P2P lending pulls in big investors - should you bite?

NEW YORK Tue Jun 25, 2013 2:46pm EDT

One hundred dollar notes are seen in this photo illustration at a bank in Seoul January 9, 2013. REUTERS/Lee Jae-Won

One hundred dollar notes are seen in this photo illustration at a bank in Seoul January 9, 2013.

Credit: Reuters/Lee Jae-Won

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NEW YORK (Reuters) - Less than a decade ago, peer-to-peer lending came to the United States as an upstart enterprise - a service that would in a very personal way link would-be borrowers with individual lenders and bypass the banking industry.

The theory was that by cutting out the middle man, online P2P services like Lending Club and Prosper could create a "win-win" situation: Credit-challenged borrowers who needed money for school, to buy a car or put on a roof could obtain loans at less-than-credit-card rates. Lenders, in turn, could cash in on better interest rates than their bank accounts would pay.

The start, however, was rocky. The business was marred by high default rates that went stratospheric during the credit crisis, and borrowers lost interest - in both senses of the word.

Now, P2P is reborn, busier than ever, with backing from some brand-name investors and even the banks that were once shut out of the business model.

Both Lending Club and Prosper say they placed a record number of new loans in April, with the former at $140 million in loans and the latter at $20 million. While that still may represent only a drop in the broader consumer-finance bucket, it is attracting attention, and more money. By acting as intermediaries, the lending services collect fees ranging from 1 to 5 percent from borrowers.

The industry has won some high-profile endorsements of sorts. Google Inc led a $125 million refinancing of Lending Club in May, and former U.S. Treasury Secretary Lawrence Summers serves on the company's board, for example. Prosper has picked up new venture funding.

But it is not just the venture funding that is distinguishing the new era of P2P - it is the involvement of a new breed of lenders. With bonds disappointing and bank instrument interest rates near record lows, professional investors are lending through major P2P sites to bolster their returns.

Banks like Titan Bank, in Mineral Wells, Texas, and Congressional Bank, in the Washington, D.C., area, and hedge funds like New York's Eaglewood Capital Management are queuing up to lend money at rates above 6 percent and as high as 35 percent, in some cases.

Prosper and Lending Club both say that new loans get snapped up by lenders within minutes or hours of being posted on their sites. It is now a borrowers' market.

Does all that new respectability and high yields mean individual investors should jump in and start lending too? Here is what you need to consider:

THOSE PESKY DEFAULT RATES

Peer-to-peer lending sports high interest rates because the loans are unsecured with any collateral and the risks of default can be high.

Lending Club says its annual default rate is around 3 percent - below the 3.6 percent default rate in the credit card industry. Depending on the grade of the borrower, annual default rates can range from less than 1 percent to as high as 6 percent, according to an independent analysis by the Lend Academy blog, an independent website that monitors the P2P industry.

Total default rates over the life of three-year loans issued in 2009 and 2010 went as high as 13 percent. And during the 2007-2009 recession, default rates were even more troubling; Prosper had some particularly bad months where more than 30 percent of loans went into default.

Prosper's head of global institutional sales, Ron Suber, says that in 2007, the loan process worked differently and that the vetting practices that led to high default rates have now been improved.

Lending Club says that it now has a two-step vetting process that weeds out 90 percent of applicants, making the remaining pool safer.

Both sites post credit scores for borrowers, and lenders can use that information as well as income and home ownership reports to pick the loans they want to supply.

You can also check third-party websites like Nickel Steamroller (nickelsteamroller.com), which uses data analysis to predict which loans will be successfully repaid in full.

Prosper's Suber adds that his company is keeping growth of loan volume at 15 to 20 percent per year on purpose. "We all could grow even faster than this, but we're maintaining good quality and servicing."

All that vetting may make the loans safer, but it contributes to the shorter supply of loans now available.

DIVERSIFICATION

To minimize the risks of those default rates, experts recommend that investors stay highly diversified, lending around $25 to each borrower in their portfolio. That makes it hard for individual investors to manage any decent-sized portfolio - there are a lot of borrowers to check out and payments to follow.

Furthermore, the most successful lenders have huge loan lists. Peter Renton, publisher of the Lend Academy blog, has $200,000 invested among 4,000 loans spread between six accounts on Lending Club and Prosper. His rate of return is 10.8 percent, according to his latest quarterly statements. (Renton also gets paid when people click through from his site to one of the P2P sites.)

Lending Club notes that every investor with at least 800 loans (requiring a minimum investment of $20,000) has had positive returns, while 94 percent of them posted annual returns above 6 percent, and some have topped 18 percent.

PERSPECTIVE

Those kinds of returns are all-too-tantalizing, says Doug Nordman, a financial advice blogger who has tried out peer-to-peer lending and written extensively about it. "People see ads on the sites that people are making 15 percent returns, and they want some of that," he says. But it is extremely hard for an untrained individual to manage the process and score that kind of return, he said.

Los Angeles-based financial adviser Brendan Ross has been putting 5 to 10 percent of all of high net worth clients' portfolios into hedge funds, such as Colchis Capital in San Francisco, Direct Lending Advisors in Oceanside, California, and Eaglewood, that specialize in peer-to-peer loans.

"Consumer lending gives them an opportunity to earn returns," he says, while the hedge fund approach protects his clients from having to vet loans themselves. "It's a toe-dip."

Soon, the fund option may be available more broadly. Lending Club is prepping its own publicly available closed-end mutual fund and should have it ready to go in about 18 months, Chief Executive Renaud Laplanche said at a conference last week.

(Editing by Linda Stern and Matthew Lewis; Follow us @ReutersMoney or here)

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Comments (1)
cfbcfb wrote:
As far as I can see, your financial advice blogger has NOT tried any p2p lending services, and just wrote an article explaining his predisposition against it. Quite a few of the claims made in his blog are not at all accurate.

For example, he harps on the lack of liquidity, locking in for 3-5 years, etc. Its simply not true. Many states don’t allow purchasing of ‘new’ notes, so lenders are forced to buy them on the secondary market. In fact, you can charge over face value of the note amount for a well curated note with no payment problems, especially once they pass the 11 month ‘seasoning’ where defaults lower through the term of the loan. So you can not only get out without much trouble, you could even turn a nice profit doing so.

He also makes a lot of noise about the lack of data. We have decades of unsecured loan data and quite a bit of current data from the p2p lenders. Nobody wants to take a 200+ point hit on their credit by defaulting on a loan, secured or not. And if you’re well diversified, a few defaults are simply no big deal. Everyone who owns a mutual fund experiences the same losses when companies held by a fund go bankrupt, its just that they don’t read that part of the annual report.

About the only downside to it is that it can take a while to fully deploy a lot of capital. I’ve been doing it for several years and it took me ~3 months to buy 50k worth of decent notes. Now I spend ~3 minutes a day looking over prospective loans and buying them ~3-5 per day.

The people I know that have taken this on as an educated investor do well. But many people buy high default rate loan types (like small business and education), they buy notes with high credit/low interest rates because they think they’ll be safer (lower credit/higher interest rate loans don’t default in proportion with the interest uptick, so you see more defaults but the huge interest payments offset that and then some) or they tinker in with 5 or 10 notes and run away when 2 of them default, thinking that’s going to be their overall long term default rate.

I wouldn’t recommend this as anything other than a ~5-10% of your net worth investment, but in a time when .02% is a good savings rate and getting north of 1% requires a 3-5 year commitment, its nice to be able to knock out ~10% on some cash and either use it or reinvest it, depending on your needs that month.

Sure. we could experience a huge drop in the economy and a resulting massive job loss and the default of many unsecured loans. I’m thinking if that happens, losing even 30% of my lending club account won’t be my biggest problem. Plus even at that default rate, I wouldn’t see much of a loss.

But that default rate only showed up once: with a brand spanking new Prosper, during the worst financial year the economy has seen since the Depression, with much lower credit rated individuals that were poorly screened, etc. Not really a benchmark I’d bother looking at given the current offerings.

Jun 25, 2013 2:51pm EDT  --  Report as abuse
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