Peer to Peer Lending Risks

While sites like LendingMemo are often aglow with the benefits offered by peer to peer lending, we also need to be honest that there are real risks as well. In this whiteboard video, we examine all the risks at once, focusing on the major risk of experiencing excess borrower defaults.

Video Transcription

Even though peer to peer lending offers us a bunch of really great reasons to get involved, such as lucrative consistent returns, we need to remember that there are some real risks involved in this asset class. People have lost money in peer to peer lending. So let’s kind of look at the major risks today.

Risk #1: Borrowers Defaulting on their Loans

The biggest one is excess borrower defaults. Now we need to remember that these are unsecured loans. They are not secured by anything like a house or car or some sort of collateral, so as a result borrowers don’t have a ton of incentive to definitely pay their loans back. Now, most of them will, but a portion of them won’t, and we need to kind of bake that into our overall investment strategy.

When people run into problems and have an overall negative experience in peer to peer lending, it usually has to do with the fact that they are not diversified, poor diversification. So, for instance, let’s say you have $10,000 you want to invest on Lending Club or Prosper’s platform, and you put $1000 in ten people. Let’s say one of those people defaults, you have lost 10% of your investment. That is a poorly diversified account.

On the other hand, let’s say you invest in two hundred loans. If one person defaults, you have only lost a half of a percent of your investment, and you can recover from that fairly easily. This is the main reason, the most common reason why people have a negative experience in peer to peer lending, both on Lending Club and Prosper by far, and that is: not diversifying their account. So this is the biggest risk, and we need to be aware of that.

Risk #2: Poor Underwriting by Platforms

Some of the other risks that are involved in this whole thing are poor underwriting by platforms and poor national factors like unemployment, and these can also cause an excess of borrower defaults as well. So, for instance, we are really dependent on these platforms to underwrite these notes, which basically means looking at each of the borrowers one by one, and giving them approval to even be on the platform and get a loan at all. As much as that, we’re also really dependent on the national picture to be somewhat stable.

So, what could happen here? And these are both pretty unlikely, but let’s just play around with this idea.

It is possible that, let’s say, the platforms would start to really poorly underwrite their loans, meaning they would allow a whole bunch of investors, I mean borrowers, to get loans who really should not have them. Then all of a sudden the default rates for all of us are going to go up. Similar to unemployment, let’s say unemployment balloons up to 20 or 25% nationally, which is just unheard of, but it’s possible I guess. If that would happen, we would definitely have a large amount of defaults in our peer to peer loans. That said, these are both really unlikely. We have been watching the default rates for both Lending Club and Prosper over the last couple years, and they are both getting better and better over time.

So the main risk involved with having a negative experience has to do with poor diversification by investors. So if I can make one request for those of you out there who are just getting started: diversify your account in 200 loans.

Now this threshold right here of two hundred is kind of a little bit up for debate. Now, I definitely believe two hundred is a pretty solid number, but some people would argue that you need more than that, and some people would even argue that it is even OK to have a few less than that. So, for instance, Prosper said that for anybody who is invested in loans since 2009 and has 100 [loans] or more, no one has lost money. And Lending Club makes the same claim for 800 notes or more for their entire history. So you can kind of see some diversity there as well. But I think 200 is a solid place to be.

We need to remember that these are $25 notes that we can invest in, that is the smallest portion of every note that you can purchase. So 200 notes at $25 each would mean a minimum investment of $5000 is needed to have a fully diversified peer to peer lending account to avoid the greatest risk that is here, which is this idea of excess borrower defaults. So diversify your account, and you will be alright.

Risk #3: Platform Bankruptcy

That said, there are some other risks involved in this whole asset class. Platform bankruptcy is a possibility. Both Lending Club and Prosper have backup servicers in place. What this would mean is that if either one of them would go bankrupt, there seems to be some sort of setup where lenders would still receive payments from borrowers over time. And Prosper has even gone the extra mile and created this thing called a bankruptcy remote vehicle. And what that would do is that, in the case of Prosper going bankrupt, actually that portion of the company would sort of separate off, and so it would be untouchable by litigation or trying to settle debts.

That said, there is no proof that any of these things actually work, like backup servicers or remote vehicles or anything, because there has never been a bankruptcy of a platform. So as a result, we do not really know what would happen if Lending Club or Prosper would go bankrupt, so we need to make sure that we only have maybe 10 or 15% of our overall investment in peer to peer lending. That said, I think we can feel safe about Lending Club and Prosper. Lending Club actually went cash flow positive (meaning they are no longer losing money to their investors) in late 2012, and Prosper looks to be hitting profitability this year as well. So a platform going bankrupt is pretty unlikely, but it is still something we need to be aware of.

Risk #4: Interest Rates May Rise

Also, interest rates may rise. Now, this is kind of an interesting one, because it is a situation that no one has ever encountered before, but it is still a possibility, and so we do not know exactly what would happen. So imagine if national interest rates would rise, and all of a sudden a savings account would give somebody like 5% returns like it did in the ’80s. What would that do to the investors who are looking for maybe a 5-6% return in peer to peer lending, when they have an option have a 5-6% return in their savings account, which is federally insured and they are definitely not going to lose money on their savings account unless, you know, national catastrophe happens or anything like that.

So as a result, we don’t really know what would happen, how peer to peer lending would change if savings accounts all of a sudden earned 5%, if interest rates rise, we do not know what will happen. But that said, I think we will be alright. I mean, we need to remember that the average interest rate on these loans is something like 14%, and the average return is around 8%, so if that is the case, it would be really rare for savings accounts to rise up and all of a sudden give 6-8% returns to people. It is possible, but it is unlikely. And that said, I think the asset class as a whole would still adjust pretty well.

Risk #5: Something Unforeseen like Regulation

Finally, we need to remember that there are unforeseen circumstances that could hit this whole thing. Now, regulations are probably the most likely of these, but there is also things like electronic hacking and fires, water damage, earthquakes, terrorist attacks and these sort of things. But new regulations are probably, I would say, out of all the things that we are totally unaware of, new regulations are the thing that is most possible.

What does that mean? Peer to peer lending has never existed before. So it is possible that, as the U.S. government starts to interact with this thing for the first time, there might be some sort of regulations that could change the game and affect our overall investment. So it is a risk we need to be aware of.

That said, those are the majority of the risks, the biggest one being excess borrower defaults, particularly through (let me put it again here, big arrow) poor diversification by the investors, the possibility of the platforms doing poor underwriting, the possibility of national factors like unemployment rising so that borrowers no longer have as much of an ability to pay their loans back, the possibility of a platform going bankrupt, the possibility of interest rates rising and kind of affecting this whole investment class, and finally something unforeseen, some catastrophe like a breech in data or a corporate scandal or something like that.

Those are the overall risks involved in peer to peer lending. The question is, “Well, OK, we know the general mechanism of what peer to peer lending is, and we know the benefits and the risks, so what are the different approaches that we can take as investors towards this investment?” Somebody who has a lot of money and needs to have very low risk involved, is going to have a much different strategy and approach towards peer to peer lending as somebody who is younger and maybe has less money to invest.

So there are different ways to be investing in this asset class, so that is what we are going to look at in the next video, the different approaches to be an investor in peer to peer lending.