Yesterday, two major reports were published on the p2p lending industry. First, the Federal Reserve Bank of Cleveland put out a positive report on the future potential growth of this industry and the same day Fitch Ratings published a more sobering report on where the p2p lending industry stands today. Both make for some very interesting reading.
First let’s take a look at the report from the Cleveland Fed. This is a quick read containing some very interesting graphs. It is focused on interest rates, particularly their comparison with average credit cards rates. I found the chart below interesting.
So, on average credit card interest rates have been significantly higher than the average rates at Lending Club. It appears that the Cleveland Fed did not use data from Prosper in their analysis. What is even more interesting is the fact that peer to peer loans have been performing slightly better than credit cards when it comes to the percentage that are delinquent.
On average, between 2010:Q2 and 2014:Q1, 3.2 percent of peer-to-peer loans were past due compared to 3.7 percent of standard consumer finance loans. Over this period, peer-to-peer loans had a lower share of poorly performing loans in 10 of 16 quarters.
The conclusion of the report is that p2p lending will continue to grow because borrowers find it an attractive alternative to credit cards and there is strong investor demand.
There are three major credit ratings agencies in the US: Standard & Poors, Moodys, and Fitch Ratings. These businesses are very important to the financial system because institutional investors use these ratings to make investment decisions. They rate the credit worthiness of debt issued by corporations and governments as well as asset backed securities.
Last month Standard & Poors rated a securitization by SoFi and that was very big news for this industry. Yesterday, Fitch Ratings released a report on peer to peer lending – this follows on from the Standard & Poors coverage from a couple of months ago. That major ratings agencies are starting to take notice.
I was able to obtain a copy of the Fitch report and it makes for some interesting reading – unfortunately the full report is not available publicly. It is helpful for those of us, like myself, who are sanguine about the industry’s future to stop and see how some impartial financial analysts view p2p lending. While the message comes through that Fitch believes the industry does indeed have great potential they do not have enough confidence yet that it will realize this potential.
Here is a summary of their concerns:
- Platforms have limited operating history – no company has been around long enough to have weathered multiple economic cycles.
- Rising interest rates could have an adverse impact – both investor and borrower demand could reduce in a rising interest rate environment.
- Regulatory risk remains elevated – they take the view regulations could change – in fact they believe that p2p lenders should be mandated to retain a portion of their loan book.
For these reasons Fitch states that any rating for this debt will be below investment grade and even then they would only consider a debt rating from one of the major platforms. This makes the “A” rating that SoFi received from S&P last month all the more impressive.
Many investors have the same concerns that Fitch has. These are all valid concerns that I hear regularly and they are part of the reason why many people still view this industry with skepticism. The way I look at it is this. As investors we are being compensated very well for risking our investment in this asset class. For me, the three concerns above are not enough to dissuade me from investing. But it is a good reminder that this asset class is still relatively new and it is not without risk.
I don’t quite understand the transition in how Fitch saying it’ll be below investment grade makes an A from S&P impressive.
“Regulatory risk remains elevated – they take the view regulations could change – in fact they believe that p2p lenders should be mandated to retain a portion of their loan book.”
This is obviously the easiest way to make sure the incentives stay aligned between the loan production and the purchaser. This disconnect in incentives (being compensated on volume vs performance) can have adverse impacts.
I don’t think the rising rate scenario is much of a concern, unless it’s stagflation. It’s more a concern for borrowers with variable rate debt. It may influence default rates somewhat.
Hi Rawraw,
What I meant is that SoFi has only been in business a little more than two years and yet their securitization still received an “A” rating from S&P. They have less of a track record than most major p2p lending platforms.
Peter,
As always, thanks for sharing. Would you mind clarifying the sentence below:
“…in fact they believe that p2p lenders should be mandated to retain a portion of their loan book.”
By using the word “lenders” in the context above, I am assuming you referring to the platforms and not the actual/real lenders [investors]?
Just wanted to ensure I understand correctly.
Hi Chris,
You understand correctly. To be more accurate they should have said “p2p lending platforms”.
But the p2p lending platforms aren’t the “lenders”. We are the lenders. Peter, are you sure they mean the platforms, or is this really going to come out of our pockets in some manner?
Mandating that the platforms retain a percentage of their loan book may sound great in theory, but what percentage would that have to be to sound credible? 4%?, 5%?………Well, last quarter LC did $1 billion in loans. 5% of that is $50 million…………..for the quarter & rising. That’s $200 million for the year. & it’ll probably be double that a year from now. I mean come on, it’s not doable if you or they think it’s coming out of LCs pockets.
LC could raise debt backed by the notes they have to buy and then full faith and credit of LC so as to avoid it looks like a standard securitization of assets taking the assets from their balance sheet
And how does that option play out longer term? How much is full faith & credit worth when they’re not even turning out a consistent profit, despite the massive increases in volume these last few years?
Yes, Dan, I am confident that Fitch means the p2p platforms. And as you point out it is simply not doable by Lending Club in their current form. But this argument keeps coming up again and again – some people are not comfortable that LC derives most of their income from originations and has no skin in the game when it comes to the loans themselves.
My argument is that, while they have no direct skin in the game, it is clearly in their best interests to keep investor returns good. If they start to plummet all the hedge fund money will leave quickly and LC will find themselves with an excess of borrower money.
Peter………………I think that it is clearly in their (LC & Prosper) best interests to keep investor returns good “enough” in comparison to fixed income returns elsewhere. Institutional, hedge fund etc. money will decrease when the gap narrows to a point where it no longer warrants the extra risk inherent to p2p.
As for the “excess of borrowers” scenario you mention………….I wouldn’t worry too much about that. As I’ve suggested a number of times, I don’t believe most of you p2p cheerleaders fully appreciate the difficulty p2p will face in finding new borrowers at an ever increasing pace necessary to going forward……………..to say nothing of the ever increasing costs in doing so. I’m confident LC realizes that. Why else would they have acquired Springstone Financial?
I think the “excess of borrowers” scenario only happens if Lending Club were to greatly reduce loan quality to get more originations but hurt lenders. Then lenders would flee and there would be an imbalance.
I can see more short term pressure to increase originations after Lending Club’s IPO. They will want to meet quarterly goals. There would be more pressure to loosen standards a little bit to get a few more originations even if that might hurt loan performance 1,2,3 years down the line.
This is my one big concern with the IPO.
There’s little doubt in my mind that LC will reduce standards of acceptance, & by extension loan quality. You’ve already seen it now with the (I forget what it’s called) special category loans. But if it’s done right, expectations can be managed. The plain reality is that “average” returns will continue to go down. That in itself is not that big of a deal as long as expectations are managed & the interest rates remain low thereby keeping ROI of other fixed income investments low.
Those of us who have been around this a while remember bold statements by companies & their cheerleaders of 9% or higher returns. Those statements have all been retired to the dustbin of history in favor of way more conservative numbers within a much lower range. Still new money pours in…………….& as I said earlier will keep doing so as long as you can’t get anything worthwhile elsewhere.