“The bad news is that reaching for yield rarely ends well.” – James Montier
“Now, if you’re chasing yield, and you’re trying to make your fixed income “do” better, then all bets are off. That’s a dangerous game.” – Carl Richards
I’ve been getting a lot of questions lately about peer to peer lending as a way for investors to increase their yield in a low interest rate environment, so I thought I’d give my take.
Peer to peer (P2P) lending involves borrowers going to a P2P website and asking for a loan from individuals. Their credit worthiness gets rated by the P2P originator and individuals can choose which loans to invest in (or lend their money to).
The rates vary by the borrower’s credit rating (as determined by the P2P company). This allows investors to find a wide range of interest rates, based on the credit quality of the different loans. You get to choose the loans you put your money into depending on the borrower and the yield you’re seeking.
Prosper, one of the more well-known P2P organizations, currently advertises rates between 6.73% and 35.36% for borrowers on their website, which can lead to interest rates of 6-12% for investors.
I think the P2P model is a very interesting idea. Anything that increases competition for the banks is good in my view. But this is still a new and emerging industry with a short lifespan. Many issues need to be understood by the investors before they dive in.
So, here are my initial thoughts on P2P lending:
- There is no skin in the game for the P2P companies. They are basically just the middlemen that handle the processing and are intermediaries for the loans. They take no risk, but they do take a fee from each loan.
- Since they take no risk (the lenders take all the risk) why wouldn’t the banks simply take over this industry? If they could facilitate loans while skimming a bit off the top without having to carry any risk on their balance sheets, why wouldn’t they do this? I’m sure there are political and regulatory reasons but if the banks could facilitate these loans, they could offload tons of risk and make huge returns.
- As bad as banks were in the housing bubble, they are still much better than the average investor at credit analysis and determining the quality and riskiness of loans.
- In a way this is how the 2008 debt crisis was amplified. The banks and other investors in mortgage-backed debt securities simply collateralized all of their debt and sold it off to investors, thus decreasing the need for the banks to closely monitor the performance of the loans. It didn’t matter to them since it was off their books (well, most of it) and investors didn’t care because they were reaching for yield (something P2P lenders may be doing now).
- Interest rates for P2P lending look great because the history of the default rates only go back a few years. I know that there are probably many highly respectable individuals that are taking out loans from these places and they will pay them back on time with no problem. But the creditworthiness of some of these borrowers is bound to be suspect if they can’t get a loan from a traditional source. Some P2P lenders allow them to sign up and be approved for a loan in minutes. Sound familiar? Think NINJA (no income, no job) mortgages in 2005-06.
- The P2P companies have much less incentive to correctly screen for the risks in the loans and creditworthiness of their clients than the banks do.
- The 35.36% rates at the high end are similar to the rates you would see from a loan shark or payday lender. Borrowers at these types of rates are usually in a fix, so don’t count on those types of loans paying off in the long run. If it sounds too good to be true it usually is.
Citigroup suffered losses in 2008 that were more than one-quarter of the cumulative profits from the previous seven years because of subprime loans. I think that could be the template for P2P lending – a few years of decent gains followed by periods of large losses. It works and works until it doesn’t. Here’s what this could look like:
I’m not saying this will happen, only that it could happen. You should always see both sides when making an investment.
US households average $149,782 in mortgage debt, $34,703 in student loan debt and $15,328 in credit card debt. Remember the subprime mortgage crisis? P2P borrowers are basically subprime.
As we saw in the mortgage crisis, defaults tend to come in waves. By September 2009, almost 15% of all mortgages outstanding were delinquent or in default. Many of these borrowers had decent credit. Not all were subprime borrowers.
It’s much easier to walk away from an unsecured loan than it is from your house.
Here’s my advice if you plan on investing in P2P lending:
- Diversify and spread your risks over a large number of different loans.
- Understand the terms before investing. This includes the term of the loan and the fine print (fees, payment schedule, etc.)
- Don’t put more than 5-10% of your portfolio in the space, and make it a small part of a diversified portfolio.
- Risk and reward are joined at the hip. Higher yields are there to compensate investors for higher levels of risk.
- You could eventually experience large losses to compensate for higher interest rates.
- Reaching for yield works until it doesn’t.
- Keep this type of investment in your higher risk bucket for your asset allocation, not as a substitute for bonds or a low risk savings account.
Those are my concerns and advice. Again, I think this is a great idea as it plays off of Kickstarter and other crowdsourcing ideas. I just want investors to be aware of the risks that can be involved when lending money to other individuals or small businesses.
As Benjamin Graham once said, “The essence of investing is the management of risks, not the management of returns.”
*Update – P2P lending was featured in the WSJ today if you’d like to read more: Consumers find investors eager to make peer to peer loans (WSJ)
US Consumer Debt Statistics and Trends (Visial.ly)
Motgage Bankers Association (Mbaa)
The Success Equation
Not sure if you still believe what you’ve written here, but allow me to answer a few of these critiques one-by-one:
“There is no skin in the game for the P2P companies.”
This is only partially true. First of all, 10% of the p2p companies profits come from investor payments, so if the borrowers stop paying, the companies lose money too. Second, the companies depend a great deal on PR. If they get even the slightest reputation for sub-par quality, their investors stop giving them money. All in all, they want a dependable investment almost as much as the actual investors.
“Why wouldn’t the banks simply take over this industry?”
The argument is that the major banks will never be able to compete on the same cost-structure as the p2p companies. Read this:
“Banks were in the housing bubble, they are still much better than the average investor at credit analysis.”
Investors don’t actually do credit analysis. They simply depend upon the p2p companies underwriting. That said, the entire credit variable set of the borrowers is public information (at Lending Club, currently not at Prosper) so skilled statistician third-parties continually monitor the credit quality on behalf of the wider investor community. If standards drop, the world would know.
“But the creditworthiness of some of these borrowers is bound to be suspect if they can’t get a loan from a traditional source.”
Most people do not get a p2p loan as a last resort. Most do it because the application is quick and the money is in their account in a week at the lowest interest rate anywhere. Major banks are pretty much out of the personal loan industry.
“The 35.36% rates at the high end are similar to the rates you would see from a loan shark or payday lender.”
This is a very small (almost nonexistent) fraction of the loans Prosper issues. Almost all the loans are actually 25% and better. The average is 12%. The lowest is 5.9%, which is the lowest large-scale unsecured loan rate in history (possible via the low cost-structure).
“Remember the subprime mortgage crisis? P2P borrowers are basically subprime.”
This is definitely not true. The open data shows an average credit score of borrowers around 700 (prime rated). If they come with a FICO below 640, they are rejected. 90% of the applications at Lending Club are denied outright.
Valid points all. Thanks for the rebuttal.