Peer to Peer Lending: A Godsend or a Disaster Waiting to Happen?
As of late, the buzz surrounding peer-to-peer lending has turned into something resembling a roar, at least in the financial space. There are plenty of good reasons for this: recently Lending Club became the first firm to IPO, and for the first time in about 15 years, the “tech start-up” vibe has finally embodied itself in a form of financial service firm. The business model, however, is not entirely new.
A Brief History
In the interest of putting peer to peer lending in context, I’ll lay out a brief history of lending. Loans have predominantly been originated (or drawn-up) by financial intermediaries such as banks and credit unions. These are your financial middle-men. Your local bank branch will pass information about your credit history and your prior banking activities to an underwriter, someone who assesses your ability to keep up with payments and the value of the collateral (physical assets which represent value against which the lender has claim). Once loans are originated for a variety of bank customers, they are either held by the bank as a money-earning asset, or they are securitized. Securitizing means pooling a number of loans together and selling them to other investors, the banks then act as loan servicers (collecting payments, passing them on to investors, etc.)
Banks, in return for providing this service, earn a spread that can range from 1% to 10% depending on country, interest rate level, and banking competition. This spread, is what peer-to-peer seeks to address. The argument goes that if banks can make a spread on this service, an exchange that allows investors and borrowers to come together to determine a fair interest rate should provide investors higher rates, and borrowers lower rates — a win-win.
Before I begin looking forward, please take a moment to consider how many times the phrase “win-win” has been used in a corporate board room and how many times it has been true.
So How about These Peer-to-Peer Lenders?
Peer-to-peer lending changes the model into an exchange. They originate loans and set their underwriting standards, before posting fractions of loans to their boards where investors can then integrate them into their portfolios. As a result, these loans are not held by the exchange — and so defaults will not impact the companies directly. The way these companies make their money is either through a fee taken for each loan, or through a spread which is much narrower than that of the banks.
As a result, interest rates on these loans are typically lower than those offered at banks (given the same loan characteristics). Investors also earn yields that are substantially higher than that of even high-yield bonds, on the order of 8–10%. In theory, diversification across many borrowers also reduces the likelihood of adverse development in the portfolio.
1. A Market Without Experts Cannot be Efficient
Exchange formats are predominantly praised because instead of having a small pool of buyers and sellers, you have an enormous pool which provides liquidity and on the whole, valuation expertise. Equity (stock) and debt (bond) markets are seen as generally efficient — able to accurately price financial assets. While most investors by count are not well versed in financial asset valuation, most of the money moving through the market is controlled by valuation experts. This includes asset managers, hedge funds and high frequency trading firms. The reason they can be considered experts is because they have the resources to gather vast amounts of fundamental data on a financial assets and use that data to accurately price the asset.
Data provided by P2P lenders is dramatically less insightful than information on public companies. Even if we were to assume that there was enough loan liquidity to form an efficient market, a professional would be unable to accurately price these loans with little more than a reason the borrower needed the money, a FICO score, and voluntary (i.e. typically unverified) income information. As a result, it is impossible for experts to force loans to yield a “fair” return on these exchanges. It’s also worth noting that FICO scores have substantially less value during cyclical troughs (recessions).
2. The Majority of Peer to Peer Loans are Unsecured
Generally, peer to peer loans are used for debt consolidation or to eliminate/reduce credit card debt. By this, the debt holders are refinancing their debt at a lower rate — and if they default, you have no recourse to take possession of their assets or future wages. Other categories such as home repair, business, and wedding loans are also non-recourse loans. To make it clearer, this means that if they stop paying down their loan, you will see your interest and principal payments fall to $0 and will have no claim on anything they own. The only result of default on these loans is a temporarily damaged credit score on the part of the borrower.
3. As a Result of #2, Peer-to-Peer Loans are Likely to be First Neglected During a Period of Financial Stress
With these loans being predominantly unsecured, P2P lenders nor you will be coming to take away their physical assets should they stop paying. Generally speaking, people carrying P2P debt also have Auto/Mortgage debt. In the event of financial hardship, it’s reasonable to assume that the borrower in question will first tend to their house and car payments in order to avoid the bank coming to repossess these items.
As an investor in peer to peer loans, your loans will be the first to experience default. For this reason, it should be expected that you will have loans that are never returned to you. A diversified pool of loans to P2P borrowers will reduce the impact of this, given each member of the pool is substantially different from the others.
It’s well known, that during recessions, diversification effects are dulled dramatically. Holding assets that are first to be neglected in a time of serious distress means that should another recessionary period arise, P2P loans will experience substantially higher levels of default — reducing returns across all grades of these loans. Remember that default implies that not only will you stop earning interest on the asset, but you will not be repaid the original loan you made.
4. These Borrowers are Less Economically Unique Than They Appear
While the borrowers using peer to peer lenders come from all over the country (predominantly US), have substantially different jobs, debt profiles, and differing credit scores, many have turned to P2P lenders for a reason — lowering debt service burdens.
Humans, in my experience, are more often reactive than proactive. High interest rates on revolving lines of credit proved not to be a deterrent at the time they were used to make purchases. For this reason, I don’t believe that rate reduction alone is the reason that most people have refinanced using P2P programs. There is a likelihood that those who have refinanced with these programs are stretched economically, and these consolidation loans allow reduced monthly payments. In and of itself, this is rational behavior, but it leads me to believe that the loans surfacing on lending platforms have an adverse selection bias, which reduces the effectiveness of diversification.
5. Lending Exchanges Benefit from Volume, not Quality — This Leads to Moral Hazard
Since P2P lending platforms do not retain the debt that they originate, they do not have significant skin in the game should the loans begin to take losses. These platforms make money based on one of two things, higher $ value of loans outstanding (if they take a small percentage of interest for servicing), or a larger number of total loans originated (if they take a fee for each loan they surface).
It’s important to remember that these platforms do something very similar to securitization of debt. The main difference in this case being that the platforms do not pool the debt themselves, but surface it in small chunks for investors to buy.
Banks that securitize (typically mortgages) will ensure that their standards meet or exceed those outlined by Fannie Mae and Freddie Mac. Should the bank’s underwriters do anything to misrepresent these loans before securitization, Fannie and Freddie (or the Federal Government while they are under conservatorship) can come after the banks should losses on the loans begin to mount. In the case of P2P lending, standards are not set by a body other than the platform itself. Even if underwriting quality should fail to be represented accurately by the platform, your recourse would appear to be a class action suit with your thousands of other co-investors in the same loans.
In summary, investors will be first to pay the price should a lending platform put itself ahead of its loan-buyers, and there is little an individual can do to evaluate whether wrong-doing is occurring.
6. Investors Do Not See this Type of Investment for what it is
In a world where yield is extremely hard to come by, it’s challenging not to be enticed by the attractive rates that you can earn by putting your hard-earned money into these loans. I gave it a shot myself and can say that as of late, I have an average rate of over 8% at a time when bank accounts are generous to offer ten times less. After much internal debate, I determined that these loans were not the right investment vehicle for me. For the time being, it will take me almost two additional years to have my loans returned to me. While some platforms have note trading platforms, you can expect to take a gain or loss depending on how interest rates have moved since you initially invested. More importantly still — if you intend on cashing out during a time of financial distress (as most Americans do), expect to see notes trading at steep discounts on exchanges, as thousands of investors try to do the same thing.
A substantial portion of these high returns come in the form of a liquidity premium, which is a very foreign concept for retail investors.
Peer to Peer Lending is Misunderstood, and Comes With Risks
When viewed conceptually, P2P lending is innovative and appears simple and intuitive. The concept of bringing together borrowers and lenders in a reasonably transparent way holds a large amount of appeal, especially in light of the recent financial crisis, when banks have never appeared uglier.
Sadly, peer to peer lenders have very similar vulnerabilities. Moral hazard remains my paramount concern, as risk lies entirely with the investor, and information is assessed by the platform which bears limited exposure to the same. I also believe that the mouth-watering rates offered by these platforms attract investors who are ill-suited for instruments which can remain nearly untouchable for more than five years.
Thankfully, the relatively small size of this industry avoids the need to worry about any form of systemic risk. Watching this new industry unfold is sure to be interesting.