Anything to fear in peer-to-peer lending?

It has always been easier to lend money than to get it back. The risks of this new form of lending are worth examining.

Summary: Peer-to-peer lenders expect a certain level of personal loan defaults and some are setting aside funds in case of future losses. In a recession, lenders could expect the rate of defaults to rise, based on the experience of history. In the case of loan defaults, it is the platforms that are entitled to recover the money, not individual investors.

Key take out: Interest at peer-to-peer lenders can be calculated differently based on whether investors leave their principal on the platform or take it back in regular monthly repayments.

Key beneficiaries: General Investors. Category: Economics and investment strategy.

At Eureka Report we’ve been covering the peer-to-peer lending industry in some detail over the past year. You can catch up on a series of video interviews with the key Australian players and read an overview of how they work here: Peer-to-peer lending: We do your homework (July 29). We’ve suggested a number of times that they are particularly interesting to anyone searching for yield.

Although each platform operates differently, in general, investors lend funds to borrowers using an online platform. Overheads are kept low because there are no bank branches or legacy bank systems involved. This should allow borrowers to obtain a cheaper rate on personal loans than at a bank, while lenders earn a higher return than they would on bank deposits – although peer-to-peer lenders are not banks, of course.

Although the model sounds attractive, history suggests no system is perfect. Today we consider what might be cause for concern. In particular, let’s address a question prospective investors have been asking us: If I put my money on one of these platforms, can I lose the lot?

Competition Review Panel chairman and Deloitte Access Economics partner Professor Ian Harper reminds prospective investors that bank regulation exists for a reason. On peer-to-peer lenders, he told Eureka Report: “There is a sense that this all looks terrific until somebody loses their money. Then what happens?... Even if the peer-to-peer lenders have got all that sorted out, I don’t know that that is well understood.

“My advice to people who are considering participating in these things is on one level quite straightforward. Do you understand how you’re going to get your money back? That’s the old saw of financial services. Lending the money is the easy part. Getting the money back is the hard part.”

Understanding the personal loan category

Executives at peer-to-peer lending platforms regularly make the point that it’s easier to predict the behaviour of a population than an individual. Although it’s not possible to predict whether one borrower will default, it is possible to make estimates about the default rates of personal loans as a class based on the experience of history, the argument goes.

For example, RateSetter, which started in the UK before opening in Australia to sophisticated and retail investors, conservatively expects defaults of around 2.7 per cent of its loan book in Australia. DirectMoney, which is also open to sophisticated and retail investors, has an estimated loss rate is 2 per cent. SocietyOne, which opened in Australia in 2012 and is available to sophisticated investors only so far, has previously said it expects defaults in the range of 2 per cent to 4 per cent.

Calculating returns

For investors, it’s worth looking closely at the fine print when it comes to returns. Interest can be calculated differently to interest on bonds or term deposits as investors receive their principal back in monthly repayments, rather than locking it all away for a fixed amount of time.

For example, RateSetter’s product disclosure statement says that the interest rate displayed for the one year lending market assumes that monthly payments received are not reinvested, using the case study of a lender who lent $1000 for one year at 6 per cent and received $60 of interest.

But for the three year and five year lending markets, the rate assumes that as monthly payments are received, principal and interest are reinvested at the original rate, the PDS says. Consider the case of Dan, a Eureka Report reader who lent $1000 for three years at 7.8 per cent. The total amount of interest he receives if he chooses not to reinvest payments received is $134.87 over three years – not $234 (i.e. 7.8 per cent of $1000, multiplied by three). After a lender has registered and lent money, they receive a loan schedule that lists the monthly payments expected and specifies the total amount of interest payable. Understandably, the lack of relevant detail in the PDS has vexed some investors. “I would have liked to have seen this information beforehand,” Dan says.

The platform allows automatic reinvestment but the rates available vary over time.

At DirectMoney, lenders can choose to leave funds on the platform and receive interest only, or to receive monthly repayments of principal and interest, with a minimum investment of three years. The company plans to update its PDS, reducing the minimum investment from $50,000 to $10,000. But as an example, founder David Doust says that $1000 invested on an interest only basis will return $75 a year at the current return of 7.5 per cent. $1000 invested for three years at a rate of 7.5 per cent with regular repayments of principal and interest will return $115.63 in total interest over three years, he says.

Provisioning for bad debts

DirectMoney is setting aside around 4 per cent of the money on its platform in a separate trust to cover any future losses on loans, and is continuing to review the level it provisions. Meanwhile, SocietyOne has quoted returns after defaults – in July, the operator said that an investor who had invested in all loans written across its platform since launch would have generated an annualised return of approximately 10 per cent after fees and defaults, although past performance can’t predict the future.

RateSetter has a Provision Fund, a pool funded by a fee for borrowers, designed to compensate lenders in the case of borrower arrears or default. The amount of money in the fund at the moment is about 2.2 times the level of expected defaults. In Australia, RateSetter has outstanding loans of $14.2 million and has not yet had a default, although four loans are more than 30 days in arrears, of which two are hardship cases.

Considering the risk of a recession

It’s all very well to plan for a standard level of personal loan defaults. But many investors are concerned about how far defaults could rise in a recession and how this would affect returns. This is particularly at the forefront of Australian investors’ minds now, with the Reserve Bank forecasting economic growth to remain below trend in the near term and some investment banks and economists even warning of the possibility of a recession.

The lessons of history are interesting. RateSetter has compiled the following graph comparing US GDP growth from 1990 to 2013 with US consumer loan default rates. For most of the period, defaults held between 0.9 per cent and 1.5 per cent. From 2008-2010, default rates were higher, peaking at 2.2 per cent in 2009. In the same year, the US economy contracted 2.8 per cent.

Graph 1: US GDP growth and US consumer loan default rates

Source: The World Bank, RBA Financial Stability Review (March 2013), RateSetter

For prospective investors wondering what level of personal loan defaults past recessions have sparked, these figures are interesting. Asked whether lenders on peer-to-peer platforms could lose their capital during a recession, RateSetter chief executive Daniel Foggo says: “Under whatever model of peer-to-peer lending it’s not like suddenly you’ve got 1000 borrowers and they all default. It’s just that the default rate goes from 2 per cent to 4 per cent, so the worst case scenario should be that people get a lower rate of interest than they expect – or worst case, no interest at all.”

Although the US has experienced a recession within the last decade, Australia has not seen a recession since the early 1990s. Nicholas Gruen, chief executive of Lateral Economics and chairman of the Australian Centre for Social Innovation, says that Australian peer-to-peer lenders might have “good reason” to believe there is limited systematic risk in personal loan portfolios, but they can’t know for certain, as the economy has changed since then. "Even if they have fine grained data about the last recession, which I doubt, they don't know how well that will predict the next recession.”

Stuart Stoyan, a former NAB banker and chief executive of peer-to-peer lender MoneyPlace, which just launched this month and is only open to sophisticated investors so far, points out that a substantial chunk of late loan payments happen because a borrower just forgot. MoneyPlace is planning preventative measures to avoid late payments, including taking regular payments as direct debits from borrowers, sending borrowers text messages to remind them payments are due, and sending follow-up texts saying the platform will try again to debit the money if the first time was unsuccessful. On the question of capital risk in a recession, he says “significant double digit unemployment rates” would be needed before loan impairments caused “significant reductions in capital” for MoneyPlace lenders.

Collections

Peer-to-peer platforms generally split up a lender’s investment across multiple borrowers to reduce the impact if one borrower doesn’t repay. This may leave lenders wondering how they would recover their small portion of a non-performing loan.

Gavin Smith, Allens partner and practice leader in startups and emerging companies, explains that even though this industry uses the language of “lenders” and “borrowers”, the peer-to-peer platforms are the lenders of record as they hold Australian credit licences. This means it is the platforms themselves that are entitled to recover the money after a default, not the individual investors – though they are regularly referred to as “lenders” – on the platform.

“As an individual, I haven’t borrowed money from the ‘lender’ – I’ve borrowed from the platform,” he says.

The platforms have their own debt collection arrangements, often with third party collections agencies.

Conclusion

Glenn Hodgeman, executive director of AltFi, an alternative finance publication, points out that in Australia these platforms are still in their very early days. He says: “The proof in the pudding will come over the next six months to one year, when people will be able to look back and analyse returns and see which platforms are delivering better returns with less risk than the others.”