Risky Borrowers May Mean Risky Business for Lending Club, On Deck

This article, originally published at 2:24 p.m. on Tuesday, Feb. 28, has been updated with market data.

A dismal fourth quarter at Lending Club  (LC) and On Deck Capital  (ONDK)  highlights the often conflicting challenges for publicly traded companies that make high-interest loans to riskier borrowers. 

The two lenders, which went public in 2014, both reported losses, with Lending Club disclosing a slide in the volume of new loans while On Deck ramped up reserves against potential defaults.

Such challenges, along with regulatory scrutiny, profitability and investor satisfaction require a delicate balancing act for the businesses, which are part of the so-called fintech industry that encompasses more than 4,000 firms in the U.S. and the U.K. Investment in the sector has climbed to $24 billion from $1.8 billion over the past five years, according to the Office of the Comptroller of the Currency, a U.S. regulator. 

"Lending Club and On Deck operate under the thesis that the poorest people or the weakest companies can pay the highest interest rates for the loans that they make," Rafferty Capital Markets analyst Richard Bove said. "The basic concept is flawed. That strategy has been employed for a long, long period and it's never worked in a public company."

The industry's potential risks -- and how regulators might curb them -- drew a national spotlight last May when Lending Club CEO and co-founder Renaud Laplanche resigned amid a disclosure that a small portion of the company's loan sales to investors didn't meet the buyer's criteria. The company's stock plummeted, and many investors -- who supply the capital for loans -- backed away.

That cast a pall on a business model that relies on such investors to extend loans underwritten by algorithms that the industry claims identify low-risk customers who can't get loans elsewhere. Profit margins can be higher since the firms don't have the same regulatory oversight -- and costs -- as traditional banks, but that means they also lack the access to cheap capital.

Increased government attention may help, however. In December, OCC chief Thomas Curry said his agency was moving forward with special-purpose national bank charters for fintech companies, giving them the option of becoming a bank in exchange for subjecting themselves to stricter regulation.

"Fintechs, while not without some risks, also can potentially deliver these products and services in a safer and more efficient manner," Curry said in a speech at Georgetown University Law Center. "Chartering companies that are finding new and better ways of satisfying those needs is another step toward supporting responsible innovation that is good for consumers, good for the federal banking system, and good for the country.

While Laplanche's successor is leading a recovery effort that includes more stringent internal controls, Lending Club's loan originations dropped 23% to $1.99 billion during the fourth quarter. The company reported an adjusted loss of 2 cents a share for the period, its third straight quarterly loss. 

"Equity investors' confidence in the platform's ability to sustain long-term earnings growth will take multiple quarters to recover," Oppenheimer analysts wrote.

Stephen Ju, a Credit Suisse analyst with a neutral rating on the stock, noted that the lender faced risk from an "increase in consumer loan default and charge-off rates, which can make it more difficult for Lending Club to facilitate origination."  

As investors return to Lending Club's platform, many want "higher credit quality grades" and are shifting away from the riskier grades that typically have higher margins.

"Last month, we implemented an additional change that resulted in our ceasing to offer credit to roughly 6% of our total borrower base. The change is disproportionately focused on our higher-risk grades," LendingClub CEO Scott Sanborn said on an earnings call. "While this change will give us some short-term pressure in the first quarter, we're building a business for the long term in a truly massive market."

On Deck, meanwhile, reported its fifth consecutive quarterly loss, of an adjusted 44 cents a share, after the firm added reserves of $19 million for potential loan losses. That brought total reserves to $55.7 million, up 53%, the company said. 

Still, fourth-quarter loan originations climbed 21% year-over-year to $81.8 million. 

"While our updated loss estimates impacted fourth-quarter results, these longer maturity loans generate attractive returns and will remain an important part of our origination strategy," On Deck CEO Noah Breslow said on an earnings call.

The company's "rapid growth" shows there's an important market to tap into, JPMorgan Chase analyst Richard Shane said in a note, but higher-risk clients remain a concern.

"On Deck's innovative use of technology could potentially result in superior execution and market penetration, especially as traditional banks are reducing their exposures to small business lending," wrote Shane, who has a neutral rating on On Deck with a price target of $5. "However, the high level of credit risks inherent in On Deck's high-yield portfolio remain difficult to assess, given the company's reliance on its proprietary algorithm for determining credit risks."

Such algorithms, which typically measure criteria including a borrower's credit score, history and debt-to-income ratio, enable lenders to extend credit with interest rates that range from as low as about 5% to as high as 34%.

While public lenders are reducing investments in riskier borrowers, Rafferty Capital's Bove noted that there is competition from non-public firms like Social Finance, known as SoFi, which provides student loan refinancing; home improvement merchant financier GreenSky and personal loan provider Avant.  

Larger banks including Goldman Sachs  (GS)  have jumped into the online lending space, too. Goldman's new Marcus platform offers fixed-rate, no-fee loans ranging from $3,500 to $30,000, with interest rates as high as 22.99%. 

Both San Francisco-based Lending Club and New York-based On Deck had initial public offerings in 2014. Lending Club's shares rose 2.4% to $5.48 on Wednesday, yielding a gain of 4.3% so far this year. On Deck increased 1.5% to $5.42, bringing its year-to-date growth to 17.1%. 

More from Stocks

The Stakes Are High for FAANG Stocks This Time Around

The Stakes Are High for FAANG Stocks This Time Around

Profit From the Good Side of Bad Selloffs: An Illustration

Profit From the Good Side of Bad Selloffs: An Illustration

Data Regulation on FAANG's Could Just Be Underway: Cramer's Investing Teach-in

Data Regulation on FAANG's Could Just Be Underway: Cramer's Investing Teach-in

Your Need to Know - Forward Look

Your Need to Know - Forward Look

A Guide to Investing in the Fast-Emerging Cannabis Industry

A Guide to Investing in the Fast-Emerging Cannabis Industry