What is peer to peer lending?
Peer to peer lending (P2P) is an alternative to traditional bank intermediated lending. Potential borrowers and lenders are brought together on a website, in much the same way that Amazon brings together buyers and sellers of general merchandise. What is unique about P2P lending is that borrowers and lenders are often both individuals, instead of a traditional business to consumer loan.
P2P lending has gained prominence in recent months following the billion dollar IPO of Lending Club in the US. In Australia, Society One has attracted the country’s second largest bank Westpac, as well as business moguls James Packer and Lachlan Murdoch as equity investors. Lending Club and Society One both specialise in personal loans, but the Australian website Balmain Private specialises in commercial property lending on a P2P basis. Ratesetter from the UK also set up in Australia a few months ago, while Lend2Fund is preparing to launch soon.
How does it work?
Potential borrowers submit an application form to the website platform, much the same as any other loan application. The platform’s systems and staff then verify the critical information (borrower identity, credit history and employment), assess the risk of the loan, set the interest rate and put the application up on the website. Potential lenders review the available applications and select the borrowers they want to fund, in part or full. Once the loan amount is fully funded the website then passes the money from the lender/s to the borrower, minus an upfront fee.
Once the loan is made, the platform is responsible for the servicing of the loan, which encompasses processing repayments and chasing up missed payments. If the borrower defaults the platform handles the debt collection aspects but the lender bears any loss.
Why does it exist?
P2P lending is growing rapidly as it fills a number of gaps in credit markets. Firstly, P2P lending is primarily unsecured personal loans, which banks struggle to make at a competitive interest rate. These loans are typically for smaller amounts with a relatively high work load to establish and maintain. Banks generally prefer to offer potential borrowers credit cards as these deliver banks higher interest rates, a perpetual loan period and ongoing transaction revenue. As with many online orientated businesses, P2P lending has a lower cost of operation than bricks and mortar retail and thus it can offer lower interest rates than banks, which attracts potential borrowers.
Secondly, P2P lending currently offers high prospective returns to investors. In a world of ultra-low interest rates, gross returns of 6-25% are very attractive relative to bank deposit rates. For reasons explained later, these rates are likely to fall in the future but whilst competition is minimal and funding is somewhat restricted the higher expected rates of return will draw in potential lenders.
How new is P2P lending?
P2P lending in its current form dates back to 2005, but its roots can be seen right across capital markets. Non-bank lenders have brought together borrowers and capital providers for thousands of years. Stock exchanges have been fragmenting the ownership of companies into marketable parcels for hundreds of years. Corporate bonds have fragmented the debt of corporations for decades. Amazon has used the internet to bring together buyers and sellers of goods, with Amazon providing the platform for the products and the support necessary to facilitate the sales. In a sense P2P lending isn’t new at all, it just uses modern technology to change the way some loans are made.
Is P2P lending risky?
Like all lending activities, P2P has the potential to range from very good to very bad. Subprime lending in the US showed that if done badly, supposedly ‘safe as houses’ residential lending can have default rates that exceed 50%. In contrast, many lenders to prime quality borrowers averaged default rates less than 1% per annum.
The first key test for P2P lending will come during the next economic downturn. Many P2P borrowers are living paycheque to paycheque (if they had savings it is unlikely they would need a loan) and don’t have material assets to sell. As unemployment rises, it is likely that default rates on P2P loans will also increase. There is limited data available predating the financial crisis but what is available for Lending Club shows that negative returns were recorded in 2007 and 2008.
How will P2P lending evolve?
P2P lending suits particular niches within the credit markets, but it doesn’t offer the prospect of completely removing banks from the picture. Loans that are relatively small, that don’t involve overdraft or revolving facilities, or that are considered higher risk are most suited to a P2P platform. Shorter term (three years or less) unsecured loans to individuals and businesses are therefore the ideal targets. Secured business lending that goes just beyond the credit criteria that banks will allow is also fertile ground. Debtor finance, which uses unpaid invoices as security, is another attractive area for P2P lending.
As P2P platforms grow it is likely that individuals will be largely replaced by institutions as the lenders, as P2P platforms turn to cheaper institutional capital for their funding. This development would mirror the way that non-bank lenders in residential mortgages, commercial mortgages and auto loans obtain their funding through bank warehouses and securitisation markets. Moody’s has recently rated a pool of P2P loans, with the lack of credit ratings previously a key hurdle to attracting more institutional capital. Banks and finance companies will ultimately set up competitor brands or buy out P2P platforms completely, with Goldman Sachs currently in discussions with the Aztec Money platform. What banks currently lack is the technology and entrepreneurship to start competing websites, but as the platforms are proven to be profitable they will attract funding and takeover offers from banks.
How should potential lenders analyse the risk?
In analysing the risk of any credit investment, the 5 C’s of credit are a good starting point. These are:
Character: assessing willingness to pay
Cashflow: assessing ability to repay
Capital: assessing the equity contribution of the borrower
Collateral: minimising the loss if the borrower defaults
Covenants: restrictions to stop the risk level increasing
Where the typically unsecured personal loans of P2P lending differ from most other forms of lending is that capital, collateral and covenants are largely non-existent. Borrowers haven’t saved much (no capital) and own few or no material assets that could be sold if they fail to repay their loan (no collateral). Being personal loans there aren’t going to be any material covenants. This leaves character and cashflow as the main items to assess.
Character will be best shown by the borrower’s credit history. Potential borrowers with a history of repaying their loans, credit cards and utilities on time and in full are the lowest risk. Borrowers with no history, or with a history of missing their obligations are higher risk. Cashflow assessment is a comparison of the borrower’s income relative to their expenses. If the borrower has a good employment history and an income that easily covers their rent and other general expenses as well as debt repayments then the risk will be low. If the borrower has irregular income or a scattered work history then the probability of default will be much higher. If the borrower doesn’t have a meaningful excess of expected income after meeting expected expenses then the probability of default will also be elevated.
P2P lending is an interesting and potentially profitable addition to the credit investment universe. The use of new technology allows credit to be made available to more potential borrowers at lower interest rates. The place of individuals as the main lenders is likely to fade over time, with their replacements being banks and securitisation markets who can offer a lower cost of capital. As with all new markets, new entrants are springing up, with banks and finance companies likely to start competitor brands or buy existing platforms. When analysing potential loans, lenders should focus on the character and cashflow of the potential borrowers and remember that the higher interest rates paid by higher risk borrowers doesn’t automatically translate to higher net returns.
Jonathan Rochford is Portfolio Manager at Narrow Road Capital. This article has been prepared for educational purposes and is not meant as a substitute for professional and tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.