I was recently interviewed by Joshua Sheats for the Radical Personal Finance podcast. Josh is a CFP with a solid understanding of general finance (and incredibly personable to boot). He is also very cautious towards peer to peer lending, and this becomes quickly apparent if you listen to the interview. The phrase he kept repeating was, “It will be interesting to see what happens” or “I’m looking forward to how this pans out.”
Lending Club and Prosper’s Thin Historical Performance
The fact is, Josh is voicing a very typical concern for the average American investor. Despite Lending Club and Prosper having years of positive returns, consistent growth, and celebratory coverage in major press, the general picture just does not leave him convinced. His solution to this critique is to give peer to peer lending more time. This current success needs to continue for decades before Josh would seriously consider jumping in with both feet.
Here’s a chart that demonstrates where Josh is coming from:
Despite record-breaking success month-over-month, just a tenth of the loans these platforms have issued have hit maturity. Overall, the dataset is very young and incomplete. In a certain light, peer to peer lending is indeed an unproven investment.
A good solution of this problem is, like Josh said, to simply give it more time. Ten years from now, all of these hundreds of thousands of 3-year and 5-year loans we’re issuing today will have been paid back or defaulted, so we will then be in a better place to judge this investment’s worth.
But peer to peer lending is not a new investment
Unfortunately, what many investors do not realize is how peer to peer lending is not actually that new or unfamiliar to American finance. It is actually part of a very proven asset class called prime consumer credit. And while Lending Club and Prosper have a very young dataset between them, consumer credit has decades of open data we can examine, specifically the money that major banks have made off credit cards.
Credit cards are the same kind of investment as a peer to peer loan, something that people like Brendan Ross have been touting for years. Both are simply a line of credit given to creditworthy individual Americans. Both are part of the ‘consumer credit’ asset class. And if we examine the historical performance of credit cards, we get a picture for how peer to peer lending may perform in the coming decades.
Why Banks Stuff Your Mailbox with Credit Card Offers
We can examine credit card performance via the Federal Reserve website. Since the government requires the issuers to publicly state the interest and default rates of their credit cards, we can download the data and figure out the return the banks have been earning. What does it show? For decades the banks have earned scads of money by issuing these lines of credit:
See the wide spread between the blue and red line? That, my friends, is the lucrative yield that the banks earned by lending money to responsible individuals.
Of course, this picture does not show the operating expenses of these issuers (how much they had to spend hunting down prospects, getting them approved, manufacturing and sending out the little plastic cards, servicing their accounts, and collecting bad debts), but the spread is nevertheless an incredible thing to look at.
Peer to peer lending allows us to join the party
For the first time in history, the internet has allowed average people to partake in this incredible asset class.
“This is the first time in history that non-bank investors can get access to unsecured consumer-credit products.” Aaron Vermut, CEO of Prosper (The Economist)
This is why peer to peer lending is amazing. Yes, this investment is socially responsible for the way it is getting people out of debt; and yes, the way it operates through low-cost cutting-edge technology is remarkable. However, the reason peer to peer lending really shines against traditional investments is for how it allows us access to the awesome asset class of consumer credit. This is what makes it a big deal. This is what gives it such great and consistent returns year after year.
The Lost Decade: Stock Market Investing in the 2000s
To really hammer this point home, here’s a chart that shows the amount investors earned per year on the Dow Jones Industrial Average (DJIA), which is an index that many look to as a representation of the stock market as a whole:
The first thing to notice is how wild and jagged this line is. Some years it rose 20%, other years it dropped 10%. This is the volatility of the DJIA. Overall though, it is worth noting how it has garnered investors a great 10% return since 1975.
The ugly importance of timing the market
What sours this return is the yellow area, which is the ten-year span of 2000-2010. During this period, the stock market returned about 0.5% to investors, which many now refer to as a lost decade (Wall Street Journal). If you were a fresh graduate from college in 2000, and you jumped headfirst into those higher-risk retirement plans they set aside for new investors, you likely had a pretty rough opinion of stock market investing by the time 2010 rolled around. Yes, the market has earned investors 12% per year since then, but if we include the 2000s, this average drops to just 4% per year.
In stock market investing, timing matters a great deal.
The point I’m trying to make here is that in stock market investing, timing matters a great deal. If you were a new investor in the 1990s, you’re probably pretty happy with 16% returns per year. But if you were a new investor in the 2000s, you took on a lot of risk and earned nothing at all. People starting to save for retirement for the first time in their lives often get anxious trying to figure out how the next 10 years will perform. Yes, the market has historically returned 10% per year, but tell that to college grads of 2000.
Furthermore, many of the newly hired are required to figure this stuff out. Many of my friends in their 20s and 30s have to self-start their retirement accounts because their employer no longer offers pension options. And when they look at volatile charts like the DJIA 40-year above, they feel nervous about how to begin.
Prime Consumer Credit Has No Lost Decade
Heck, it doesn’t even have a lost year if we focus on credit cards. Here is the net return the banks earned on issuing credit to people for the past twenty years (interest rates minus default rates):
Consumer credit has at least twenty straight years of positive returns. It probably has many more decades, but the Federal Reserve only provides figures going back to 1994. Long charts show the interest rates remaining healthy for forty or fifty years running.
At no point in recent history have banks lost money on credit cards.
The best part of the above chart is how the blue line never touches the bottom. At no point in recent history have banks lost money on credit cards. Even in the ugly economic environment of 2008 the banks likely earned 2-3%, which is strikingly similar to what Lending Club returned their investors. This is even more amazing when compared to the stock market. In 2008 the DJIA lost investors a staggering 33%, and has on average crossed into negative returns every fourth year since 1975.
When it comes to my own personal retirement, I have to put it in the hands of the most trustworthy investment I can find. If I do this wrong, I have to remain employed into my eighties. With that fact in mind, I just don’t feel comfortable centering my investment on the stock market.
Consumer Credit is an Awesome Investment
What I do feel comfortable with is entrusting my cash to responsible American individuals, which is the foundation of peer to peer lending. As the charts above show, people with good credit are easily one of the most stable and rewarding investments available. The problem is, like Joshua Sheats communicated, that most people see lending money online to total strangers as something highly risky and speculative.
But peer to peer lending is not highly speculative. Yes, there are definite risks to consider like platform bankruptcy and regulatory burdens, but at the end of the day it is a way of investing that our nation has actually practiced for decades, and with great results — it is just unfamiliar because it’s been the privilege of major banks.
The question I would ask the new American investor is this: do you want a rocky investment that may earn you 10% per year, but has a history of losing entire decades? Or do you want a simple and stable investment that still offers historical returns of 7% per year, and has never had a down year?