Peer-to-peer lending hit the headlines in early December when former Citigroup CEO Vikram Pandit invested in Orchard, a New York City-based startup that aims to create a secondary market for P2P loans. Pandit is part of a group including venture capital firms Canaan Partners and Spark Capital that is investing $2.7 million in Orchard.

Peer-to-peer (P2P) lending bypasses banks by connecting borrowers with lenders through online platforms for mostly small loans — like credit card debt — using proprietary technology to assess risk, creditworthiness and interest rates. Enthusiasts say banks have left open a wide and growing market for P2P lending, given that the banks are burdened with stiffer capital adequacy requirements, brick-and-mortar costs, legacy technology and impaired loan portfolios.

Indeed, despite a few red flags raised by critics, participants in the industry feel it is ready for broad-based expansion. The two biggest P2P platforms in the U.S. — LendingClub and Prosper, both based in San Francisco — are witnessing triple-digit growth. LendingClub expects to close 2013 with loan origination of $2 billion, while Prosper is looking at $350 million, compared with a combined $871 million last year. Last September, Prosper raised $25 million in a round led by its existing VC partner Sequoia Capital and BlackRock.

How P2P Lending Works

Borrowers can list loan requests of between $2,000 and $35,000 on lending platforms. Retail and institutional lenders can select from those requests and invest as little as $25 in a part of each loan, called “fractional loans,” or invest in “whole loans.” P2P lending platforms carry the loans on their books, collect repayments and pursue defaulters. For those services, lending platforms charge investors annual fees of 1% of the loan amounts. These fees are the “skin in the game” for the platforms, which forgo the fees for unrecovered loans. The platforms also charge borrowers loan origination fees of between 1% and 5% of the loan amount, in addition to the interest rate.

The minimum FICO credit score requirements are 660 at LendingClub and 640 at Prosper. (FICO credit scores are the most widely used in the U.S., and range between 300 and 850. The higher the score, the lower the consumer’s credit risk.) These lending platforms evaluate each loan application to decide on the interest rate, which ranges between 6% and 35%. On average, only one tenth of the loan applications find willing lenders, either because of poor credit scores or because credit histories cannot be verified. LendingClub’s average loan size is $14,000 with an average interest rate of 15.5%, while the corresponding numbers at Prosper are $11,000 and 16.3%.

P2P lending is a “full-fledged mega trend and a brand-new legitimate asset class.” –Ron Suber

Because the lending platforms do not have banking licenses, they use WebBank, a bank in Salt Lake City, Utah, to make the loans. The platforms then sell pieces of those loans to investors, who use proprietary risk evaluation criteria to select the loans they want to finance.

“This is a niche that probably has some future,” says Wharton finance professor Franklin Allen, adding that the P2P lending industry has overcome the biggest hurdle in capturing the market of credit card debt. “Unless you have some kind of a technology platform or computing system, it is extremely costly to process these loans.” Using advanced techniques for credit scoring and risk evaluation, the major platforms have made P2P lending viable, he adds. P2P lending also has a natural advantage in the current financial system, Allen says. “If you think of the low rates that most depositors get and the high rates on credit cards, it is a big opportunity.”

Wharton management professor Keith Weigelt describes P2P lending as an attempt at disintermediation of the banking system, a form of “shadow banking.” He draws a parallel with such practices in China, where many private lenders thrive amid government restrictions on bank credit.

Ron Suber, head of global institutional sales at Prosper, calls P2P lending a “full-fledged mega trend and a brand-new legitimate asset class,” noting that Prosper closed November with loan originations of $50 million, 10% higher than in the previous month. (LendingClub closed November with $234 million in loan originations, a 5% growth over the previous month.)

P2P lending is seeing growth because it is in “one of the best credit cycles we’ve ever been in,” Suber says. He explains why: “Unemployment is low. People are consolidating debt and improving their personal financial balance sheets. At the same time, lenders are hungry for yields and cash flow every month. Banks are lending less. And P2P platforms have grown and institutionalized the credit process.”

Suber also suggests that the younger generation prefers to borrow or lend online at P2P platforms through their smartphones and tablets rather than visit a traditional bank for their needs. “It is easy, and it is quick,” he says, adding that P2P platforms have cut the time taken to process loans from 10 to 11 days or longer to about four days.

P2P lending has many factors in its favor, according to Bill Kassul, a partner at Ranger Specialty Income Fund, a $15 million P2P fund that Ranger Capital Group in Dallas, Texas., launched last November. One, the banking industry is not challenging P2P lending platforms even as they disrupt the existing business model. By contrast, technology disrupters have faced stiff opposition from the entrenched leaders elsewhere. Examples include Napster in the music industry, and Travelocity and Expedia in online travel reservations, he notes.

Banks cannot enter the P2P space “even if they wanted to because they are brick-and-mortar, have legacy technology and would almost have to start all over with a clean slate to compete with the online platforms,” says Kassul. However, Allen is not so sure: “Banks may be able to set up subsidiaries that mimic these platforms,” he suggests.

Second, P2P lending is an attractive alternative for investors who “are starving for yields,” says Kassul. P2P investors can earn net returns between high single digits and low double digits with lower risk than in conventional fixed-income securities, he adds, noting that Ranger wanted to launch a distinctive fixed-income product before it decided that a P2P fund would be a better option. He expects the fund to grow to between $150 million and $200 million by the end of 2014.

Banks cannot enter the P2P space “even if they wanted to because they … would almost have to start all over with a clean slate to compete with the online platforms.” –Bill Kassul

Peter Renton, publisher of P2P lending website Lend Academy, says in a blog post that as a P2P investor with LendingClub and Prosper, he earned his best-ever returns of 11.62% last quarter. “It is a win-win for all parties,” he writes. “The investor gets a better return on their money than a traditional savings account or CD, and the borrower gets a lower interest rate than they would likely pay for a credit card advance or bank loan.”

Cherry Picking Loans: The P2P Business Model

“We look for mispriced loans our technology platform identifies,” says Kassul. For example, if a platform assigns a 15% interest rate for a specific loan, Ranger’s technology might determine that the borrower carries lower risk and is eligible for a 10% interest rate.

Joshua Rand, one of three partners at Petra Partners LLC in New York City, which also launched a P2P fund in November, is equally bullish. He is aiming for net returns of between 12% and 17% from his approximately $2 million fund. Petra Partners cherry picks the loans, hoping to find borrowers saddled with a relatively higher interest rate than their creditworthiness and risk of default might warrant. Like Ranger, Petra Partners also relies on proprietary tools to assess borrowers’ creditworthiness.

Consumer loans form the biggest chunk of P2P loans, and most of those are for credit card debt settlements. Kassul says his fund will have 60%-70% of its investments in U.S. consumer loans, and 15%-20% in U.S. small business loans. International consumer loans and small business loans will make up the remainder of Ranger’s investments. Kassul’s sights are on the European market, especially the U.K., Australia and New Zealand.

Kassul says he prefers countries like the U.K. among overseas markets because they have an existing base of P2P lending platforms, supportive government policies and sufficient data and credit histories of borrowers. The major P2P platforms in the U.K. are Zopa, Ratesetter and Funding Circle. Loan originations in November were $32.3 million at Zopa, $24.9 million at Funding Circle and $24.2 million at Ratesetter. P2P lending has begun in India as well, with at least two new platforms – and – launching operations in the last six months.

Credit card debt is the biggest market for P2P lenders and makes up about 70% of Prosper’s business. Suber says total U.S. credit card debt is about $850 billion. “We are looking at 10% of that; we have $82 billion to go.” He is seeing a “rapid increase” of 5%-7% each month in demand for the second biggest category: small business loans. Home improvement loans are also becoming popular, as are loans for vacations, tax payments and products like solar panels or motorcycles, he adds.

Investors in payday loans may also come into the P2P space and create lending platforms, Kassul suggests. Payday loans are cash advances that borrowers repay on their next payday. They typically carry very high interest rates of nearly 400% (such as a $15 fee for a two-week loan of $100), but also suffer high default rates of up to 20%. The motivation to create platforms is because Wall Street tends to assign them valuations of up to six times earnings, compared with a multiple of two for finance companies like Ranger, he adds. The next big push for P2P valuations will come when LendingClub goes public next year as planned, he says.

Suber does not expect P2P lenders to enter big-ticket corporate lending any time soon, but sees possibilities in weddings, student loans and medical expense loans like those for elective surgery. Other asset classes he sees within reach for P2P lending include residential and commercial real estate such as land purchases, car loans, furniture purchases, litigation and finance, among other areas.

Regulators in the future will have to pay closer attention to “the integrity of lending platforms, check out their credit scoring models and see how reliable they are.” –Franklin Allen

Prying open another market, LendingClub has begun selling its loans to small community banks that need to diversify their asset portfolios, says a recent report in American Banker. The platform has partnered with seven banks so far, and is working with some of them to make personal loans to their customers, according to the report.

Beginning this month, Orchard expects to advise financial institutional investors on developing risk prediction models and regulatory compliance, among other aspects of P2P lending. Later next year, it plans to launch a secondary market for loans from lending platforms like Prosper and LendingClub. With secondary trading platforms for P2P loans, investors can sell the loans they finance instead of holding on to them through their tenures of three years or more.

The creation of a secondary market for P2P loan portfolios will catapult the industry to its next growth level, says Kassul. “The Achilles’ heel of the investments in this market is it is not liquid.” He expects the secondary market to expand in the next two years with more entities like Orchard coming up. He also sees the possibility of funds like Ranger creating an exchange where they could trade in loan portfolios.

Yet securitization, or trading in bundles of loans, will take time, according to Allen. “These loans are pretty small, and the cost of checking them out will be quite large. That will be difficult to do until these platforms become big.” According to Suber, a few funds have already securitized and sold parcels of P2P loans.

Concerns over Loan Performance

Amid all the enthusiasm, the performance of lending platforms has not exactly been stellar. After being 120 days past due in repayments, a loan moves into default status and is then charged off, states a blog post on Orchard’s website. According to the post, a review of LendingClub loans since January 2012 showed large fluctuations in recoveries. The percentage of accounts paying some amount of recovery ranged from a high of 79.5% of charge-offs in October 2012 to a low 11.6% in June 2013. Total recoveries of charge-offs fell from about 8% in January 2012 to almost zero in June 2013. Prosper, too, went through an uneasy patch with charge-offs and recoveries last year. “Recovery amounts are highly dependent on the collection techniques of the agency along with what agencies are able to offer the borrower as an incentive,” says the Orchard blog post.

Weigelt describes the uninspiring performances on charge-offs and recoveries as “growing pains” and does not consider them to be red flags suggesting that the P2P industry might face a crisis, especially with high-risk loans. The industry, he adds, is currently too small to worry about those types of loans. At the same time, however, he labels P2P lending an “unproven model” and expects lending platforms to be aware of that and exercise caution in the early years. “If you take on risky loans and you have a lot of defaults, they will get in the business news, and people reading that will be more hesitant to go to these platforms and lend money,” Weigelt states.

The high default rates turn off many prospective investors, acknowledges Kassul, but it would be the wrong way to evaluate investment opportunities, he says. “You have to look at the net yield. You need enough of an interest rate to offset the defaults.” Typically, an investor looking for a 10% net return needs to select loans with an average interest rate of about 18%, with the difference taking care of defaults, fund fees, expenses, etc., he says, adding that funds also need to diversify their investment in loans across the spectrum of high-interest and low-interest loans to hedge their risks.

Prosper under its new management has “dramatically improved the pricing risk, and credits and defaults have declined significantly,” says Suber. The performance of its new management team is evident in the 500% growth in originations since [last] February, he adds. Last January, Prosper came under new management led by former Wells Fargo executives Stephan Vermut as CEO and Suber.

According to Allen, regulators in the future will have to pay closer attention to “the integrity of lending platforms, check out their credit scoring models and see how reliable they are.” They must also take a careful look at the contracts borrowers sign, he adds.

The regulatory environment for P2P lending is evolving, although most of the major players are subject to some form of supervision. For starters, each U.S. state has different rules for borrowers and lenders of P2P loans. Currently, residents of 47 states can apply for Prosper loans, and those in 44 states for LendingClub loans. Only residents of Iowa, Maine and North Dakota cannot apply for P2P loans. Investors in P2P loans have a narrower field: 30 states allow their residents to invest in Prosper loans, while only 26 states are open to LendingClub, ostensibly because of how they perceive the risks.

Investors in P2P funds, whether they are individuals or institutions, are not subject to any specific regulation. However, the states that permit their residents to become P2P lenders require them to be “accredited investors.” The SEC defines accredited investors as those with net worth of $1 million, not counting the value of their primary residence. The U.S. Securities and Exchange Commission regulates P2P lending platforms like LendingClub and Prosper that deal with accredited investors. They also come under the purview of the Federal Trade Commission because they entertain non-accredited retail investors. The Federal Deposit Insurance Corp. regulates WebBank, which makes those loans.

“The main problem is whether these platforms can overcome fraud issues,” says Allen, adding, however, that P2P platforms should be able to handle such issues once they get big enough to invest in mechanisms that can combat fraudulent activity.

Suber says the lending platforms file documents with the SEC every day and work closely with the Consumer Fraud Protection Bureau. “The regulators are incredibly supportive because they view us as helping consumers pay less interest and get more credit, and investors get more returns.” According to Rand, the platforms are transparent enough with their financial statements, and “the possibility of fraud is zero.”

Recent developments in China dampen the cheer in P2P lending circles. Dozens of P2P lending platforms have gone bankrupt in China since October, with the amount of money involved reaching one billion yuan (US$164.5 million), according to a report in early December by Want China Times, a Taiwan-based news site. The site attributed the estimates to Wangdaizhijia, a P2P lending portal in China. It blamed the closures on risky loans that bypassed the traditional banking system, inadequate regulatory oversight, poor managerial capabilities and tardy responses to security breaches and hacking.