What are the Risks of Peer to Peer Lending?

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?

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Bilgefisher
May. 10, 2011 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

Matthew Paulson (P2P Lending News)
May. 10, 2011 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.

Dan B
Dan B
May. 10, 2011 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.

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

– 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.

Dan B
Dan B
May. 10, 2011 5:43 pm

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

Matthew Paulson (P2P Lending News)
May. 10, 2011 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.

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

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

Dan B
Dan B
May. 10, 2011 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.

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

– 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.

Dan B
Dan B
May. 11, 2011 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

Bilgefisher
May. 11, 2011 7:46 am

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

. 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

Dan B
Dan B
May. 11, 2011 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.

Dan B
Dan B
May. 11, 2011 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.

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

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

, 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.

Matt Jabs
May. 14, 2011 9:21 am

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

Scott
Scott
Jul. 9, 2014 12:22 pm

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

Ken
Ken
Dec. 12, 2014 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.

Ken
Ken
Jan. 20, 2015 9:24 am
Reply to  Peter Renton

Interesting. Thanks for the link and the reply.

John
Nov. 27, 2018 10:37 am

Insightful post indeed!
I think that the P2P platform is a facilitator to manifest contact between a lender and a borrower. Any risk associated with lending to other individual is the exposure that is solely taken by the individual lender. The platform does not have or guarantee any protection on this.