A Step Toward ‘Peer-to-Peer’ Lending Securitization

Fresh ideas are scarce right now in financial markets, but a New York hedge fund has closed a deal that took an innovation - and innovated on it.

Eaglewood Capital was set up two years ago to invest in loans made by Lending Club, a relatively young company that matches individual borrowers with all sorts of investors who want to lend to them. Fans of this type of “peer-to-peer” lending say it fulfills a big need in the economy. Banks, they say, sometimes fail to reach certain types of borrowers. Lending Club’s investors include Google, which led a $125 million deal earlier this year to buy a stake from earlier shareholders.

Enter Eaglewood, which is run by Jonathan Barlow, a 35-year-old former Lehman Brothers trader. In a new development, Eaglewood took some of its Lending Club loans and sold them in a securitization, the industry term for a deal in which investors buy bonds backed with a type of financial asset. In this deal, that asset is Lending Club loans that Eaglewood had selected. Cash flows from the loans effectively pay the interest and principal on the bonds.

Since the financial crisis showed the risks of securitizing riskier loans, investors have avoided anything too experimental. Still, on Friday, Eaglewood managed to pull off a $53 million deal.

“We believe this transaction will be the first of many for Eaglewood,” Mr. Barlow said.

Securitization may be a crucial development for peer-to-peer lending because it might allow a wider array of investors to buy such loans. The Eaglewood deal mostly went to a large insurance company, according to a person familiar with the transaction. That buyer probably operates under restrictions that prevent it from directly investing in Lending Club loans. The Eaglewood deal, however, effectively allows it to gain financial exposure to such loans.

Eaglewood, which has $130 million of assets under management, declined to identify the insurance company. It also said it did not want to reveal the actual yield that the insurance company is getting on the deal, claiming that it could damage Eaglewood competitively.

It’s not clear how many peer-to-peer loans could become available for securitization. It ultimately depends on how much money is injected into the peer-to-peer companies. And the securitization may not end being the best distribution model for such loans.

One of securitization’s big flaws was exposed in the crisis. Banks made shoddy loans and then dumped them into bonds, saddling the investors in the bonds with searing losses. Since the crisis, financial experts have said firms that do securitizations need to keep a portion of the loans on their own books, so that they have “skin in the game.”

Eaglewood says it is doing that, agreeing to take losses of up to $13 million before other investors take a hit. That works out as a loss buffer of around 25 percent on the $53 million pool of loans, which, according to Mr. Barlow, is high for deals that contain similar loans to individuals. He added that Eaglewood is legally vouching that the Lending Club loans meet agreed-upon standards.

Of course, Eaglewood stands to profit from the transaction. It may be able to book a gain on the loans it sold. And the deal also provides it with cash that it can now invest in other loans. In some ways, the deal allows the hedge fund to take on leverage, the financial term for borrowing money to enhance returns.

“What we’ve told our investors is that we do not intend to take on leverage of north of four times our equity, Mr. Barlow said. “But, today, we are below three times leverage in our fund.”

The risk is that losses end up higher than Eaglewood or the insurance company expect.

But Mr. Barlow notes that Lending Club has six years of loan history to analyze. In that period, credit losses have run at a little more than 3 percent of the value of the loans, he said. In the Eaglewood deal, a majority of the assets are debt consolidation loans. These group together loans in the hope of reducing the overall debt service costs for the borrower.

Lending Club says its loans are made to people with relatively high credit scores.

If they are strongly creditworthy, why haven’t ordinary banks already made such loans to the borrowers? Banks might have perceived them as too much of a risk. A typical Lending Club borrower might have low savings and high levels of credit card debts, but, at the same time, they may benefit from higher-than-average income levels.

In Mr. Barlow’s opinion, the loans hit a sweet spot. He thinks their credit quality is solid, they have an attractive yield and a relatively short maturity.

“Very rarely can you find that combination,” he said.