In late 2007, a panic struck the the United States. Mortgage-backed securities, which had become a popular investment in the financial sector, had begun to collapse in value. Many of the subprime borrowers who had received these loans began to stop making payments, and as they did so, the financial world began to teeter on edge.
Things came to a head in September of 2008 with the fall of Lehman Brothers, the fourth largest investment bank in the United States. This company had existed since 1850, back when people traveled by horses instead of cars, so you can imagine the shift that was happening to the country at this time.
The nation fell into an historic recession, a Great Recession that lasted until the middle of 2009 according to the National Bureau of Economic Research (NBER). Everybody nationwide experienced significant loss (Wikipedia):
- Around 15 million Americans lost their jobs as the unemployment rate soared to more than 10%.
- The net worth of households in the country fell by 22%, loosely meaning: Americans lost about a fifth of all they had.
- Retirement funds in the stock market lost 57% of their value in 6 months.
Because of this fallout, people everywhere began to struggle in their financial commitments. With 15 million people out of work, every kind of loan was negatively impacted, from home loans to credit cards:
How might peer to peer lending perform during a recession?
Perhaps this memory is still fresh in your mind. You might wonder how peer to peer lending might perform during a similar national downturn in the economy. Actually, this is one of the most common questions we grapple with in peer to peer lending. How might a loan issued by Lending Club or Prosper perform during a recession?
The Impact of Unemployment on Consumer Credit
To begin to answer that question, we can look at a mature credit industry that did experience both of these recessions: credit cards. Both p2p loans and credit cards are a similar investment: unsecured lines of consumer credit. And if we take the unemployment rate provided by the US Bureau of Labor Statistics and stack it against the return that banks earned on credit cards (interest rates minus default rates provided by the Federal Reserve), an informative picture begins to form:
As the nation experiences a recession, the national unemployment rate begins to rise. Then, as people lose their income streams, they also lose their ability to pay their debts. So you can watch the overall return of consumer credit fall during a recession.
As an aside, it’s amazing to note that banks still did not lose money on credit cards during the 2008 recession. The stock market fell 57% in six months, yet major banks kept earning and earning. Related: This Investment has 20 Years of Positive Returns
During a Recession, Credit Card Returns Can Drop 20%
Let’s take a closer look at this data by shaping the credit card return into a rolling three-year average, a figure that more corresponds to the term of a p2p loan.
What we see is the average return of 8.8% steadily dropping after each recession:
- After the 2000 recession, avg. credit card returns fell 20% to an ROI of 7%
- After the 2008 recession, avg. credit card returns fell 40% to an ROI of 5.2%
In short, investors never lost money on credit cards, even during the 2008 recession, the worst economic catastrophe since the Great Depression. But returns did steeply dive by 20-40%, depending on the severity of the unemployment rate.
If this is equally felt in peer to peer lending, it could mean:
- A more typical recession may also drop a peer lending return by 20% – say from 6% to 4-5%.
- A more serious recession may also drop a peer lending return by 40% – say from 6% to 3-4%.
Of course, these losses will be easier if investors hold more A-grade loans, and more ugly if investors hold more E-grade loans.
Lending Club During the 2008 Recession
Interestingly, Lending Club was actually issuing loans during this entire recession (Prosper, less so). And while the industry was immature and their credit model somewhat untested, the data is still interesting to look at. Here are all the loans Lending Club issued during this recession (dates via NBER, loan data via NSR):
Peer to peer lending gave investors a positive return during the 2008 recession.
Similar to credit cards, peer to peer lending gave investors a positive return during the 2008 recession, particularly with the help of safer A-grade loans. These loans were issued to safer borrowers with better credit history and employment, and thus were less impacted by the unemployment. On the other hand, riskier D-G grades earned investors an overall negative return of -0.8%.
In contrast to peer to peer lending’s positive return, the S&P 500 lost a third of its value during this same period:
Thus we arrive at the popular 2-part consensus in peer to peer lending: that (1) returns will drop during a recession because of unemployment, but (2) that investors should also earn a positive return. Of course, there is no guarantee this will actually happen, but I think it remains a likely prediction. Further, I think the next recession will be significantly less ugly to p2p returns than before since Lending Club and Prosper’s 2008 credit model was so new and untested.
How a Recession Affects P2P Loan Grades
Let’s finish this by taking the loan grade window and expanding it until today. Unfortunately, the first year where we have enough loans per grade to analyze is actually 2009, but it still gives us a pretty decent look into loan grade performance during a recession.
Here is how every Lending Club grade performed over the past seven years:
The 2008 recession continued until July 2009, so I would suggest that Lending Club’s returns during this period are a decent window into typical recession performance. By comparison, 2011-2015 represent performance during more healthy economic cycles.
When unemployment rises, the grades reverse to read ABCDE.
What we see is this: during a healthy economic environment the best performing grades are the alphabet in reverse — EDCBA. But when unemployment rises, the grades reverse to read ABCDE. During recessions, the riskier loan grades earn the worst return. During healthier economic times, the riskier loan grades earn the greatest return.
Additionally, I find the All loan data at the bottom very interesting. Though the return is a full point higher than A-graded loans, the spread (worst year vs. best year) is almost the same. This shows the benefits of diversifying across loan grades, treating them like subgrades of stocks (small cap, medium cap, etc). The grade-diversification potentially gives an increased return without much of an increase in risk.
How much loss can you tolerate?
In conclusion, it is impossible to perfectly predict how peer to peer lending will perform during a recession. Perhaps returns will drop 1-3% like credit cards. We honestly don’t know. What we can say with a fair amount of certainty is that safer loans will be less impacted.
The question you should be asking yourself is this: How much loss can I tolerate? Am I willing to invest in peer to peer lending if the 6% average return drops by 20-40% and I only earn 4% over three years? See: Risk Tolerance 101
Prepare by Selecting Your Ideal Mix of Loan Grades
One way to adjust this question is to not just pick up every loan grade at Lending Club or Prosper, but to lean into the correct grades for your personal situation. If you’re a retiree simply wanting to outpace inflation, sticking with A-graded loans should keep your investment more predictable and your nest egg more protected. For all the completed loans we have, the difference between A-grades best year vs. their worst year is just 1.2%, a pretty manageable swing.
In contrast, the swing of E-G graded loans can be much wider. In 2009 these risky loans gave investors just 2.7%, while 2011 gave their investors a 9.4% return, a spread of almost 7%. And this difference could be even bigger during some future recession. You really should invest in riskier rated loans if you have a long time horizon, meaning you have more time to bounce back should you earn a poor return during recessions.
Riskier loan grades are best as a long-term investment
It is my belief that future recessions will also deliver paltry (or even negative) returns to investors in riskier C-E graded loans. But averaged over a century, these grades should reward investors with the highest average return. If you have many decades of time to put your investment to work, the riskiest graded loans seem an awesome investment to make cash grow.