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Is Peer-to-Peer Lending a Magic Bullet?

While the Federal Reserve’s recently-concluded “quantitative easing” program has been a boon to several asset classes (including domestic equities, which are once again broaching record highs), the policy of deliberately low interest rates has been a burden to investors with large allocations to fixed income.  With 10 year U.S. Treasury notes yielding less than 2.4%, and even riskier “junk” bonds barely yielding 6%, the risk-averse retiree is hard-pressed to generate steady income from his portfolio. At the same time, large banks have become more circumspect in their lending, as they work to rebuild their balance sheets in the wake of loan losses, billions of dollars in civil settlements and fines, and more stringent regulatory requirements.  The end result is an environment where credit is ostensibly “cheap,” yet many individuals find it more difficult than ever to borrow.

Stepping into this void is a new class of middlemen aiming to disrupt consumer lending by disintermediating the established class of middlemen (ie bankers). So-called “peer-to-peer” (P2P) lenders such as Prosper (founded: 2005) and Lending Club (founded: 2006) play matchmaker between investors with excess capital, and borrowers seeking credit on better terms than are offered by traditional banks.  On paper this is a win-win; investors earn higher returns, and borrowers have better access to credit.  But how do P2P loans stack up as investments?

To begin with, Prosper and Lending Club serve the critical role of underwriters, crunching data on borrowers (monthly income, FICO score, etc) to determine an appropriate rate of interest that properly compensates lenders for the risk of default.  Borrowers are segregated into tranches according to perceived credit risk, and those deemed to be at higher risk of default are compelled to pay higher rates.  At Lending Club, these rates currently range from 6% to 26%, while Prosper’s range from about 7% to 35%.  At a glance, investors may find these rates compelling, but the picture is incomplete without factoring in anticipated default rates and the resulting net adjusted yield.  As you can see from the tables below, historically-observed loss rates are substantial (particularly among lower-rated borrowers, where losses typically negate more than half of the nominal return):

graph 1

Source: lendingclub.com

graph 2

Source: prosper.com

To put this data in context, we can compare the charge-off rate on P2P loans with the charge-off rate on consumer debt among the 100 largest U.S. banks, as reported by the Federal Reserve.  As of Q2 2014, the charge-off rate across all consumer debt was 2.08%.  Credit cards (the riskiest class of consumer loans) had an aggregate charge-off rate of only 3.29% (though to be fair, credit card charge-offs peaked at over 10% during late 2009 and the first half of 2010).  Nevertheless, it seems clear that the credit performance of P2P loans is materially worse, on average, than consumer loans underwritten by banks.

When you think about the nature of P2P loans, this should not be a surprise.  Unlike say, an auto loan, P2P loans are unsecured (not backed by any collateral).  This means there are no assets which can be repossessed and liquidated to compensate creditors in the event of a default.  Moreover, a quick scan of the listed loan inventory on Lending Club and Prosper reveals a heavy preponderance of borrowers (87% on Lending Club) identifying “debt consolidation” as the purpose of their loan.  In other words, these are people who have already run up significant debt with traditional banks, and are now finding their access to credit restricted.  One might ponder the creditworthiness of a borrower for whom a 20%+ interest rate (not to mention an incremental 3-5% in “origination fees”) represents an attractive offer, relative to his other financing options.  Finally, it’s worth noting that the explosive growth in P2P platforms has largely occurred during a period of steady job growth (unemployment now stands at 5.8%, down from a peak of over 10% in late 2009).

As with any other investment, we should also consider what fees are involved in a P2P loan.  Both Lending Club and Prosper charge investors a fee amounting to 1% of loan repayments.  This is in-line with the expense ratio of a typical equity-oriented mutual fund, but well higher than our core fixed income holding, the Vanguard Total Bond Fund, which carries an expense ratio of only 0.08% for its admiral class shares.

Leaving aside the karmic benefits of social investing, the aspect of P2P loans which is likely most appealing to the average investor is muted volatility. Since there is not much of a secondary market for P2P loans, there is no regular price discovery as there would be with other forms of debt (ie treasuries or corporate bonds, which trade daily on an active and liquid market).  If all goes to plan, P2P investors receive their regularly scheduled interest & principal payments without ever having to witness a fluctuation in the value of their asset (ignorance is bliss!).

To the extent that P2P loans reduce the overall volatility of an investor’s portfolio (thereby reducing the tendency toward ill-timed shifts in asset allocation during market downturns), this isn’t such a bad thing.  However, muted volatility comes at a cost, which is lack of liquidity (typical loan terms are 3-5 years). For this reason, P2P loans should not be viewed as an effective substitute for other forms of fixed income (remember: the core function of fixed income is to serve as ballast within the portfolio, not to enhance return).  In conclusion: P2P loans offer a fair return for a higher level of risk, but should only be used in moderation and not with funds where liquidity and safety of principal is paramount.