Sunday, June 21, 2015

Peer to Peer (P2P) Financing

I've been carefully researching Peer to Peer (P2P) financing as an investment vehicle for my portfolio. While P2P financing has always been with us in one form or another (think of no-bank-needed owner financed home sales) the mass market availability of P2P funding emerged as a disruptive force in the lending marketplace about 8 years ago. Someone in the UK wondered out loud if buyers and sellers could come together easily on eBAY, with eBAY taking a cut of every sale, why couldn't investors and borrowers come together on a similar platform with the platform owners taking a cut of every loan?  That way, borrowers could borrow at rates lower than the "evil faceless" banks charge and investors could earn a much bigger return than banks offer. Win-win all around, neighbor helping neighbor, kumbaya, and all of those fuzzy sentiments. Venture capital was secured, the concept was launched into production, and the money began rolling in.

Nearly a decade later and the idea has been copied again and again by entrepreneurs around the world. Today the two largest P2P lending platforms - Lending Club and Prosper - are both hosted in the United States. Measured side by side on all success indicators, Lending Club is the better investment vehicle, offering a greater range of loans to choose from, higher interest rates, and lower default counts. Mind you, even though Lending Club trades only prime loans (i.e you won't find anyone with a credit rating under 620 on the site) default counts are a matter of course; P2P lending is not for the faint of heart. On the Lending Club platform, loan investment information (loan purpose, borrower's credit report and score, borrower's verified income) is provided in detail for each loan, along with a summary grade (A,B,C,D, etc). The concept is simple - all else being equal, the lower the grade for a loan the higher the interest rate AND on average the higher the predicted default rate. Investors can fund all or part of a loan requested through the site (the latter is recommended for maximum diversification of investment assets) and loan terms are generally 36 to 60 months in length.

The platform offers loan investment screening so that investors can filter out loans based on their personal standards or preferences. For example, I filtered out loans requested for vacations or weddings because these are not things I want to encourage debt in pursuit of. Additionally, I filtered out loans to folks whose summary grade was so low that it would peg to high interest and high default rates because it is a hole I do not wish to enable my fellow man into dropping (best case scenario they are burdened with a high interest loan they must climb out of with great personal difficulty and worst case scenario they default and are worse off then they started thanks to my misguided intervention). My point of view is that when your credit is that poor or your income is that low, whatever the solution you need to get back on your feet (something tailor made to you? charity? money and budgeting courses?), more debt is not it. These are just my personal preferences of course, and when combined with my desire to push my rate of return as high as possible while keeping the default rate below 4%, they guided my portfolio to the intersection of a 13% average interest rate and a 3% projected default rate. That's 13% return BEFORE defaults or the platforms cut (~0.54%) are figured in. Net return is projected at 6-9%. In contrast, I've read several blog posts by investors who lend exclusively at the low grade end who have the stomach for the rollercoaster ride of high risk/high return (ie high interest rate/high default rate) and they're clearing typically 13-17% net AFTER the default rate and platform fee is subtracted.

The latest development in P2P lending that investors need to be aware of is the recent influx of institutional cash into the marketplace. Institutional cash = banks, hedge funds, mutual funds, and other "traditional" investors that P2P was originally designed to exclude. It seems that the marketplace became so attractive with the high demand, good returns, and low overhead, that even the big guys wanted to play. And while P2P lending represents just a fraction of the over 1 trillion dollar loan market in the US, institutional investors are already beginning to dominate both Lending Club and Prosper. These investors have deployed powerful algorithms that analyze new loan requests as soon as they are released and quickly sweep the most attractive ones up before ordinary investors can grab them. In fact, it's been reported that to outmaneuver the competing institutional investors some of them are even deploying their servers physically closer to the Lending Club and Prosper data centers in order to gain the edge on analysis triggered by new loan request alerts (every step closer to the platform routers on the internet can mean milliseconds in receiving the alerts faster). The net result of this race to fund is that the supply of P2P loans is now operating at a constant shortage and there is some concern among investors that loan requests remaining after the big banks cherry pick their spoils may not be quality investments (otherwise the banks would have scooped them up). Unfortunately, only time will tell if the banks know something the rest of us don't and if the requests rejected by their algorithms will evidence a higher default rate.

I'll post updates twice a year on my Lending Club portfolio performance so that you can get a better view through my eyes of the success of P2P investments.
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