LendingClub shows the corrupting power of debt

LendingClub shows the corrupting power of debt
Courtesy stevepb

LendingClub is a peer to peer loan broker. In other words, LendingClub helps connect people who need loans (borrowers) with people willing to offer loans (investors).

LendingClub’s CEO, Renaud Laplanche, resigned last week under pressure. Bloomberg published an article on Thursday with some of the details. In short, Laplanche was an investor in a hedge fund. He tried to get LendingClub to invest in that fund, to his advantage, without disclosing his conflict of interest to the LendingClub board. The board found out and forced his resignation.

I’m not interested in the details. I am interested in LendingClub as another example of high profile Wall Street firms trying to get too clever with debt. It was a fundamental theme during the global financial crisis. And it has reemerged here, on a smaller scale, with LendingClub.

Debt is the reason we have our modern economy. If we couldn’t connect people with excess capital with people in need of capital, we wouldn’t have anywhere near today’s level of prosperity.

In fact, look at Berkshire Hathaway, the company Warren Buffett runs. It’s one of the largest companies on the planet. And it’s competitive advantage is that some parts of its business generate enough surplus capital to feed other, more capital-intensive parts of its business.

That’s the way the holding company model works. The value that would otherwise be captured by an outside creditor is kept in house, with different component businesses playing the roles of internal creditors and debtors.

That’s a long way of me saying, I’m not at all against debt.

With that said, it seems like our financial sector has a huge problem with being super, super greedy around debt. We try to push debt on all kinds of businesses. Have you seen all the bankruptcies unfolding in the oil and gas sector? The reason you see those bankruptcies is because oil and gas companies fell way too deeply in love with debt, and didn’t realize how much commodity price risk they were absorbing with those loans.

Debt arithmetic is as simple as it gets. You have $1. I have $0. But, I know that if you gave me your $1, I could transform it, via my existing business, into $2. Then I could pay you a fee for borrowing your $1, and I’d keep what remains.

Again, very simple arithmetic. The problem is, we routinely underappreciate the risk between me taking $1 from you, and transforming that $1 into $2 via my business. It’s very easy to make a spreadsheet show the desired outcome. It can be very difficult to make the market cooperate.

You’re seeing the political fallout from Puerto Rico’s debt crunch. You’re seeing China drown in debt. Greece continues to be consumed by its own debt crisis.

For such a simple, foundational economic lever like debt, the world sure seems to have a tough time using it responsibly.

Let’s return to LendingClub, which ostensibly is doing the world a service. It’s connecting borrowers with investors that otherwise may never find each other. In principle, that’s great. LendingClub is overcoming economic friction that inhibits real growth and job creation.

Under the surface, there are a bunch of potential problems. I’ll focus on one. Brokers are incentivized to make deals. LendingClub gets a cut of every loan, from both the borrower and the investor. The more loans that are consummated, the more revenue LendingClub generates.

Sound familiar? That was the fuel for the subprime mortgage crisis, that spiraled into the global financial crisis. Subprime lenders were incentivized to create mortgages. The mortgages were securitized, then broken into pieces and sold. Since the risks were so poorly understood, the obvious incentive was to keep creating mortgages. The more mortgages, the more revenue for everyone involved.

At the end of the day, that’s the biggest problem with debt. Because financially powerful actors have incentives to match creditors with debtors, the best interests of the creditors and debtors themselves can be lost.

There appear to be many moving parts in the LendingClub story. Still, one overarching lesson is be very, very careful with debt. Debt is essential for our modern economy. But the mechanics by which debt is established are too easily abused and manipulated. Individuals and companies both have been swallowed by debt. Don’t fall into that trap.

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