Judging by the recent explosion in media coverage, Peer to Peer (P2P) lending seems to be approaching a tipping point where it will move out from its current base of early adopters, and into the mainstream of the investing (and borrowing) public. From my perspective as an investment advisor in Madrid, Spain, I see new P2P platforms sprouting like mushrooms after a spring rain throughout the United States and Europe. These newcomers will accompany and compete with the established market leader Lending Club (www.lendingclub.com) and the number-two-but-trying-harder Prosper (www.prosper.com). My adopted country Spain already has several entrants, with Loanbook Capital (www.loanbook.es) being the best placed among them.
There is certainly nothing revolutionary about people making loans to one another at a fixed rate of interest. Mesopotamian tablets have been discovered from 1900 BC that codify the maximum rates of interest for loans on grain and silver, at 33.5% and 20% respectively. The high interest rates on outstanding credit card balances clearly have historical precedents.
How Does P2P Lending Work?
The combination of the internet and information technology enables platforms such as Lending Club and Prosper to serve as very low cost, high value-added intermediaries between multitudes of people who have money to invest, and multitudes of people who seek fixed rate loans for 3 or 5 years at a competitive interest rate (as compared to other funding sources available to them, basically credit card debt typically at a 16-18% rate). These platforms most certainly are not banks, as they do not receive the investor's money, nor crucially does this money enter onto their balance sheets for even an instant. At the same time, the borrower does not owe the money to the platform, but rather directly to the holder of the "note" which represents the investor's fraction of the entire loan issued to the borrower.
The fact that the retail investor typically buys only a small fraction of each loan in which they participate (typically $25 dollars per loan) is the key to the magic of P2P lending. Information technology makes it easy for investors to participate in dozens, hundreds or indeed thousands of loans, dedicating only a very small part of their capital to each loan. Though Lending Club and Prosper carefully screen loan applicants, assigning each a risk level and an interest rate in line with that risk level, experience has demonstrated that approximately 3% to 4% of loans will default (that is, the lender will fail to complete the scheduled payments) at some point during the life of the loan, even though only approximately 10% of loan applicants are accepted by the two leading platforms.
This default rate is not a major problem for investors, considering that the average borrower pays an interest rate of approximately 13% (less for borrowers with high credit scores and good credit history, more for borrowers with lower credit scores and poor credit history). Even after deducting the three or four percent losses for defaults and any service fees charged by the platforms themselves to the investor, this still leaves a typical return of 8% to 12% experienced by the enormous majority of holders of broadly diversified portfolios of P2P loans on Lending Club or Prosper. While the 13% average cost to borrowers many seem very high to those who have excellent credit ratings and always pay off their credit card balances each month, it most certainly is not abusive, especially compared to the cost of outstanding credit card debt. In fact, Lending Club states that fully 75% of their borrowers list credit card debt consolidation as their reason for requesting their loan.
In order to understand P2P lending and its potential, it is useful to continue to compare these loans to credit card debt, and note the key differences. Firstly, loans on Lending Club and Prosper are for either three years or five years. If a borrower takes a loan (at a lower rate of interest than their credit card rate) and uses the funds to pay off the credit cards, they will realize an immediate savings of several percentage points per year as the rate of their P2P loan will likely be lower than their credit card interest rate. The savings may be very substantial in the case of a borrower who has a very good credit rating, but for some reason has a large outstanding balance on their credit card. This good credit risk would likely be able to secure a loan at the very low end of the interest rates scale on the platforms. Crucially, the loans are not revolving credit loans, but rather structured similarly to traditional fixed rate mortgages, that is, the borrower pays interest on the outstanding balance of the loan plus the corresponding fraction of the outstanding principal (one 36th for three years loans, one 60th for five year loans). The borrower does however have the right to end the loan at any time through paying the entire remaining outstanding balance as a lump sum at any point. This structure is important for the borrower because if they make their payments on time and do not continue to run up new credit card debt, they have a clear date when they will become free of the high cost credit card debt. For investors, this interest plus principal payment structure means that each time that they receive a payment for one of their loans, their risk is reduced significantly, as they will have received not only their interest for the period, but also a fraction of their principal as well. This is a very significant advantage for investors as compared to standard bonds, where the entire principal is recovered only at the maturity of the bond.
One way of understanding P2P lending is to see it as a way for ordinary savers to participate in the huge (and hugely profitable) consumer credit industry. Year in and year out, in boom times and in recessions, the consumer credit industry earns good profits on high interest rate loans extended automatically to cardholders with outstanding credit card balances. The interest rate applied on these outstanding balances is uniformly very high, even for people with an excellent credit rating who normally pay their credit card bills in full each month. The P2P lending revolution in a sense is nothing more than a way to disintermediate the banks and the credit card companies from this lucrative lending business, permitting savers to benefit from these very high returns, even after the inevitable defaults take place on a small percentage of the loans.
Why do Individual Investors Love P2P Lending?
In my twenty years career as an investment advisor, and particularly in these times of very low interest rates on certificates of deposit, I have rarely seen an investment solution better than P2P lending. This new approach satisfies the central desire of clients, which is simply to earn a steady, reasonable return on their savings. In my opinion, the investment advisory industry has been rightly criticized for the tendency of advisors to present themselves as the experts who help the client navigate the extremely complicated waters of the investment world, thereby justifying charging high fees. Well, things do not need to be this complicated. Most people who seek the services of investment professionals are in fact not investors, rather they are simply savers. Their objective is to earn a worthwhile return on their hard-earned savings without having to master the jargon of the investment world. They would like to find something more interesting than the 1% to 3% available through a bank certificate of deposit or direct purchase of a high-quality bond. Savers, as opposed to many sophisticated investors, (especially hedge fund investors) place primary importance on knowing where their money has gone, when they are scheduled to get it back, and what will be the likely return on their investment. P2P lending provides an enormously satisfying solution to these needs, in a much better fashion than any other investment alternative currently available, especially when compared to a typical fixed income mutual fund or ETF.
Additionally, P2P lending has one other advantage of tremendous importance for retail investors. Success as a P2P lending investor does not require any market timing whatsoever. Rather than staying up nights wondering if this is a good time to buy or sell this fund or that stock, P2P lending investors can rest assured that time has become their ally as they see monthly interest and principal payments returned to their account, ready to spend or reinvest to buy new participations in new loans. In my experience, neither the concept of market timing nor "buy and hold" has served well the broad investment public. The beauty of P2P lending is that, in this case, buy and hold does work, as can be demonstrated through the data publicly available for download on the websites of Lending Club and Prosper for all their loans since they began in 2007 and 2005, respectively.
Is P2P lending a one stop solution for investors? Of course not. For one thing, these loans should not be seen as liquid instruments, though both platforms maintain a secondary market for those seeking to sell their loans to gain liquidity or buy outstanding loans, possibly at a discount. To better manage the lack of liquidity, I recommend to my clients three year rather than five year loans. The fact that the investor recovers a fractional part of their principal each month makes three year loans acceptable for most investors, even without liquidity provisions. In any case, P2P lending investors should only commit a reasonable fraction of their total financial assets to P2P lending, precisely because of this inability to make the loans liquid quickly and efficiently, in contrast to financial instruments listed on organized exchanges.
Seeking Alpha with P2P Lending
Those who might think that P2P lending is too insignificant to merit serious consideration at this time should consider the fact that the two leading firms, Lending Club and Prosper, are experiencing exponential growth and together have managed already over 4 billion dollars of loans paying out several hundred million dollars of interest to savers. In May of this year Lending Club received the ultimate vote of technological confidence when Google (GOOG) took a $125 million stake in the company, valuing Lending Club at $1.55 billion, fully three times its value at the previous fund raising a year earlier (see the Dara Albright article, "How Google's Investment Into P2P Lending Will Impact The Financial Markets") https://seekingalpha.com/article/1427621-how-googles-investment-into-p2p-lending-will-impact-the-financial-markets).
The Board of Director of Lending Club includes such luminaries as former Visa Inc. (V) President Hans Morris; the former U.S. Secretary of the Treasury Lawrence H. Summers; Morgan Stanley (MS) Chairman Emeritus John Mack and Kleiner Perkins Caufield & Byers General Partner Mary Meeker. Not to be left behind, in January of this year Prosper put into place a new management team backed by Sequoia Capital, and since then the Prosper platform has posted steady growth in loan originations, up 103% over June of 2012.
Investors and investment advisors spend endless hours in the pursuit of alpha, that elusive quality that provides a portfolio with a return better than that gained by the performance of the underlying market. P2P lending, offering net before tax returns typically between 8% and 12% annually, is surely a source of alpha which merits some of these hours of pursuit, at least when compared to the available returns from the current market for fixed income instruments for clients who seek a low volatility portfolio. P2P lending through tax-sheltered retirement accounts offered by both of the leading platforms is a particularly attractive alternative to capture a higher yield to build retirement savings faster.
In short, it is my hope that this article will serve as a call to action for both investors and investment advisors. The P2P lending train is leaving the station, not only through Lending Club and Prosper, but also through a myriad of new platforms focusing on other sectors of consumer lending such as student loans, real estate and automobile financing. P2P lending offers attractive yields in a yield hungry world, accompanied by low volatility that grants freedom from the burden of market timing. It is my contention that both individual investors and advisors who serve them should begin to take seriously this emerging asset class, and dedícate some of their "Seeking Alpha" energies to take steps now to prepare themselves to add P2P lending to their investment tool kit.
For further information from very credible sources, be sure to see the article in Seeking Alpha last year by Zach Miller, "Why I'm A Converted Believer In Investing in P2P Loans" https://seekingalpha.com/article/612141-why-im-a-converted-believer-in-investing-in-p2p-loans as well as the excellent resources available at www.lendacademy.com by Peter Renton, a pioneering figure and noted authority on P2P lending.