In your personal finance journey, you may or may not have come across peer-to-peer (P2P) lending platforms. The great news is, these have proven to be solid investments over the past few years, providing much higher returns than what you could earn on bank investments. But we have to wonder: will P2P platforms continue to be reliable investments, particularly if the economy begins to weaken?
Since P2P lending only got its start in the early 2000s, we don’t have a particularly strong or reliable track record to fall back on. The first platforms only began coming on line as the last recession – the Financial Meltdown – was unfolding. So while they have been a picture of success since their inception, we don’t really know how they’ll hold up under pressure.
What Effect a Weakening Economy Might have on P2P Lending
In the absence of any substantial performance data from the last recession, we can only speculate what effect a weak economy will have on P2P lending. But we can rely on the general performance of loans in past recessions for strong clues.
When the economy declines, asset prices fall and unemployment rises. In turn, default rates on virtually all types of loans rise. Since P2P loans are unsecured and taken for a variety of purposes, they most closely relate to credit cards.
According to the Federal Reserve, credit card default rates were at 2.34% at the end of 2016. However, they hit a high of 6.77% during the second quarter of 2009, in the middle of the Financial Meltdown.
While P2P loans are priced to accommodate certain default levels, they are based on the most recent default experience. Should default rates rise to something close to what they were in 2009, P2P loans priced based on today’s default rates will likely suffer disproportionate losses in interest rate return.
The Flood of Institutional Money Might Weaken Lending Standards
The basic concept of P2P lending is simple. Individual borrowers come to lending sites in search of loans, which will ultimately be funded by individual investors. But as interest rates have continued low, institutional participation in P2P lending has grown, as banks and other large lenders seek higher returns. For example, Lending Club recently reported that banks funded 31% of loan originations in the fourth quarter of 2016, compared with 13% in the third quarter.
One of the concerns over increased institutional participation is loan quality. As institutions bring larger amounts of capital into the space, loan quality may decline. That can happen as P2P lenders lower underwriting standards in order to draw in a larger number of loans. As they do, the quality of those loans will gradually decline, eventually increasing the rate of default.
It remains to be seen if that will play out as a worst-case scenario. However, not only is the industry itself relatively new, but institutional participation is only very recent. That means that the impact of greater institutional participation has yet to be felt.
Lending Club’s 2016 Scandal
In May of 2016, Lending Club’s CEO, Renaud Laplanche, was forced to resign amid a scandal. A summary of the event disclosed that:
Lending Club conducted a review, under the supervision of a sub-committee of the board of directors and with the assistance of independent outside counsel and other advisors, regarding non-conforming sales to a single, accredited institutional investor of $22 million of near-prime loans. The loans in question failed to conform to the investor’s express instructions as to a non-credit and non-pricing element. Certain personnel apparently were aware that the sale did not meet the investor’s criteria…The review further discovered another matter unrelated to the sale of the loans, involving a failure to inform the board’s Risk Committee of personal interests held in a third party fund while the Company was contemplating an investment in the same fund.
Since Laplanche’s resignation, earnings have gone negative three quarters in a row. What’s more, the pattern of losses are expected to continue through 2017. The company is forecasting losses of $69 million to $84 million, on revenue in the range of $565 million to $595 million for the year. The company cites the loss of investors in the aftermath of last year’s scandal.
We should reasonably expect that Lending Club, as the largest platform in the P2P space, will recover. However the episode should serve as a warning that the development of P2P lending won’t necessarily be an elevator ride straight up. With the number of P2P lenders increasing steadily, there are bound to be more negative surprises.
Read More About Reducing Risk With Lending Club here.
That might make a strong case for spreading your P2P investments across several lending platforms.
The Nature of P2P Loans Themselves
Despite the positive overall performance of P2P lending over the past few years, the practice contains two built-in issues.
The first is the fact that the loans are largely comprised of debt consolidation loans. Though such a loan can potentially improve a borrower’s financial situation by lowering the interest rate and monthly payment that he or she is paying, it also holds the potential to borrow even more money.
For example, many borrowers engage in serial debt consolidation. They have a few credit cards, and then do a debt consolidation to lower the monthly payment. But one or two years into the debt consolidation, and they rack up more credit cards. Eventually, there’s another debt consolidation – and maybe even a third, and a fourth.
From a risk standpoint, the problem is that the borrower is never actually paying off debt. Often, the debt consolidation simply sets the stage for the next round of borrowing. As that cycle continues, the risk of default on the latest debt consolidation loan increases.
The second major concern is that most P2P loans are unsecured. Borrowers can typically take loans as high as $40,000, and for nearly any purpose, without having to put up any collateral. In the event of a loan default, there will be no assets to seize in order to satisfy the debt.
In an economy with low unemployment, low interest rates, and rising asset prices, neither issue is a major concern. But when the economy eventually weakens, both run more than a slight chance of becoming more pronounced.
Positioning Your P2P Portfolio for Leaner Times
All of this should be a reminder that P2P lending, like virtually all other types of investing, is not completely risk-free. And despite recent healthy performance, the situation could change — and change dramatically — in the event of an economic slowdown.
None of this is to discourage investing in P2P lending. Since the next recession is virtually inevitable, though, now is the time to prepare your investments for a change in circumstances.
How can you protect yourself?
- As noted earlier, consider investing on several P2P lending platforms. That will minimize the risks associated with any one platform.
- Don’t use P2P investing as a substitute for the fixed income portion of your portfolio. Instead, make it part of your fixed income investments, to offset and increase the lower rates paid on traditional but safer fixed income investments. You should have both P2P and traditional fixed income investments.
- Invest across various risk grades, despite the fact that returns may be higher on the weaker grades. Lending Club’s Statistics page (“Loan Performance Details” chart) shows that default rates increase substantially with each lower credit grade.
In regard to the last item in particular, it’s important to realize that default rates are likely to increase more dramatically in the lower credit grades in the face of a bad economy. Those are, after all, the highest risk loans being made.
We don’t have much information available as to how well P2P investing performed in the last recession. But that makes it even more important, at this late stage of the current economic recovery, to make some reasonable assumptions about what’s likely to play out. This will allow us to best prepare for it.
How do you think P2P investing will do when the economy takes the next nosedive?
Updated March 9, 2017 and originally published March 8, 2017.