"Loan Stacking" - The Blind Spot That Could Blow Up The P2P Model

Back in February we noted that there were cracks starting to show in the world of P2P lending, and more specifically, with LendingClub's inability to assess credit risk of its borrowers that were causing the company to experience higher write-off rates than forecast.

From that February post, here is a chart that was used in a LendingClub presentation showing just how far off the company was in predicting write-off rates - it was evident then that their algorithms weren't working very well.

Here is what we said at the time:

What the slide above shows is that LendingClub is terrible at assessing credit risk. A write-off rate of 7-8% may not sound that bad (well, actually it does, but because P2P is relatively new, we don't really have a benchmark), it's double the low-end internal estimate.


That's bad.  In other words, we said, the algorithms LendingClub uses to assess credit risk aren't working. Plain and simple.

And now courtesy of Reuters, we learn of a critical blind spot in the world of online lending. The risk to these online P2P companies such as LendingClub, is that as shown above, robust enough credit checks have not been developed to gauge true credit risk of borrowers. If said borrowers had what are referred to as "stacked" loans, meaning they have taken out one loan in order to pay for a prior loan, sometimes the algorithm won't be able to pick up all of those obligations in a timely enough fashion, and the borrowers credit risk is significantly understated.

As Reuters explains:

Many online lenders have failed to detect the “stacking” of multiple loans by borrowers who slip through their automated underwriting systems, lending company executives and investors told Reuters.


The practice is proliferating in the sector - led by LendingClub, OnDeck and Prosper Marketplace - because of many lenders’ hurried, algorithmic underwriting, use of “soft” credit inquiries, and patchy reporting of the resulting loans to credit bureaus, according to online lending and consumer credit experts.


Such loopholes, they said, can result in multiple lenders making loans to the same borrowers, often within a short period, without the full picture of their rising obligations and deteriorating ability to pay.


Stacking is “causing problems with the whole industry," said Brian Biglin, chief risk officer of LoanDepot, a five-year-old mortgage lender that last year started making personal loans online.

However, even if lenders are aware of the issue, and run further credit checks, the reporting can still be sketchy enough where the risk still is not picked up properly.

In their haste to give applicants quick loan decisions - sometimes within 24 hours - some marketplace lenders do not conduct thorough credit checks, known as "hard inquiries," according to industry executives.


Such checks create an updated log of credit and loan applications, and they can lower a borrower's credit score. Soft inquiries don’t require the borrower’s consent and don't usually show up on credit reports.


OnDeck said it runs only soft checks. LendingClub and Prosper said they initially run soft checks but run hard checks later in the process, just before funding loans.


Running hard checks only at the last minute, however, can also leave other lenders in the dark, said Gilles Gade, president and CEO of Cross River Bank, which invests in many online lending platforms. At that point, the borrower may have already obtained other loans, he said, because hard checks can take about 30 days to show up on a credit report.


Another problem: Loans that never show up on credit reports at all, because of uneven reporting by online lenders.


“Not all lenders in our industry report to bureaus," said Leslie Payne, a spokeswoman for LendUp, which makes high-interest installment loans. In a February blog post, Experian, the credit bureau, said a “significant number” of marketplace lenders do not report their loans.


Prosper, Avant and LendingClub told Reuters that they report their loans to all three major credit bureaus at least monthly. OnDeck said it reports to several leading commercial credit bureaus, including Experian and PayNet.

These new revelations could scare off investors who are already concerned about the loose underwriting standards and rising default risk. As Reuters notes, some major backers such as BlackRock and Citigroup have already retreated from the space.

Firms such as Blue Elephant Capital Management stopped buying loans from Prosper for several months over concerns about weak underwriting and profitability. Brian Weinstein, CIO at Blue Elephant said that marketplace lenders need to slow their lending processes and improve sharing of credit information, adding "stacking was one of the reasons why we think we saw credit deteriorate last summer when we stopped our marketplace lending program."

Industry leaders LendingClub and Avant said they are aware of stacking and its dangers, but they downplayed the risks Reuters notes.

With the turmoil that LendingClub has been involved in as of late, namely the prompt resignation of CEO Renaud Laplanche as a result of knowingly selling $22 million in loans to Jefferies that didn't meet the agreed specifications, the last thing the firm needs is to blow up (further) because it was too nonchalant about ensuring it had a robust credit approval process.