Is Lending Club Really Bubble Proof?

There are two popular theories about Lending Club (NYSE: LC) and its business of peer to peer lending out there. The first is that peer to peer is a bubble similar to the subprime mortgage catastrophe of the 2000s. The second is that the business is bubble-proof because of the due diligence done by the lenders.

These theories reveal both the risk and the opportunity that peer to peer lending presents for investors. If the first thesis is true, peer to peer is a bubble to be avoided and an opportunity for investors in traditional lenders. If the second proves correct, Lending Club could be a great contrarian or even value play because it is well positioned to take advantage of a changing economy.

There is certainly some evidence for the bubble hypothesis. The industry is growing fast; Bloomberg estimated that the amount of peer to peer loans issued this year could rise to $76.9 billion. If that estimate holds up, the amount of peer to peer loans issued in 2015 would be nearly double those issued in 2014—$41.4 billion.

Lending Club also reported a quarterly year to year revenue growth rate of 109.6% on March 31, 2015. That growth rate far exceeded that of traditional lenders. For example, Bank of America (NYSE: BAC) reported a growth rate of -6.04%, and Wells Fargo reported a growth rate of 3.17% on the same day.

Is Lending Club Losing Money?

Such breakneck growth is certainly indicative of a bubble. A more telling sign of a bubble could be Lending Club’s net income.

When it went public in December 2014 the Club reported a net income of $7.308 million; by March 2014 its net income had fallen to -$.03 million, and in March 2015 it reported a net income of $31.97 million. That indicates Lending Club could be losing money on the loans it is making.

To be fair, there are some signs Lending Club is starting to make money. According to its financials, Lending Club had $64.6 million in cash and short-term investments when it went public. Yet on March 31, 2015, Lending Club had $874.13 million in cash and short-term investments. That shows us that it is capable of generating a lot of cash in a very short period of time, but can it keep that up?

How Good Are Lending Club’s Loans?

The real determining factor for Lending Club’s survival and success and that of the entire peer to peer business model is the quality of the loans. The $77 billion question is, how likely are the borrowers to default on the loans?

The mortgage market melted down when it was revealed that many of the mortgages would never be paid off. Large numbers of loans had been made to people without the income to pay them.

Lending Club founder and CEO Renaud Laplanche claims his company can avoid this trap; it requires borrowers to have a good credit score. The club currently requires borrowers to have a score of 660, while its main competitor, the privately held Prosper, requires a score of 640.

The problem with credit scores is that they are based on past consumer behavior and not cash flow. A person with no money or even no income whatsoever can have a great credit score. This was the source of the notorious “no income, no job, and no assets,” or NINJA, mortgages written during the boom. The reverse is also true; somebody with a lot of cash or a high income can have a lousy credit score.

One potential risk at Lending Club is that many of its borrowers could have been using their credit cards to make up for limited income. They could be trying to use the Club’s debt consolidation loans to pay off balances or, worse, simply increase the amount of credit they have access to.

Another related risk is that the peer to peer boom is being driven by the lousy economy and income inequality. People are turning to peer to peer because they cannot qualify for a traditional bank loan or they have maxed out their credit cards. Many of the borrowers may simply lack the cash to pay off the loans they are taking out, which happened during the mortgage bubble.

Why PayPal Might Be a Better Investment Than Lending Club

That could make Lending Club vulnerable to an economic downturn or even a sluggish economy. If large numbers of borrowers start losing jobs, it could find itself with a portfolio full of worthless paper.

That might make PayPal’s business lending model, which bases loans on a percentage of a borrower’s revenues, far less risky than Lending Club’s. One safeguard that PayPal uses is that a loan applicant must have done at least $20,000 in sales through PayPal over the past year.

PayPal is making hard money loans based on actual cash flow rather than consumer loans based upon a borrower’s supposed reputation. That still makes PayPal vulnerable to the economy but less vulnerable to no job no income borrowers. It at least knows that its borrowers have cash flow; Lending Club has no way of knowing that.

Another advantage to PayPal’s micro-lending system is that it collects loan repayment directly from a borrower’s balance. That ensures payment, and it could be a more effective take on micro lending because the entrepreneur is effectively borrowing against his or her own business. One problem at Lending Club is that it could have to resort to expensive collections efforts to get the money back from borrowers—something PayPal may have avoided.

This means that PayPal could be the real value investment in micro lending when it spins off from eBay Inc. (NASDAQ: EBAY) later this year. It has devised a lending model that eliminates some of the risks inherent in micro lending.

My take, though, is that peer to peer and micro lending are simply too new and too risky for the average investor. Even though peer to peer might not be a bubble, value investors should stay away from it for the foreseeable future.

Disclosure your friendly neighborhood blogger owns positions in eBay and Bank of America.