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Is P2P Lending A Low Risk Investment Now?

by Peter Renton on March 19, 2013

I have been thinking about this idea for some time. With Lending Club now profitable and growing like gangbusters and Prosper with a new bankruptcy remote vehicle for all investors I think it is time to revisit the idea of risk.

Despite the question in the title of this post I don’t truly believe that p2p lending is a low risk investment. I think most of us would agree that Treasury bills or an FDIC-insured investment is pretty much all we can consider as low risk.

But let’s look at the mainstream investments for a moment. The stock market is at an all time high and yet everyone remembers that it has had two major corrections in the past 13 years where values went down roughly 50%. The bond market has had a great run for many years now but at some point in the next couple of years that run will likely be over. Both those investments represent a real risk of principal loss going forward.

Lending Club in a Very Strong Financial Position

Now, let’s consider an investment in Lending Club today. In February it issued $120 million in new loans and is now running at a profit. It is safe to say that loan volume in March will be north of $130 million and increase steadily from there. Returns to investors continue to be strong and there is an IPO looming on the horizon where it will pocket a huge cash war chest.

There is very strong demand from institutional investors with new large investors coming on board all the time. But in recent conversations I have had with Lending Club management they say retail investor demand is also growing very strongly. When their IPO happens this will become even more pronounced as investors from all 50 states will become eligible to invest. Suddenly investors from large states like Texas, Ohio, Pennsylvania and New Jersey will come flooding in to Lending Club.

The future is indeed very bright for Lending Club and it would take an unforeseen calamity to alter their growth trajectory now. With a well-diversified investment there is little risk of principal loss at Lending Club and the potential return is 10% or more.

Prosper Offers Additional Protection for Investors

Taking a look at Prosper they are clearly not in as strong a position as Lending Club. In recent months they have been reduced to a tiny market share but there are early signs of a resurgence. They are going to post a better month in March (month to date volume is up 73% over last month) and all signs point towards a record month for them in April.

Even though Prosper is clearly the number two player and they are in a weaker financial position they have implemented a bankruptcy remote vehicle for all investors. This provides an added level of protection for investors that offsets the increased platform risk in my opinion. With a new management team and their recent large cash infusion they are also in a relatively good financial position.

Now, anyone who has been reading this blog for a while knows I am a big cheerleader for the industry. I do not pretend to be completely objective in my coverage; I invest a lot of my own money in Lending Club and Prosper and plan on investing a lot more. I want the industry to continue to flourish.

So, while I don’t really believe that an investment in p2p lending is a low risk investment I think we can all agree that it is a lower risk investment today than it was two or three years ago. I would also propose that today it is also a lower risk investment than an S&P 500 index fund or a total bond market index fund.

But what do you think? Am I crazy to even suggest this? As always I am very interested to hear your comments.

{ 26 comments… read them below or add one }

SarahV March 19, 2013 at 8:31 am

In my mind… it’s not so much a low-risk investment as an unknown-risk investment. It may be low risk; it may be high risk; but I think in general we have very little idea of what may happen. People classify it as high risk because the risk is not well understood.

My biggest worries aren’t so much defaults or bankruptcy as things like:

1. The secondary market will collapse when Lending Club does an IPO, making it impossible to offload distressed notes
2. Institutional investors will have the scales weighted more and more in their favor and retail investors will be left with crumbs and dregs
3. Lending Club will ease the loan restrictions too much to get more borrowers
4. The investment side will grow faster than the borrower side, and loans will disappear so quickly that people will not be able to do due diligence
5. Institutional investors will develop automated investment systems so good and so fast that retail investors literally can’t invest without paying money for some kind of software or online service

etc.

Most of these things are preventable by Lending Club and Prosper. I’m hoping for the best, but sometimes I think this is not sustainable for much longer. I just doubled my investment though, so I am at least bullish in the short term :-)

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Andrew N March 19, 2013 at 9:19 am

I agree. What is going to happen to both the primary and secondary market once Lending Club goes public? Is there investor demand going to be so high that I have to be online every morning at precisely 9 AM EST to find decent loans? Perhaps Lending Club is going to start offering loans with even more risk in order to get more borrowers onto the platform. In Peter’s article “Peer to Peer Lending News Roundup – March 16, 2013″ there was a link to a USA Today article that mentioned Lending Club was considering getting into subprime loans. However, only institutional investors would be able to invest in the subprime loans.

Either way I’m curious to see where the P2P lending industry is headed over the next few years. I just hope that individual investors do not suffer in order to provide greater profits for large institutions.

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Dan B March 19, 2013 at 6:08 pm

I think you’re spot on in that people classify as high risk due to the fact that the risks are not well understood. It is wise to be cautious. Nevertheless, I’d like to address a few of the points you’ve brought up.

It’s highly unlikely that the secondary market will suffer a collapse after an IPO. What I’m assuming that you’re saying is that the secondary market users will suffer a drastic reduction n their ability to sell notes. That too is highly unlikely. In fact if any of your items 2-5 come true then it is actually more likely that the secondary market notes will be more sought after, not less. (due to shortage of notes in the primary market as you’ve suggested) Furthermore, even if none pf your concerns 2-5 become a major issue, one can easily look at the Prosper Folio example where the secondary market provides adequate liquidity despite it being confined to only states where Prosper is already available.

In terms of your points 2-5 (which are really all related), I have no doubt that all of these risks/concerns will be with us forever. I doubt we will ever be rid of them & no doubt some of them will be an issue from time to time.

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Walter March 20, 2013 at 10:49 pm

As a small LC investor, I’m already having serious problems with loans funding before I can get to them. I use LendStats filters and until about a month ago I could invest most of them after work (I’m on CST). Now they are fully invested before I get home. I don’t think what’s left are “crumbs and dregs” yet, but they are a definite step down from what meets my filters. I think that smaller investors will need some kind of API in the very near future.

FWIW, I’ve had a much harder time selling my problem notes in the past month than I ever had before, even at steep discounts.

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Craig March 21, 2013 at 12:02 pm

I agree regarding your comment about selling problem notes on Folio. It used to be that just a moderate discount for grace notes, and a midsize discount for 16 to 30 notes and they would sell quickly in most cases. That has changed lately for some reason.

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samuel hu March 21, 2013 at 1:12 pm

Walter – can you quantify “steep” discounts

Craig – can you quantify “moderate” and “midsize” discounts

i exclusively invest in secondary prosper notes (which can’t be listed if they are past due) and have had good returns – but my experience with LC secondary notes was not very good

my strategy was to buy ’16 – 30′ notes at ~ 15 – 20% discount

by principal amount invested, i have had 21% pay back in full, 55% charged off and 23% go further delinquent (i.e. 31 – 120) – and my absolute return on these notes is ~ -68% (assuming the remaining notes are charged off eventually)

i’m sure there are people who have had good returns investing in LC problem notes but i won’t be getting back in until they become much, much cheaper (maybe 75% discount on 16 – 30 day notes)

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Walter March 21, 2013 at 5:21 pm

I consider the discounts to be steep relative to the discounts that I had been selling them for. I usually sell Grace or Late Notes based on the recovery percentages posted by LC. Usually I could easily sell Late (16-30) for 25% discount to principal due, but now it’s more like 40%. 31-120s are now discounted to 35% when they usually sell at 50% to principal, and they still aren’t being bought. I do not sell that many notes (5-10 month) but it has definitely helped my account to be able to offload them for more risk tolerant investors. I wonder if LC note buyers on Folio are having the same experience as you. I’ve invested in mostly B-D loans for awhile and haven’t changed my filters significantly for about 2 years. These are $50 notes, which I have not typically had to sell, so that may have something to do with it. I have sold them before, but not in the same quantities as my $25 notes, which is about 3/4 of my portfolio.

storm March 22, 2013 at 11:07 pm

I have a low tolerance for notes that are paid in their grace period. If you have a lot of notes, you can sort them by due date on FolioFN. It becomes evident which payments LC has not processed yet, and the “current” loans that will inevitably go into their grace period within 24 hours rise to the top. (Watch out for loans that are about to be paid off…they seem to take an extra 24 hours to be processed. It is unlikely the borrower would miss their final payment.) I look for these almost-grace loans every weeknight and I list them at a 5% discount. I used to be able to sell them quickly at par or a meager 1% discount, but I think Folio buyers have become wise to this trick. Maybe I’m giving Peter and SarahV. too much credit, but it seems to have all started with the “Guide to Investing on Lending Club with FOLIOfn” post back in January where it is wisely recommended to stay away from notes where the payment is processing. Anyway, after 24 hours, the note goes to grace. If no one has bought it yet, I discount it an additional 5% every day until it sells. Usually I can unload a $25 note at a 5-10% discount. I’ve noticed $50+ notes seem to need a higher discount to sell…around 20-25%, so it’s best if you can stick with a $25 investment. Because of the current shortage of new loans, I’m having a hard time keeping my money invested at $25 per note though. Yes, a majority of loans that go into grace period go back to current, but they are much more liquid at a modest discount than a late loan. If the borrower makes a payment while the note is listed, the sale will be cancelled, and you will retain the note.

dontvote March 19, 2013 at 10:06 am

Crazy isn’t the right word. Low-risk isn’t either.

Many companies have been making unsecured loans to individuals for many years. Profitability of this business is based primarily on the strength of the economy. In good times, this is an awesome business and you can control your ‘risk’ by having decent underwriting criteria and significant diversification. When bad times come, this business is hurt, you can’t change your model fast enough, portfolio recovery is 2 years out, etc.

P2P has at least one advantage – a corporation generally will borrow money to invest in this type of business whereas we are using our savings or for institutional investors equity. We are able to weather a downturn better because we need positive returns and not positive over our cost of capital.

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samuel hu March 19, 2013 at 12:09 pm

Hi Peter –

One issue I think you might be mistaken on is that an IPO for LendingClub will not automatically allow people in all 50 states to invest in LC loans. Rather, people will be able to buys shares of LendingClub and earn dividends and price appreciation based on the shares (which will reflect LC’s profitability)

However, individual states may still retain the right to prevent their residents from being a ‘lender’

anyway, my biggest concern is that the current model is an ‘originate to distribute’ model not unlike the model employed by many mortgage originators prior to the crisis. i understand that LC and Prosper has reputation risk if the loans they originate start experiencing substantial defaults (which, in the case of Prosper, actually materialized) however, they will continue to grow (and be profitable) if they can ramp up origination and keep finding investors to buy the notes. based on what we are seeing, i don’t think the investor demand is at all subsiding.

Do you think p2p lending platforms should be required to retain a small portion of each loan?

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SeanMcD March 19, 2013 at 2:06 pm

Prosper’s bankruptcy vehicle is a great move for protecting new loans, but I’m not at all sure that it will successfully protect loans issued prior to its creation. In a worst case scenario, where the current class action suit did end up bankrupting Prosper, I think they would have a very difficult time convincing a judge that the vast majority of their assets were no longer available for offsetting debt because they had been transferred to another company after the suit had been filed.

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Peter Renton March 19, 2013 at 8:22 pm

Really great comments everyone – the different perspectives are always illuminating to me. A couple of points:
1. While it is true we don’t really know the exact risk of p2p lending, unsecured consumer loans have been going on for decades, so the asset class has a long history. Everyone I have spoken with says that the most important macroeconomic data point is the unemployment rate. If this can stay under 10% we should be relatively unaffected.
2. I agree with Dan that the secondary market will only get more popular with new investors coming on. The availability of loans there is much more democratic with no big institutional investors playing in this area and there will always be investing looking to snap up discounted late loans to try and get a high return.
3. Sam, that is not what I have heard. My understanding is the Blue Sky Exemption allows individual investors to buy securities in LC once it is a public company – that is all types of securities the common stock and other debt instruments like the p2p notes. And no, I don’t think LC and Prosper should have to hold a portion of the loans – they know if their underwriting does not perform they will lose investors.

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Fred March 20, 2013 at 8:28 am

Peter,

I agree with your point about the unemployment rate as being an important macroeconomic data affecting P2P market.

However, I can think of Treasury rates as being another important macroeconomic factor. Perhaps the 2-yr and 5-yr Treasuries are the most appropriate in this case. See: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/. Currently, they are close to zero, causing mortgage rates and other consumer loan rates to be also very low. Once Treasury rates start to climb, the rates of those consumer loans (mortgage, auto, boat, etc.) will also rise. Assuming P2P rates remain stable even after Treasury rates start climbing, this might cause the rates from P2P market to be relatively cheaper, thus increasing demand.

SarahV,
I’d also like to comment on your point 3 “Lending Club will ease the loan restrictions too much to get more borrowers” after its IPO. In my view, the popularity of LC will increase significantly after IPO, causing quite a few new prime borrowers to pay attention. IPO has an embedded marketing element to it. So I think there would me more prime borrowers in LC after IPO. I don’t think LC need to ease loan restrictions to get more borrowers.

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Mr. 1500 March 22, 2013 at 12:17 pm

It would seem to me that when rates for everything else start going up, rates for borrowers will go up too. If we have Internet savings accounts paying 5% like they were 6 or 7 years ago, LC will have to raise rates to be competitive. All ships rise with the tide so they say.

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Peter Renton March 23, 2013 at 8:55 am

That is the other unknown. Although when LC and Prosper started FDIC insure CD’s were about 5% and they attracted plenty of borrowers and investors. And we probably have a long time before rates get above that.

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samuel hu March 20, 2013 at 10:25 am

Peter – you raise an interesting point – you are correct in that if LC is a public company (i.e. its equity is listed on a national exchange), blue sky laws are preempted with respect to other securities issued by LC that rank equal or senior in to the listed securities – this would mean that bonds issued by LC would not be subject to blue sky rules – I just don’t know that p2p notes would also count since they are not technically obligations of LC

it will be interesting to see what position LC takes when/if it does go public.

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Bryce M. March 20, 2013 at 11:34 am

P2P Notes are technically obligations of LC that are “borrower dependent.” I’m pretty sure that’s in the prospectus.

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samuel hu March 20, 2013 at 12:35 pm

you are probably right about the description of the p2p notes in the prospective – my point simply is whether or not p2p notes (because they are generally non-recouse to LC) will be treated as obligations of LC for the purposes of the National Securities Market Improvement Act (which created the blue sky exemption that we are discussing)

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B. Mason March 20, 2013 at 6:54 pm

A case for the courts! I bet LC takes the stance that they are.

Peter Renton March 21, 2013 at 6:25 am

Sam, Now I have no idea how deeply LC has looked into this but there seems to be consensus within the company that the blue sky laws will allow them to offer the notes to investors in all 50 states. I have repeatedly heard that as one of the benefits of the IPO.

writing2reality March 20, 2013 at 11:27 am

I also believe that peer-to-peer lending is slowly reducing it’s overall risk as it continues to grow and solidify as a viable alternative investment class. Time has proven thus far that the returns at this point are far outweighing the loss of principle, even through the “dark days” of the recession. Certainly there are many changes ahead as an IPO for Lending Club will quickly alter the investor and borrower demand, and as Prosper’s new management team works to turn around their ship. I believe that these changes will only be for the best, provided that Lending Club makes wise use of the IPO cash, and Prosper can continue to track upwards like they have in the past month.

As an aside, certainly the ongoing struggle between retail and insitutional investors will always be a battle, but one can hope that these will be appropriately mitigated and handled when the time comes.

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AmCap March 22, 2013 at 9:58 am

Sam’s statement about equally-ranked and senior securities with regard to blue sky preemption is correct. But, and Peter I’ve mentioned this before, if LC moves those notes to an SPV I don’t think they can avail themselves of preemption anymore. The notes would not be senior as to publicly traded securities any more.

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Peter Renton March 22, 2013 at 11:41 am

So, AmCap are you saying that if Lending Club creates a bankruptcy remote vehicle, as Prosper has done, that the blue sky exemption will not apply? This is going to be very interesting to see how it all plays out.

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AmCap March 22, 2013 at 12:08 pm

That is my analysis Peter, yes. The NSMIA establishes sole federal regulation of publically traded securities and securities 1)”of the same issuer” 2) “that is equal in seniority or that is a senior security” to a publically traded security. No problem so long as LC is the issuer, but if you move to an SPE I don’t see how the exemption applies. The SPE would be the issuer, not LC.

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samuel hu March 22, 2013 at 4:50 pm

AmCap and Peter – couple points

1) agree with AmCap that if LC moves to the prosper model, the notes issued by the new SPV will not be exempt

2) i’ve talked to another securities lawyer who use to head up the blue-sky compliance practice at Sullivan and Cromwell – he also doesn’t think the p2p notes will fall within the exemption referenced above. the analysis being that assets of LC are NOT available to pay the p2p notes (i.e. the only recourse for holders of the p2p notes are the payments from the underlying borrowers). on the other hand, the assets of LC are available to pay dividends etc. to the equity holders – as such, it would be hard to argue that the p2p notes are “equal or senior” to the equity

even if LC does try to make this argument, i would expect the state regulators already in opposition will take a hard stance

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AmCap March 22, 2013 at 5:13 pm

From the prospectus:

“In a bankruptcy or similar proceeding of LendingClub, there may be uncertainty regarding whether a holder of a Note has any right of payment from assets of LendingClub other than the corresponding member loan. In a bankruptcy or similar
proceeding of LendingClub, it is possible that a Note could be deemed to have a right of payment only from proceeds of the corresponding member loan and not from any other assets of LendingClub, in which case the holder of the Note may not be
entitled to share the proceeds of such other assets of LendingClub with other creditors of LendingClub, whether or not, as described above, such other creditors would be entitled to share in the proceeds of the member loan corresponding to the Note.

Alternatively, it is possible that a Note could be deemed to have a right of payment from both the member loan corresponding to the Note and from some or all other assets of LendingClub, for example, based upon the automatic acceleration of the principal obligations on the Note upon the commencement of a bankruptcy or similar proceeding, in which case the holder of the Note may be entitled to share the proceeds of such other assets of LendingClub with other creditors of LendingClub, whether or not, as described above, such other creditors would be entitled to share in the proceeds of the member loan corresponding to the Note. To the extent that proceeds of such other assets would be shared with other creditors of LendingClub, any secured or priority rights of such other creditors may cause the proceeds to be distributed to such other creditors before, or ratably with, any distribution made to you on your Note.”

It looks very unclear – but if I’m reading Sam correctly, it looks like the securities law analysis will look to the substance rather than the form of the notes to determine if they are actually superior. Very uncertain.

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