Peering into Peer to Peer Lending

This is the first of two posts that are going to be long on detail and short on humour,  but the subject matter is important and I don’t think it’s been covered very well for retail investors unless you happen to read the FT on a regular basis.

This year is setting up to be a transformative year for peer-to-peer lending (p2p) – an area of finance that began matching individual lenders and borrowers using the advantages of the internet.

It now has its own body, The Peer-to-Peer Finance Association, which announced at the end of July that UK lending platforms had arranged over £500 million in new loans in the first half of the year. And, after much lobbying from the p2p industry, it became regulated by the FCA on the 1st April.

But the biggest impetus for growth was highlighted by Giles Andrews, Chief Executive of one of the market leaders, Zopa. In a Reuters article he noted, “The peer-to-peer industry is growing faster than ever and we’re looking forward to offering new products like ISAs in the near future”. He was referring to the Spring Budget when it was announced that p2p loans would be eligible investments for ISAs from April next year, although the exact structure has yet to be announced.

Zopa pioneered the model for p2p in 2004 by providing the original platform where personal savers could be matched with personal borrowers. In doing so, by cutting out banks, both savers and borrowers could get better rates. But there is naturally a concern about the risk of default involved in this direct funding model, especially as these are personal loans and they are unsecured (not guaranteed against an asset).

If you are making unsecured loans, your first defence is that you know enough about the borrower and that you are the getting the right rate of interest. But Zopa does more than screen borrowers for their chance of default, it also allows loans to be split between many borrowers to spread risk. And an internet based platform is ideal for bringing all those factors together.

It also means you can tailor pools of loans with different risk profiles for lenders with different appetites for risk. And this was the dominant model until 2010 when a competitor called RateSetter was launched.

It offered simplicity and an additional way to help manage risk to reassure lenders further. It charges borrowers a small fee that together add up to what it calls its Provision Fund to meet the likely costs of default. And since launch that fund has been sufficient to meet any losses.

RateSetter also looks more like a saving site. And now so does Zopa, which since May of last year has its own default protection fund called Safeguard. Again, it has met all its default claims so far. Both companies explicitly state that loans/savings are not covered by the Financial Services Compensation Scheme, but they are doing their best to give you peace of mind with this part of their overall offering.

So what to make of this relatively new and rapidly growing part of the investment landscape?

Well, I first have to state my admiration for those involved in getting these companies to where they are now. There have been some small failures at other companies, but these two are well established, regulated and growing. I should also point out that there are other p2p companies specialising in areas other than retail loans – one called Funding Circle has a successful model lending to smaller businesses.

They are all, no doubt, benefitting from a general desire to move away from banks. But I think that does them a disservice. Their main attractiveness is price and the nature of their service – lenders and borrowers are getting better rates.

And the p2p industry clearly wants to bring this to as broad a market as possible. Hence the innovations by RateSetter to look more savings friendly, which have been mirrored by Zopa. Both their headline returns of just over 5% look enticing, especially if put in an ISA. And the ISA development is important, because outside of an ISA tax is charged on the interest earned and default losses, if there are any, aren’t deductible from those earnings.

But, as ever, there are several important things to consider. Some are to do with risk and some to do with how the market develops.

Clearly the main point is that funds are not covered by the Financial Services Compensation Scheme, but I’ll cover the other substantial points in my next blog. And it’ll be a bit different to the marketing information found on the p2p company websites.

In finance we love growth, but if you see one of these growing in your garden don't smoke it.
In finance we love growth, but if you see one of these growing in your garden don’t smoke it.

All this talk of rapid growth is reminding me that I need to remove a rather large weed from outside our bedroom window that my wife and I thought we’d let develop as we’d never seen anything like it before. It turns out to be a plant called Jameson weed or ‘datura strarmonium’ to give it its proper name. Apparently, it is a powerful hallucinogen and deliriant. And I thought our chickens that share the same area were just getting paranoid.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

Are CoCos Nuts?

I was going to write about peer-to-peer loans this week, but instead I am going to concentrate on another new type of investment that offers high headline rates of interest.  They are known as CoCos and this week the Financial Conduct Authority used a new tool in its armoury to effectively ban their sale to retail investors.

Any resemblance between myself and this coconut is purely coincidental.
Any resemblance between myself and this coconut is purely coincidental.

The ban states that contingent convertible instruments, to give CoCos their full name, are ‘risky and highly complex instruments’. And indeed they are and I certainly welcome this pre-emptive ban. If a product can’t reasonably be understood by a private retail investor or, frankly, those advising them then clearly trading in it should be restricted to those with far more experience.

But I thought I’d give you a bit of insight into what they are and why they exist. And it’s not a story about financial recklessness, quite the opposite. They are a tool intended to aid financial stability – although with billions now in existence, that has yet to be tested.

One of the great realisations of the recent crisis was that some financial institutions were ‘too big to fail’. In other words, they had become so large and so complex that if they became troubled, that trouble would quickly spread to other financial institutions and threaten the whole financial system. I have written in previous blogs about a ‘network effect’ and this made the financial sector especially vulnerable.

And the poster child of this problem was an investment bank called Lehman Bros. When it failed in 2008 it set off waves of destructive ripples through the balance sheets of other financial institutions that were more severe than regulators in the States or elsewhere expected.

They had hoped that through a process known as ‘resolution’, the bankruptcy of Lehman could actually be orderly and give confidence to the rest of the market. And it’s true to say with other failing banks this did work, such as Washington Mutual. But with Lehman, which had a large and highly leveraged international operation, it patently did not.

And that realisation meant that regulators around the world knew that, given the resolution process was so inadequate, that they would have to keep their major financial institutions alive – even if that meant providing them with vast tax payer funded loans.

Now you don’t need me to tell you how unpopular those bailouts were and remain. And institutions, such as the Bank of England have been looking at ways ever since to improve that process of resolution so that if a bank gets into trouble it can be resolved in a more orderly fashion – and without resorting to the national purse.

To do that it wants to insure that, not only do banks have sufficient capital as a buffer against losses, but also that those who provide that capital via loans (bonds) and equity (shares) know that if that buffer gets depleted they are first in line to meet those losses – not depositors, not those who have lent the bank money that is secured against an asset for example and not tax payers.

So how do CoCos make this process more orderly? Well, the buffer I mentioned above is officially known as Tier 1 capital and a loan to a bank that helps meet this buffer has very little protection in the event that a bank needs to use the loan to meet losses.

What then normally happens is that there is a long drawn out process where the lenders meet with the bank to see how much of their money they will get back and only when it becomes clear it will be very little will lenders reluctantly accept shares in the bank as compensation for losing the value of their loans – known as a debt for equity swap.

Now, long drawn out processes are not good for market confidence or stability. Investors like certainty and this is why the Bank of England has championed the development of CoCos, because they have this whole process already built in.

If you own a CoCo loan with a bank, you already know that if the Tier 1 capital is threatened your loan will be converted to shares in the bank. The Lloyds Bank CoCos convert if the Tier 1 capital falls to 5%. And from the Bank of England’s perspective, they have control over this simplified process as they are responsible for announcing the conversion has been triggered.

It also ensures that at exactly the time that a troubled bank needs the benefit of swapping a loan for shares it is able to do so. You could call it repayment insurance for the original loan.

One of the proponents for these types of convertible loans or bonds is Andrew Haldane, the Executive Director for Financial Stablility at the Bank of England. He laid out the case for their use in banking and other areas in a speech titled ‘Debt Hangover’ in 2010.

I got to hear him speak on the more recent topic of ‘This Market’s Nut’s’ at Camp Alphaville, which I mentioned in my last blog. He was one of several speakers on the topic and it was not his choice of title, but there was clearly awareness that all this liquidity central banks have created, coupled with a low interest rate environment have led to a chase for high interest rate investments – whatever the risk profile.

And I suspect this is also in part where this ban has come from. Not only do the Bank of England and the FCA want to avoid poorly informed investors holding such products at this time, but if the Bank of England ever pulls the conversion trigger on one of these loans they do not want to be dealing with a bunch of retail investors claiming they never understood the risks.

Far better to be dealing with experienced investors, used to valuing other complicated hybrid investments such as convertible bonds – my own specialist area for several years.

And even where investments are allowed it’s important to know their limitations or know someone who does. And this whole series of blogs is designed to help you do that. It’s so easy to get over confident as I have mentioned before.

My wife and I still have the emotional scars from the time, given a background in art, I offered to apply her makeup for her. I was hoping for the subtle look of Coco Chanel, but she got the more distinct appearance of Coco the Clown. The pictures are here.

But that’s enough cocos for one day!

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing