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What are the Risks of Peer to Peer Lending?

by Peter Renton on May 10, 2011

I was chatting with a friend of mine over the weekend who has just inherited a small amount from her grandfather’s estate. She knew about my involvement in peer to peer lending and asked me if it was a good place for this money. Of course, I told her it was a great idea.

Then she asked me what the risks were and I rattled off a few of the points I mentioned below. But after our conversation I realized that I had never done a post detailing the risks of p2p lending and it is most likely one of the first questions potential investors will ask. So here it is.

The prospectuses of both Prosper and Lending Club go into great detail (over 20 pages each) about the potential risks of p2p lending. While I encourage everyone to read these prospectuses I realize that few people will take the time. So, here are the five main risks as I see them:

1. Borrower Defaults

When you invest in borrower loans these are unsecured loans, meaning there are no assets backing the loans (such as a house in a mortgage loan). So, if a borrower defaults on the loan there is little an investor can do. You just take the loss of whatever amount of principal is left unpaid. With p2p lending default rates averaging around 3% a year, most investors will encounter defaults at some point.

2. Poor Loan Diversification

The best way to mitigate the risks in point one above is to carry a diversified loan portfolio. By that I mean you should invest in a large number of notes. Let’s say you have $5,000 to invest. It would be a huge mistake to invest in five different loans of $1,000 each – if one of those loans defaults you will lose a good chunk of your money. That is poor diversification. It would be much better to invest in 200 different notes at $25 each, so one default will not impact your bottom line very much.

3. Bankruptcy of Lending Club or Prosper

Both Lending Club and Prosper are losing money. They are still many months (or possibly years) away from breaking even. Even when they start to make money there is no guarantee that they will continue to do so. In the case of a bankruptcy, both companies have a backup loan servicer that is expected to continue processing borrower payments. But there is no legal precedent for a bankruptcy of a peer to peer lender so no one knows exactly what would happen. Having said that both companies are on strong growth trajectories so I see a bankruptcy of either company as unlikely, but the possibility will always exist.

4. Interest rates may rise

We are currently in the midst of the lowest interest rate environment in many decades. Eventually interest rates will rise and the impact this will have on p2p lending is unknown. Right now, it is relatively easy to attract investors with expectations of returns of 8-10% or more. But a few short years ago investors could get FDIC insured returns of 6%. If we return to an environment like that investors may leave for safer returns elsewhere. As an aside, this is why I find the lowest interest rate notes unattractive. An A1 rated 36-month loan at Lending Club or a AA rated 36-month loan on Prosper will yield less than 5% for investors. In two or three years time you may well get an FDIC insured account at a higher rate than that.

5. Regulatory changes

Peer to peer lending is still a new industry and the government doesn’t quite know what to do with it. Lending Club and Prosper are regulated by the SEC in a similar fashion to stock brokers and investment banks (institutions that have little in common with p2p lending). While there has been talk of regulatory changes nothing has happened yet. There is, of course, a slight possibility that the entire p2p lending concept could be legislated out of existence but that is something I consider highly unlikely.

Almost all investments carry some level of risk.While the risks are important to consider, I like to focus on the risk/reward equation. As an investor are you being compensated for the level of risk you are taking? With p2p lending I believe the answer is yes. My friend also agrees and she is going to start investing this month.

What do others think? Did you carefully weigh the risks before investing?

{ 26 comments… read them below or add one }

Bilgefisher May 10, 2011 at 12:41 pm

When it comes to diversification, I follow a bit different path. My % risk of having default is the same with 20 loans or 2000 loans. Since I do not use an automated plan, I would rather spend as little time as possible finding loans. Time is our greatest asset. I can’t get that time back I squander looking at 1900 more loans. That means when I do find one, I fund it with much more money. I’ll fully admit I haven’t looked closely at automated plans to aid this.

The downside is I think it will hinder my use of folio if I need to liquidate any loans. Smaller loans will likely sell quicker on folio. May have to do what some investors do and invest several smaller amounts on one listing.

That’s my take. I see prosper as more of hobby investing unless you have much larger amounts to invest.

Jason

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Matthew Paulson (P2P Lending News) May 10, 2011 at 1:05 pm

The concern that I worry about the most is the bankruptcy of either company. The reality is that both of them are VC backed companies and not profitable. If either company can’t keep the venture capital flowing until they are profitable, they’re out of business. Prosper was likely close to out of cash before they got their D round last April. It would be interesting to see what would have happened if it had gone under.

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Dan B May 10, 2011 at 3:41 pm

@Billgefisher…………Though technically correct, your statement on defaults can easily be construed by novices to be a recommended way to invest/diversify. But since I can’t find the appropriate diplomatic language right now, I’ll pass on commenting any further.

@Peter…….Tell your friend that I’ll take the entire amount off her hands & pay her 8% a year on a 5 yr. secured loan. Secured by my good name.

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Peter Renton May 10, 2011 at 3:46 pm

@Bilgefisher, I have disagree with you here. While your percentage risk is the same whether you have 20 or 2000 loans the impact of a default on your bottom line is so much different. I don’t like spending too much time on loans either which is why I have developed a system that allows me to invest in 20-40 new notes a week with about 20 minutes of effort. And you bring up a good point about Foliofn. It is much harder to sell a $500 note than it is to sell a $25 note.

If you are doing this for a hobby then your approach is probably fine. But if you want to make some decent money here then creating a system with a more diversified approach would decrease your downside potential.

@Matthew, Good to hear from you on here. I know many people who were nervous about Prosper last year but they got their round of funding and are now looking much better. Of course, they will need another round here soon, which I expect will be forthcoming in the next 2-3 months.

@Dan, Hmmm. I am just not sure whether your good name will be enough assurances for her but I will put in a good word for you….

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Matthew Paulson (P2P Lending News) May 10, 2011 at 4:24 pm

@Peter – I’d be curious to know what leads you to believe that Prosper will need another round of funding soon. I know they had a pretty high burn rate between their C and D rounds, but I don’t know if that’s continued or if they’re cut down on costs.

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Peter Renton May 10, 2011 at 4:41 pm

@Matthew, Prosper had $4.3 million in cash on hand at December 31st, 2010 according to their annual report. Their burn rate was about $800K a month last year. Their revenues would have gone up this year with the increased loan volume but I still expect them to go through their cash on hand by the end of July allowing for a slightly lower burn rate.

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Dan B May 10, 2011 at 5:43 pm

Do you know off hand what type of interest rate they’re paying on their VC money?

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Matthew Paulson (P2P Lending News) May 10, 2011 at 7:57 pm

@Dan – I don’t believe that any of the VC money that Prosper has now is a loan. I’m pretty sure it’s all equity. There was a small convertible note last year, but my guess is that converted into equity.

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Matthew Paulson (P2P Lending News) May 10, 2011 at 8:21 pm

On a somewhat related note to this post, Lending Club issued a new prospectus this month: http://www.sec.gov/Archives/edgar/data/1409970/000095012311037225/c15734posam.htm#C15734106

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Dan B May 10, 2011 at 9:22 pm

@Peter…………I don’t see what the problem is. After all, I’ve already shown that I can certainly make over 8% here & therefore my business model works. Therefore I would think that you’d be happy to point out that I’m a better credit risk than any p2p company…………….to say nothing of most of the borrowers!

@Matthew………….Thanks for the info. Didn’t Prosper also float something a few months ago about a “warrant” that they were coupling with large lump sum investments into Prosper?
I rook a quick look at the new LC prospectus. Is it my imagination or is there substantially more verbiage on defaults, insolvencies etc., compared to the previous prospectus. The section on backup servicing of notes also appears to be re-written or more extensive than I remember. I may be wrong.

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Peter Renton May 10, 2011 at 9:47 pm

@Matthew, I seem to recall someone mentioning a small short term loan that Prosper took out at 15% interest last year – not sure if that was converted to equity or repaid. But I heard their Series D round in April was all equity.

@Dan, I happen to have saved the old LC prospectus and I while I haven’t been through it completely there are definitely some changes. It has gone from 89 pages to 105 pages with Risk Factors increasing to 20 pages (from 17) and more information about the historical loan performance.

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Matthew Paulson (P2P Lending News) May 10, 2011 at 10:44 pm

@Peter – Yes. I think they took out a $1 million bridge loan before their D round of funding. I think that was either paid off when the new round of funding was announced or was converted into equity.

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Dan B May 11, 2011 at 12:11 am

@Peter………Well that’s just great. As usual, the powers that be have deemed it so that the only people who are truly going to get wealthy out of all of this are the lawyers.

And the worst part is that some of the stuff inside the prospectus is just nonsense……………..probably written by the same people who used to copy their school reports straight out of the encyclopedia without bothering to check if it’s even applicable.

I especially enjoyed the part where it’s stated that one of the “risks” to the business is that it is going to be increasingly difficult & competitive to retain the highly qualified people that currently work in the business. Oh yeah, I don’t know about you guys but I absolutely sensed the “quality” & caliber of the people employed there whenever I’ve come into contact with them. I mean they all just ooze intelligence. lol

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Peter Renton May 11, 2011 at 5:47 am

@Dan, More than most industries it seem financial institutions of all kinds seem to please the lawyers first and the customers second. It is a sad state of affairs but that seems to the reality these days. And I am sure it was a lawyer who said we need to put in a section about the risk of retaining quality people – is there a business anywhere that doesn’t have that as a risk?

I disagree with you about the quality of people at Lending Club and Prosper. I have found them to be helpful, intelligent and service oriented in my dealings with people in both companies.

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Bilgefisher May 11, 2011 at 7:46 am

@Dan. I’d rather you not hold back. The truth is far better than a sugar coated turd.

@Peter. I agree with your points and should have mentioned it all depends on how much you are investing. If your investing $100,000, I think its a huge waste of time to scout out loans and invest $25 when $500-$1000 would still minimize the defaults margin of error from hurting your bottom line.

Other than auto investors, I doubt many people have systematized their investing like you have. I would venture to guess many spend hours investing a measly $100-$200 in 4-8 loans each paycheck.

Jason

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Peter Renton May 11, 2011 at 10:14 am

@Bilgefisher, Once you get into larger numbers then yes, I agree that you should not stick with the $25 loan amounts. You would end up with a portfolio of 4,000 notes and that is what I would call over-diversified. My feeling is that the 800-1000 note range is the sweet spot for diversification. Otherwise an investor will find it hard to beat the averages. But I think even with 100 loans you are taking unnecessary risks that a default will impact your bottom line too much.

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Dan B May 11, 2011 at 12:34 pm

@Bilgefisher……….Well your initial post seemed to imply that 20 notes was adequate diversification so I’m guessing now that it was in jest. I think that 100 notes is a bit on the low side in terms of diversification but it all depends on your willingness to take risk. It’s very possible that you can end up with a very healthy return with 100 notes……………..& equally possible that you’ll end up with a crappy one. But the main problem with a portfolio of that size (apart from volatility) is that you won’t be able to draw any accurate conclusions from your performance regardless of whether it’s good or bad because luck will be the overwhelming factor in determining that performance.
Having read your blog I’m almost certain that you realize all this so I don’t see the point of going on & on here.

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Dan B May 11, 2011 at 12:46 pm

@Peter…………We either have very different definitions of efficiency & intelligence or I’ve been real unlucky. I’m very confident in saying that I have more information/knowledge at my fingertips about LC than any of the 3 reps that have been assigned to my account at LC. In fact I’d still say the same thing if I were a blindfolded one armed man.

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Peter Renton May 11, 2011 at 1:57 pm

@Dan, Maybe some of both. All I know is that I speak with my LC rep almost weekly and I have found him to be helpful and responsive every time. Others in management I have spoken to are also very sharp and helpful.

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Ed D. May 11, 2011 at 5:46 pm

I’m really appreciating this blog and threads like this one. So needed.

@Peter, I second the notion that (my?) LC reps have been helpful and on the ball. There was one instance of a support person not having enough info on the bonus program, but in general I’ve been impressed by the support I’ve been given. Now if they can finally get the occasional hangout of the system at the purchase note step–better lately though.

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Peter Renton May 11, 2011 at 8:10 pm

Thanks @Ed. I appreciate your kind words. Glad to hear of another positive experience with the Lending Club reps. I agree I think the web site could still use some work to fix the occasional hangup.

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Matt Jabs May 14, 2011 at 9:21 am

Good point about the companies going bankrupt in light of their lack of sustained profits… I was not aware of that.

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Peter Renton May 14, 2011 at 3:28 pm

@Matt, Thanks. I think it is important to highlight it as a potential risk that investors should be aware of, but it is not something that concerns me much, especially with Lending Club and their current growth.

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Scott July 9, 2014 at 12:22 pm

Any updates on solvency or bankruptcy risks for LC and prosper?

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Peter Renton July 15, 2014 at 9:00 pm

I think the risks are far reduced at both companies now, particularly when compared to three years ago when this article was written. Both companies are financially very stable, with plenty of cash and they have begun making money. Prosper has a bankruptcy remote vehicle in place now for all investors.

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Ken December 12, 2014 at 1:22 pm

Peter,

I didn’t see this addressed in the previous comments so I will ask here. What are your thoughts on peer to peer lending risks regarding general macroeconomic problems? Arguably ~2009 to now (with declining charge-offs from initiation until now) looks differently than from if the company was established in 2004. In the event of a large recession or economic decline, the unsecured and online nature would seem to lead to larger defaults (no collateral / no connection with your lender). These loans and credit card debt may be the first to default. Recovery percentages on both are low I assume. I have not looked at credit card default from the most recent recession but I again assume it was high and low recoveries.

I realize as an example I use one of the most severe recessions in our history. How has credit card debt and other comparable debt went during other economic declines? With the stock market I may lose 50% of the value of my holdings, but I still own X number of shares of Company X. With the latest recession I may have only held 50% of my LC / Prosper holdings with little hope for any recoveries (as opposed to holding stock).

Just curious of your thoughts on the big picture. Thanks.

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