P2P lending company Lending Club was in the news lately. After the discovery of some internal control problems, its CEO resigned. Some institutional investors stopped or slowed down buying its loans, which reduced Lending Club’s funding for new loans. Lending Club announced a layoff of 12% of its workforce.
The case for investing in P2P loans is that of a loan shark. Borrowers pay high interest rates; after the company takes a cut, you get the rest of the interest. The borrowers for one reason or another (a) can’t get a loan from elsewhere; or (b) can’t get a loan as quickly or as easily from elsewhere; or (c) can’t get a loan at a lower rate from elsewhere. Because of their dire strait, the interest rate they pay when they get a loan from a P2P lending company is quite high, as high as 15%, 20% or more.
You justify profiting from the borrowers’ misfortune by saying the interest rates they must pay elsewhere are even higher. So you are actually helping them when they borrow from P2P lending to pay off the higher-interest loans they currently have.
P2P lending grew fast, but it’s still relatively small in overall consumer lending, even among the borrower population who must pay high rates. For each person borrowing from P2P companies, probably 10 or more people are borrowing from other places, paying higher interest rates. Here’s a question:
If you see investing in P2P lending as attractive, why not invest in those other companies who have more borrowers paying even higher interest rates?
As a part owner of these other companies, you get 100% of the net profit from the higher interest rates paid, after the cost of doing business, default, collection, and recovery.
What are those other companies?
Credit Card Issuers
Banks issue credit cards. Many people carry a balance, at very high interest rates. Bank of America, Chase, Citi, American Express, Capital One, Discover, and Wells Fargo all have large credit card portfolios with billions in outstanding balances. These are all very large publicly traded companies. As an owner, you benefit from the interest paid on the credit card balances carried at high interest rates.
Some of these banks have substantial other operations besides credit cards. You would be buying into those other operations as well if you own them. Among the companies mentioned above, American Express, Capital One, and Discover have more of their business in credit cards.
Consumer Finance Companies
If American Express, Capital One, and Discover aren’t pure enough in lending to consumers at high interest rates, there are also other companies that specialize in consumer finance.
Synchrony Financial (SYF) offers credit through retail stores, doctor/dentist offices and so on.
OneMain Holdings (OMF), through its Springleaf and OneMain brands, offer personal loans and auto loans.
Credit Acceptance Corporation (CACC) offers auto loans through car dealerships to consumers with poor credit. Interest rates are high and the loans are secured with the threat of a repo.
Santander Consumer USA Holdings (SC) offers auto loans to subprime borrowers. The interest rate can be 17% APR or higher.
SLM Corporation (SLM), also known as Sallie Mae, offers private student loans. Interest rates aren’t as high as those on credit cards but these loans are very hard to default on.
All these companies are worth at least $1 billion. There must be other smaller players as well.
Equity vs Fixed Income
Some may say buying the stock of these companies is investing in equity and P2P lending is investing in fixed income. Other than having the cost of marketing and underwriting rolled up and expressed as a percentage of the loan, I don’t see a fundamental difference between lending to consumers through credit cards or subprime auto loans and lending to consumers through P2P. In each case, the profit drivers are interest rates and default. If you are able to maximize the gap between interest rates and default, you win.
Already In Index Funds
Astute readers would realize all these companies lending to consumers at high interest rates are already in index funds. Through a total market index fund you already own a small piece in each. You are already profiting from the misery of consumers paying 12% on their auto loans, 19% on their credit card balances, or 25% on personal unsecured loans. The question now is whether you should invest more in this part of the market.
Is this part of the market more attractive than other parts? What do you know that makes you think yes or no? Just the high interest rates aren’t enough. You must also properly account for risk. If the economy turns bad and borrowers lose their jobs, default will jump higher.
Why then do you see a lot of talk about investing in P2P lending? Remember picks and shovels. Allegedly during the Gold Rush era those who sold picks and shovels to gold miners made more money than the gold miners themselves. The same is true here. It’s more profitable to help others invest in P2P lending than investing in P2P lending themselves.
[Photo credit: Flickr user doug solomon]
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Alex C. says
I have substantial (for me) investment in Prosper.
I agree, that as a investor(lender) at Prosper I am basically in the same business as a credit card company. Making small unsecured loans to individuals with a wide range of creditworthiness and situations.
Here’s why I strongly prefer it, and see it as different, not necessarily listed in order of importance:
# I have more control over who I lend to.
# My money is not going to some board members or CEOs of a financial institution that played dice with our economy (and still are doing so) and wrecked it and walked away with huge bonuses.
# I, for about 2.5 years, have been earning about 11% consistently (mix of low and higher risk loans) …. I doubt I could get that by buying shares of some of the companies you suggest.
# I like that I am participating in a small way in taking customers away from the traditional credit card companies and banks. (I dislike the traditional VISA/mastercard model for the same reasons that I admire its cleverness. That is they (traditional credit card lenders) have EVERYONE by the balls, as follows: They have most cardholders by the balls by charging massive interest and sneaky ways to get more(lowering and encouraging minimum payments, offering Christmas “skip a payment”, etc.) They have the merchant by the balls taking significant margin off his/her sales. And they even have the person who pays cash by the balls because the merchant’s prices to cash buyers reflects adjustments for what the merchant loses selling to credit card buyers.
# I can at anytime change if I want my payments and interest reinvested or paid out to me, or any mix of reinvest and payout.
# I’m not paying stock purchase and sales commissions.
# The principle value of what I have in there is not subject to what other investors think. That is, for example, no one can reduce the value of my notes by “shorting Prosper stock.”
# I have talked to many employees at Prosper and am convinced they are sincere about what they’re doing and competent.
# My personal opinion is that I am at relatively low risk for an 11% yielding investment.
Alex C. says
Additional comment re risk:
Yes, of course if economy turns more sour again, defaults will increase, even slightly so among the AA (lowest risk) borrowers I have loaned to.
In my portfolio at this point a huge and unrealistic percent of my borrowers would have to default for me to actually lose money.
Here’s two other factors suggesting risk in a diversified loan mix at peer-to-peer is not very high:
# Since 2009 (after prosper cleaned house and got their act together on better rating the credit worthiness of borrowers) no investor with more than 250 loans has ever lost money.
# Take a look at what happened to credit card companies and the other entities suggested as alternatives during the 2008 meltdown.
They DID suffer increased defaults. But AFAIK none of them LOST money…..just made less profit than they had previously and less than expected.
That said… no one honest and clear thinking can say Prosper or any 11% investment is risk free.
Dividend Growth Investor says
One reason why some investors invest in P2P loans in the first place, is because a lot of large profile well followed bloggers are incentivized to refer people to invest. It puzzles me that people who claim to be indexers, because supposedly they do not know anything, end up “investing” in something as risky as P2P loans.
There was one blogger, who reinvested maturing CD’s into P2P loans. Of course, he probably made enough money off referral fees to justify this move.
Many of those who have invested in P2P loans have only done that during a time when the general economy was expanding. But if we had a recession, the results on unsecured loans would not be very good.
Back when I started my journey in 2007 – 2008, plenty of sites were talking about P2P lending. I know that the subsequent results were atrocious for many of those who were reviewing them favorably, as we had the financial crisis soon thereafter. I am simply not confident that the collections process was as robust as it should have been.
But to answer your question, I view P2P loans in a similar manner to High Yield Bonds. However, I would much rather own a long-term CD yielding 2.50% for my fixed income allocation than P2P or a HY bond. This is because I prefer to take my “risk” by investing in equities, but keep the fixed income portion risk free ( CD’s, Treasury Bonds, Agency Bonds etc)
Sam Seattle says
What are the examples of the ‘picks and shovels’ in P2P lending?
Harry Sit says
Many, but I’m not going to name them publicly. I don’t want them to get mad at me.
Eric says
@Sam Seattle,
Presumably the middle-men: companies that offer P2P like prosper; debt collectors, bloggers who ‘inform’ others; and advertising platforms are a few that come immediately to mind.
To continue Harry’s analogy and reading between the lines of his blog, picks and shovels are agnostic to whether they are used to mine gold, fool’s gold, or just good old dirt.
Duncan says
I don’t quite buy in to the argument that investing in P2P loans is equivalent to an equity investment in a credit card company. That makes as much sense as saying investing in Etrade is equivalent to investing in an index fund since you buy it through Etrade. Investing in the loan vs investing in the servicer are two different businesses, and two different things.
I’m in LC, not Prosper and have been pleased for a long time. Benefits I like are…
– you can build a portfolio >250 (as you mention) quickly. That is the real secret to the lending business.
– you can choose your risk level. If you don’t trust the risk ratings, you can dig deeper and experiment with specific criteria of all sorts.
The income has been steady and strong and I’ll continue.
Now one true equivalent you did not mention is the comparison with CDs… Banks fund loans with time deposits, at a high spread. P2P lets you get in the game with more control (not always a positive, I concede) and a much narrower spread. You mentioned a 3%, 3 yr CD you went for… I think you should have compared that to a basket of 3 yr A-quality loans through P2P. With a wide enough portfolio, the risk would be equivalent, but your returns would be at least double after defaults.
Harry Sit says
The credit card companies and subprime personal loan and auto loan lenders are not just servicers. They lend to those borrowers and they directly profit from the high interest the borrowers pay. They are the game. By becoming a part owner, you are now part of the game. By comparison E*Trade only gets a commission when you buy a stock. It doesn’t get any profit from the underlying company.
Alex says
IMPORTANT SUPPLEMENT TO DISCUSSION ABOUT SELLING PROSPER NOTES ON FOLIO:
Got this in an email from Prosper…
“””as of October 27, 2016, Prosper will no longer offer the Folio Investing Note Trader platform, the secondary market for Prosper Notes. Prosper has found over time that very few investors are using the secondary market and, as such, has made the decision to no longer offer this service….”
This is significant, as it move a Prosper investment from a category I loosely call “semi-liquid” to rather un-liquid. AFAIK the only way to get one’s cash out of Prosper after October 27 would be to wait for all the notes to mature. Worst case it could be 5 years before my last dollar came out.
Doesn’t mean I won’t invest in Prosper, but does mean I’ll invest less….knowing that it would be harder to get my cash out than most any investment I can offhand think of.
Even a piece of bare land can be sold relatively quickly if you’re willing to take a loss.
Can anyone think of any way to liquidate a Prosper account quicker than wait-for-all-notes-to-mature? Could one sell their whole account, or control/access to it, with a legal contract?
anonymous says
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