nemorin May 19, 2011 at 11:19 am

@Dan – yeah we are structured to provide a fixed rate of return much like the existing platforms

Brian B May 20, 2011 at 7:06 am

Jerry,

Currently interest income on LC and Prosper is considered regular taxable income to investors. This cuts into profits by 25%, 35%, etc depending on investors tax brackets, and that’s a sizable chunk.

Is it a part of your business model that large portions of investor profits would be considered Long Term Capital Gains, eligible for a lower 15% tax rate? If so, I think you have a very clever way to increase overall ROI.

Assuming this works, is there a reason you wouldn’t take it even further? In your example above, you settle the 15k debt for 8k, then give a loan for 12k @9.5%. Why not turn it all into capital gains and just give a loan for 15k at 0%?

Peter Renton May 20, 2011 at 11:02 am

@Brian, You raise an interesting point. I didn’t focus on the tax issue but if we can reduce taxes with Lendstreet that would certainly be a mark in its favor. Although I don’t think we could ever get down to 0% (I think there are minimum interest rates needed by the IRS) a lower interest rate could benefit all parties. What do you think Jerry?

R. Jerry Nemorin May 20, 2011 at 3:27 pm

@Brian, it is a concept that we’ve given a lot of consideration to but decided to go with a structure that provides immediate relief to the debtor for strategic reasons. The discount gives us a lot more flexibility to maximize ROI for investors. While we believe our structure comes with a tax advantage, my lawyers would hang me if I did not end with the “consult your tax advisor to determine how the tax treatment of interest income or capital gains or losses may impact your individual situation” disclaimer.

TheAlchemist May 23, 2011 at 8:20 pm

@R. Jerry Nemorin: Great idea! Open up an IRA and I’ll be put a few grand in.

Interested Borrower May 24, 2011 at 9:58 am

I completely get the P2P default model, there are actually a few others doing the same thing it’s just sold differently. However, the key is that the client still has to default on payments with a settlment ranging near 60% plus the interest, I am not sure it makes much sense. If anyone has been in the settlement industry, we all know banks will in affect accept far less than 60% settlement and will usually auto offer 20%-30%. How is LendStreet going to compete with the already offered settlements. What about the possibilty or Lawsuits by the original creditor. What keeps a borrower from learning the system and therefore just defaulting on the new LendStreet loan. Couldn’t you just settle that eventually as well. The bottome line is that a client that falls behind does so out of habit. I don’t think a penalty for taking out new loans is enough. Who would lend to a borrower months behind anyway. However, it does make sense to take a LendStreet loan to reduce the amount to 60% and then default on that down to a possible 20%-30% settlmenet with LendStreet.

R. Jerry Nemorin May 24, 2011 at 10:31 am

@TheAlchemist – ironic, I am actually reading the book right now…thanks for the support and we look forward to having you as a lender on the platform.

@Interested Borrower – thanks for the input, we’ll be sure to pay close attention to those possibilities.

Peter Renton May 24, 2011 at 10:47 am

@Interested Borrower, You are assuming that most borrowers are looking to game the system. I highly doubt that. There will be a small percentage looking to do that and these will need to be weeded out. But I believe that most people who are struggling are doing so from a lack of education or some bad luck (or both), no one wants to be struggling. This is one of the components that I think makes LendStreet interesting – borrowers will be rewarded for completing some financial literacy education.

Interested Borrower May 24, 2011 at 12:00 pm

@Peter, as a person that talks to potential borrower everyday. Trust me most people feel entiled and if they don’t get exactly what they want, have no issue in giving it to the man or “big institutions.” You may be able to weed this out if all underwriting is done in person but certainly not in an automated way. I find that it is the exact population LendStreet would market to that would like nothing other than to game the system. This is clearly evident in our current mortgage modification/strategic default market as well as evident in the choices we make in US Policy.

R. Jerry Nemorin May 24, 2011 at 12:48 pm

@Interested Borrower, there are many organizations (particularly debt settlement world) out there who market to the individuals looking to “giving it to the man”, that is not our business model, hence why we’re not advocating settlement for 20-30% as you alluded to in your earlier post. We are a proactive solution that markets to the individuals who are looking for a solution to maintain their credit in time of distress. As you know, debt settlement is not a credit repair solution, quite the opposite, so naturally you attract the clients who only care about the minimum settlement and looking to game the system. Also, once the loans are originated they are no longer dealing with the “big institutions” but rather their peers who are lending a helping hand. By the way, the mortgage defaults analogy is not relevant since most defaults are strategic, meaning people do not want to continue pouring money into an investment that is now a fraction of the price they initially paid for it. Most people who default on mortgages are actually paying their credit cards. I would be curious to hear your view on this article below…study shows half of american households are financially fragile http://blogs.wsj.com/economics/2011/05/23/nearly-half-of-americans-are-financially-fragile

Dan B May 27, 2011 at 11:57 pm

On the off chance that this discussion is still going on…………….Interested Borrower makes some very good points. Whenever there’s a opening to be exploited you can be sure that it will be. Before I was a p2p investor I helped a girl fill out her Prosper 1.0 loan application. I didn’t think she could afford the payments but I helped her so that i wouldn’t have to face the discomfort of saying no to personally lending her the money. Needless to say she defaulted after a few months. She knew that she’d be stiffing individual investors. Do you think she cared? I didn’t care either & frankly still don’t. Why? Because you’d have to be moron to lend money to someone who was working part time at a Jamba Juice. I mean really!

So yeah, she may have wanted to pay it back but at the first discomfort she didn’t. And yeah I helped her game a system that was begging to be gamed. Interested Borrower is correct in pointing out that there’s plenty out there that will try to game your system too. And honestly…………it would take nothing more than some prolonged cleavage exposure to get me to help them game you as well. I’m not really joking.

Peter Renton May 28, 2011 at 6:09 am

@Dan, I am sure Jerry will respond but I wanted to give my 2c worth. I think the lessons of Prosper 1.0 are etched into the mind of every entrepreneur in this space. In my conversation with Jerry we did speak about borrowers wanting to game the system and he was fully aware of that and felt like he head some systems in place that would make it very difficult. I will leave it to Jerry to elaborate.

T Gruber May 28, 2011 at 1:09 pm

I like the idea from earlier, of diversifying by spreading across different platforms, and I slightly disagree with Peter in this case that over-diversification is bad, since all the platforms have a high-yield tranche, and therefore you can mange your portfolio in a way that does not dilute the upside potential (like mutual funds… ugh!). @ Jerry, please sign me up, and come to market quickly. We can argue the theory till the cows come home, but I agree with an earlier comment, that I’ll pull a couple thousand bucks in, and ride it out for a while. The great thing about all these platforms, is the ability to scale up so easily, when you feel comfortable.

R. Jerry Nemorin May 28, 2011 at 1:40 pm

@Dan B, Prosper 1.0 was susceptible to those gimmicks because there wasn’t an underwriting process incorporated into the business model. It trusted that the market would be wise enough to screen out those who were seeking to game the system or were not credit worthy. Credit underwriting is a complicated process and should not have been left to individuals without the appropriate experience, hence why your friend was able to take advantage of the system. Our process will be comprehensive and include hurdles that make it harder for those individuals to game our system. I think it is prudent to be mindful of the risk within that segment and would also be fair to see what our process entails before jumping to conclusion. Rest assured, we have all learned quite a bit from Prosper 1.0.

R. Jerry Nemorin May 28, 2011 at 1:56 pm

@Peter, thanks for the comments
@ T Gruber, we look forward to having you as an investor on the site…we’ll be here soon

Peter Renton May 28, 2011 at 3:29 pm

@T Gruber, My main point about over-diversification is that if you want to beat the average p2p lending return then if you have thousands of notes you will find it more difficult. But as for as diversifying between platforms I am all for it. I am also looking forward to when Lendstreet launches.

Dan B May 28, 2011 at 4:45 pm

Jerry……………I can see your point, but the bottom line (as I’m sure you know) with any type of unsecured consumer loan is that people can walk away from it & there’s very little that can be done about it………….especially if you really don’t have anything in terms of assets.

Perhaps you will have things set up so well that the risks will be minimal/acceptable. The natural skeptic in me seriously doubts it, but I guess we shall see. After all I do know quite a few irresponsible people who seem to often be in need of a loan & God knows I’m not interested in lending them money :)

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