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These are tough times in the financial markets. As we discussed last Saturday in our post on subprime, borrowers are beginning to feel the pinch of higher interest rates and much tougher underwriting criteria. Even for borrowers with prime credit (FICO score above 620), it is difficult to qualify for a loan now. Those that do qualify face tougher terms, limits, and more.

The credit crunch looks like it is here to stay for a while. The markets will continue to react to ongoing disclosure of subprime exposure. The Fed is doing a good job of trying to inject confidence into the markets by lowering the discount rate, and we think that they are likely to lower the fed funds rate at their September meeting. According to a poll conducted by Reuters, 71.4% of economists think the Fed will cut the fed funds rate at or before its September 18 meeting.

Until then, companies are having a hard time issuing commercial paper – the buyers have all pulled out of the market. This is leaving a number of deals at risk. For example, one of the big private equity deals this year was the sale of Home Depot Supply is supposedly facing pressure because the banks are having a hard time lining up the financing for it. There is even speculation that private equity debt issuance will stay dried up for months – because commercial debt is so hard to place. Mortgage companies and mortgage units of financial services companies have responded to the crisis by cutting costs. Lehman Brothers, Accredited Home Lenders Holding, and HSBC Holdings announced thousands of job cuts this week.

What should consumers do? If you do not need to borrow or refinance, you should be fine from a credit perspective. You may want to talk with your financial advisor about your overall portfolio during the time of turmoil.

If you need to borrow, shop around for great rates. If you need to borrow 25,000 or less, and you have good credit (640+ FICO, 20% or lower DTI), consider getting a loan with Lending Club.

If you are looking for somewhere to put your money to work, consider lending it at Lending Club, where you can put it into a diversified portfolio of loans that can earn from 7% to 17% before losses.

Please send us your comments.

By now, most people have noticed that something is going on in the financial markets. For those of us who follow the equity and debt markets as closely as I do, it has been a gut-wrenching few weeks. What exactly is going on? The financial press is calling it the Subprime Meltdown. We think the situation is serious, and we want to let you know how we think it impacts you and Lending Club.

What is subprime? Subprime, short for subprime debt, is credit that has been extended to riskier borrowers. In credit score terms, most lenders consider borrowers subprime when they have FICO scores below 620 – there is no fixed definition. For individuals, subprime loans were made by mortgage companies and, to a lesser extent, by banks to people who were not creditworthy by traditional standards. Basically, these institutions were lending too much money to people who could not afford the houses they were purchasing. For the markets, subprime investments were debt instruments comprised of thousands and thousands of loans, including some percentage of subprime loans.

What happened in the markets? Mortgage lenders securitize their loan portfolios periodically to raise money for new mortgages. These portfolios are sold in the market through collateralized debt obligations (CDOs) that are split into risk tranches so that investors (including hedge funds, financial institutions, investment banking companies, trusts, mutual funds, and individuals) can invest in the higher-yielding risky portions (the subprime pieces) or the lower-yielding, less-risky portion of the portfolios. This approach creates liquidity in the economy by allowing financial institutions to lend to more borrowers, which is generally a good idea.

However, one of the key triggers for the subprime meltdown was that CDOs were often rated AAA because the higher-risk tranches of the CDOs were set up to take all losses first, hopefully leaving the lower-risk AAA pieces of the CDOs unaffected by losses. These high credit ratings led to hedge funds and other investors investing in debt that looked less risky than it really was. Adding to the risk, many investors buying the securitized mortgages were highly leveraged in an attempt to maximize their returns. Based on market conditions, the lenders to these investors called for payment of these loans that had allowed them to leverage their investments. The credit markets froze and values of good investments plunged as the borrowers sold their good investments to generate cash.

We believe that the entire mess was originally caused by aggressive lending practices – loans and mortgages given to people whose likelihood to pay the loan back was low. Additionally, the practice of piggyback lending – offering additional loans on top of mortgages – contributed to the practice. Why did mortgage brokers and financial institutions do this? They could maximize profits by originating as many loans as possible and then selling off the resulting loan portfolios to the market. This approach took advantage of people with weak credit who are now facing serious financial problems.

We understand that many lenders are worried about potential losses, and that many borrowers are concerned that they will not be able to qualify for or afford new credit. What is the impact of subprime on Lending Club and its members?

• First of all, the impact on our members will be limited. As the Fed continues to make moves to settle the markets and to increase liquidity, we think there is a high probability of the fed funds rate being reduced following the 50 basis point reduction in the discount rate. Since our loans are fixed rate loans, current borrowers and lenders will see no changes in their payments

• Second, we think that borrowers will see us as a great alternative to banks. There are a growing number of banks that have had to raise their credit standards because they have not been able to sell their loan portfolios on the open market very easily, leaving them with less capital to lend to new customers. Our credit policy and risk management practices are conservative, but we are not planning on drastically changing our underwriting practices in response to the market situation – we believe that we have been originating loans correctly since we got started

• Third, we think that lenders will see us as a safe haven from the fixed income market. Our borrowers’ strong credit (640+ FICO score and non-mortgage debt-to-income ratio no higher than 20%), our members’ shared affiliations, and our portfolio-based diversification make lending money at Lending Club attractive. We offer good returns and relatively low risk, making lending a good strategy for many people over the long term

Please watch our video interview that discusses the subprime situation on YouTube: http://www.youtube.com/watch?v=HClLkBM4obc

We welcome your comments.