P2P Lending: Yet Another Risk for Investors?
With Lending Club founder Renaud Laplanche forced out for questionable lending practices – and three P2P lenders concerned enough about the image of the field that they just founded the Innovative Lending Platform Association to ensure More Disclosure for Online Borrowers – P2P lending has never been under so much scrutiny. Individuals who've invested in these loans are likely worrying whether they really even have what they thought they'd signed up for. And now there's another problem for potential investors: Could the way that investors screen borrowers before agreeing to lend them money make them liable for the illegal discrimination practice known as "redlining?"
Some peer-to-peer investors have acknowledged that they don’t invest in P2P notes in certain states where borrowers are statistically less likely to repay their loans. Investors use this screening technique in an effort to boost their returns. But does it qualify as discrimination with potential legal ramifications? Let’s take a closer look at so-called peer-to-peer “redlining.”
What Is Redlining?
True redlining is the now-illegal practice of refusing to provide banking services to residents of specific geographic areas because of the predominant ethnic or racial characteristics of those areas. Redlining gained notoriety for its destructive impact on black neighborhoods in the 1950s and ’60s. In a January 2014 editorial by Simon Cunningham called “The Joy of Redlining: Why I Never Lend Money to Florida,” the founder of a peer-to-peer lending education and news website called LendingMemo explained why he uses state of residence as a screen when deciding which P2P notes to invest in through Prosper and Lending Club. Cunningham calls this strategy “a new version of redlining, a smarter, more modern derivative of its ugly racist former self.”
If a borrower defaults on a P2P loan, the investor loses the principal extended to that borrower, plus the interest that would have accrued on the loan. So just as an investor might screen out borrowers with low credit scores to minimize default risk and improve returns, some investors screen out borrowers in certain states. While this practice is not new, what is new is that the Consumer Financial Protection Bureau is currently asking borrowers who have had problems with marketplace lenders to submit their complaints to the agency. Complaints about filtering out borrowers in certain states could affect how these lenders and the investors in their notes operate. (For more, see How the Consumer Financial Protection Bureau Works and When, Why and How to File a Complaint With the CFPB.)
Why Exclude Borrowers in Certain States?
When Cunningham wrote his article, data showed that Florida residents were more likely to default on their P2P loans than borrowers in any other state, with a 6.21% default rate, followed closely by Nevada at 6.19%. These default rates were significantly higher than the 4.93% average across all states where P2P loans were available. By comparison, default rates in the least risky states were 2.25% for Indiana and 2.80% for Tennessee. The high default rates in Florida and Nevada resulted in a lower average return on investment (ROI) of 7.17% for Florida and 7.47% for Nevada versus an 8.68% average and a high of 12.44% in Indiana.
At the time of writing, the states with the highest loss rates for Lending Club loans have changed; Iowa now leads the way with an 11.15% default rate and a 0.51% ROI, and Florida comes in sixth with a default rate of 6.78% and an ROI of 7.02%. For Prosper loans, Arkansas comes in first in losses with a default rate of 8.52% and an ROI of 5.52%; and Florida comes in seventh, with a default rate of 7.11% and an ROI of 6.50%.
The states with the lowest default rates and highest ROIs were North Dakota (10.99% ROI and 2.11% loss rate with Lending Club), Nebraska (9.59% ROI, Prosper) and New Hampshire (3.93% loss rate, Prosper).
Redlining and Protected Classes
Under the Equal Credit Opportunity Act, lenders cannot discriminate against a prospective borrower based on race, color, religion, national origin, sex, marital status, age, the applicant’s receipt of public assistance income or the applicant’s good faith exercise of any right under the Consumer Credit Protection Act. What does that mean for borrowers in states such as Iowa, Florida, Arkansas and others that appear to be poor credit risks? “The constitutionally protected classes do not include state residency,” says Alexandra Damsker, a former securities and corporate attorney with more than 15 years of experience. “There is also no federally mandated or constitutional right to borrow money.”
You would have to show that the excluded borrowers were members of a protected class, Damsker continues: “If, for example, Florida is included, but Arizona, New Mexico, New York and California aren’t, the Latino population is likely not a target. If Mississippi, Alabama and Louisiana aren’t included, the African-American population likely isn’t targeted.”
Refusing to lend to borrowers in the entire state of Florida – whose population of more than 20 million is about 56% white, 17% black and 24% Hispanic, according to the latest census data – doesn’t meet the definition of redlining. Investors can’t see borrowers’ race or gender when deciding to whom they will lend. What they may be able to see, depending on the site, is partial zip code data, but P2P platforms don’t let you exclude borrowers by their specific zip codes or even cities, only by entire states.
It’s clear that investors can’t be reasonably accused of redlining for refusing to fund P2P loans to borrowers based on their state of residence. But let’s take a more in-depth look at some other reasons why investors don’t need to worry. The first has to do with how P2P lending works.
“The investors are not lending to the borrowers; they are lending to the P2P company,” says Sean Murray, a platform lender and chief editor and publisher of deBanked, a magazine for and about consumers who reject traditional banking services. “The P2P company is the lender. The investor has simply purchased a note whose payout is tied to the performance of a loan the P2P company has made.” Technically, the note is a security – Lending Club and Prosper notes are registered with the Securities and Exchange Commission – and its performance dictates what the P2P company pays to the investor, explains Murray.
Madeline Wallace, a public relations agent for Lending Club, says that Lending Club itself doesn’t make loans; a Utah-chartered, FDIC-insured institution called WebBank does. “Residents in all states where Lending Club and the bank operate can apply for loans. No geographic area is excluded from the platform due to credit performance,” says Wallace.
Investors are not funding the loan – the bank is – and Lending Club and WebBank are subject to fair lending rules that preclude redlining, according to Wallace. “Still,” she notes, “out of an abundance of caution, Lending Club obtains representations from investors to not make loan decisions on a prohibited basis: geography, gender, religion, marital status, etc.”
There isn’t any way for borrowers to know that investors are screening them out based on their state of residence, says Murray. But in today’s market, where about 99% of all approved Lending Club and Prosper loans are getting funded, demand outstrips supply, and any filters investors are using don’t seem to be hurting borrowers. Wallace confirms this, saying, “To date, all loans on the Lending Club platform have received full investment, so we have not seen any harm.”
Ryan Lichtenwald, senior writer and analyst for Lend Academy, an educational website about peer-to-peer lending, says that while investors have access to various data points that they can use to direct their investments, including state, FICO score, income, credit utilization and more, there is no regulation that prevents investors from excluding borrowers in certain states and no way for borrowers to know they’re being excluded. Borrowers only know how many investors have funded their loans.
And Sarah Cain, a spokesperson for Prosper, says, “Prosper has controls in place to help prevent unlawful discrimination from occurring on its marketplace lending platform, including limitations on the information that investors can see about potential borrowers.” (For more, see P2P Loans: Selling Your Notes with Folio Investing.)
A strong economy makes it easy to borrow right now, and low interest rates on savings mean investors are seeking out alternatives, such as P2P lending, where they can earn a better return. “This will be an interesting subject to revisit in a recession, when investor demand has dried up and loans potentially go unfunded for reasons unknown,” predicts Murray.
The Bottom Line
P2P investors don’t appear to be at any legal risk if they exclude borrowers in certain states when deciding which notes to purchase. They may, however, face regulatory risk: If the CFPB places additional regulations on P2P lending in the future, it could hurt investors’ returns. (For more, see Peer to Peer Lending: How Retirees Can Make Money.)