39 Fen End Lane.
Spalding, Lincs. PE12 6AD.
I apologise again for the length of these last two posts, but these will soon be eligible ISA investments and advice is unregulated at present. In due course, I’ll produce a more comprehensive guide – if you are interested just email me.
I mentioned in my last blog that I certainly have admiration for those who are responsible for getting the peer-to-peer (p2p) industry in the UK to where it is today. Over £500 million in loans were matched in the first half of this year and it is now regulated by the Financial Conduct Authority.
And there are plans to make p2p loans allowable investments for ISAs from April of next year. The latest consultation, containing 24 questions, was announced by the Treasury on Friday and the delay in this post is in part due to waiting for its release.
Much of this nascent industry’s growth is put down to its positive image as an alternative to traditional banking. And while that may be a real cause-celebre for a lot of lenders and borrowers matched in this way, they are also benefitting from a rather fundamental thing – price. Borrowers are paying less interest and lenders are receiving more.
But, lenders are also taking on two significant types of risk, credit risk and liquidity risk. Depositors in a bank may earn less for similar time frames and there may be certain access restrictions, but within the FSCS limit of £85,000 they know they are getting their money back.
Both of the leading p2p companies, Zopa and RateSetter, look to mitigate credit risk, the risk that borrowers default on their loans, by offering protection funds. These are pools of money, funded by fees paid by borrowers that aim to meet in full the costs of expected defaults according to each company’s own risk models.
And to date they have. Both Zopa’s Safeguard Fund and RateSetter’s Provision Fund have 100% records – in other words, all default losses to date have been met by the capital buffers in their respective funds. Zopa has even lowered the level of contributions as its overall rates of default have been so low – it claims to have the lowest default rate, including the high street banks, although I do not know if they are strictly comparing like for like.
I mentioned in my last blog what they’ve got right, but what could go wrong?
Well the main concern has to be that these products and their protection funds have only been operating over a short time frame economically – RateSetter was established in 2010 and although Zopa is several years older, it’s Safeguard Fund is only a year old. The corresponding period also happens to have been one of the most benign environments for consumer lending.
And there is a danger that in such an environment confidence in their own credit risk models becomes self-reinforcing. Rather than creating a larger loss buffer that might work better over a full economic cycle, it could be they are set at a level that suggests near term default rates are the best indicator of future ones.
At present, it looks as though Zopa’s buffer is set about 1.5% of loans outstanding. But, during the financial crisis, albeit with a far smaller loan book, their website shows a default rate of 5%. Of course, they may have improved their risk analysis since then and it’s important to appreciate those conditions are viewed by many as a once in a lifetime extreme event.
But it wasn’t an extreme event in terms of the level of interest rates in the UK, and I know Zopa haven’t used consumer lending data from before they were established in their risk analysis, because I asked their CEO, Giles Andrews this summer at a FT conference.
We are also still in the midst of a false environment where interest rates are at generational lows due to central bank intervention. They would like to roll that back gently, but they may not get that wish given recent volatility.
As a comparison commercial banks are required to hold buffers of nearer 10% against potential loan losses over a full economic cycle. But, and it is a big but, loans extended by banks are somewhat different because banks are allowed to use leverage i.e. lend more money than they have in deposits or other assets. They also have a broader range of lending from short term retail loans to long term commercial mortgages.
Understanding liquidity risk
The second major concern is liquidity – the ability to get quick access to your money by selling your loans to another investor. Both p2p providers have plans in place to enable lenders to do this for a fee – in Zopa’s case 1%. And it all sounds very straightforward and, at present, I am sure it is.
But your ability to sell your loan on to someone else, depends on there being another willing lender. If the market interest rates for the type of loans you are holding have risen you will have to pay the balance in interest to the new holder of those loans. And the availability of other willing lenders may be affected by a variety of things, such a sudden increase in default rates, interest rates in general or a loss of confidence due to problems at another p2p provider.
So, there are no guarantees to return money within a given time frame, even though at present it may work well. And this liquidity in what is known as the ‘secondary market’ in p2p loans is at the centre of a lot of the questions about their eligibility for ISAs – all other eligible investments have established secondary markets i.e they can be bought and sold relatively easily.
The market is evolving.
What began as a matchmaking service for individual lenders to meet individual borrowers has begun to change. New institutional lenders are now being catered for that are looking for packages of bespoke loans. This is particularly true in the States, where the FT reports that the two leading p2p firms Lending Club and Prosper are each about to package loans so that they can be sold as a single security, complete with a credit rating.
This has all sorts of implications, but as far a retail investors are concerned the regulator needs to ensure that they are not being disadvantaged as what is effectively a marketplace in these loans develops
If you think this is all sounds very corporate and far removed from the original ethos of the p2p business model. I’d note that a new p2p company in the US called Payoff has just hired Galen Buckwalter, the brain behind the compatibility matching engine for eHarmony, the dating website (hat tip to the FT for that snippet). He’ll be introducing a bit of behavioural science into their loan assessments, no doubt based on the lessons of love. Aww.
Apparently money does grow on trees
I am already way, way over my allotted blog word limit, but I want to emphasise that I am not against p2p lending at all. Any regulated competition for high street banks is welcome. And there are other parts of Europe, especially Italy, where the traditional banking credit lines are broken and new sources of credit for their small and medium sized firms and consumers are really needed.
I just want to emphasise that while returns from this type of lending are very seductive, particularly as they can be structured to pay out in the same style as a plain annuity. And you need to be aware of risks, especially as the current p2p investment environment is so welcoming – by the companies themselves, the government and the FCA.
And it’s worth noting that, while these firms are now regulated by the FCA, under the current regulatory regime, not all regulation is the same. The provision of advice to lenders/savers on entering into a peer-to-peer loan is not a regulated activity.
Here’s Zopa suggesting money can grow on trees.
For clients interesting in learning more, please feel free to contact me for more comprehensive analysis. The information contained in this blog draws, in part, on information gained during the excellent FT sponsored Camp Alphaville event this summer.
- 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