The Great American Search for Yield has led many clients to seek investment opportunities that promise higher returns than traditional asset classes. Crowdfunding and peer-to-peer lending allow investors to provide capital directly to start-ups and individual borrowers. Who needs investment banks when I can use technology to cut out the middleman?
According to Andrew Zumwalt, a University of Missouri Extension professor and expert on online banking, many investors “have gotten caught up in the shark tank mentality. It’s exciting! Who doesn’t want to be a shark?” The question, of course, is who is going to be eaten?
Both peer-to-peer lending and crowdfunding get rid of the traditional financial intermediary. Peer lending allows individual investors to place dollars in the hands of borrowers without a bank taking a cut of the transaction. Equity crowdfunding allows investors to sidestep Wall Street and place dollars in the hands of entrepreneurs. Banking seems ripe for disruption, and the time may be right for individual investors to get on board.
Peer-to-peer lending is the oldest alternative online banking platform, so it provides a useful window into the potential benefit of online investing. Prosper has been around since early 2006. On Prosper, you can join over 2 million lenders who each chip in as little as $25 per loan (or note). Credit score is used by Prosper to place borrowers into risk categories, and lenders can review borrower information to select the loans they want to make. Lending Club is now larger than Prosper (currently $13 billion lent and rising) and essentially operates the same way.
There is now ample net (after default) return information on both Prosper and Lending Club to suggest that peer lending is a solid investment. It’s worth hitting Lending Club’s remarkable historical loan return Web page to understand how well investors have performed on their peer loans. For example, borrowers with the highest A-credit rating have provided investors an average net return of 5.2% from an average interest rate of 7.7%. The difference represents the defaults. The lowest credit rating borrowers (F&G) have returned 9% from an average interest rate of 23.5%. Generally investors willing to accept a higher risk of default are rewarded with a higher expected net return.
According to Zumwalt, “it’s better when you diversify across all the credit categories. I also only put $25 in each loan to reduce my risk with each borrower.” Because you can diversify your investments among individual loans, the only real risk of selecting borrowers with a lower credit rating is the possibility of widespread defaults during a severe recession. “If there’s an economic downturn, everyone could just default. They’re unsecured loans,” notes Zumwalt. And none of the loans are FDIC insured.
It’s useful then that Prosper and Lending Club were established before the financial crisis, and the returns from these years don’t look as bad as you might expect. If we look only at returns on loans made from the first quarter of 2007 through the first quarter of 2010 on Lending Club, default rates are higher than on newer loans but net returns to lenders still range between 5.5% for A-rated borrowers to 5.25% for E-rated borrowers. The lowest credit borrowers returned only 2%, but the return was still positive. And even during the financial crisis, investors were rewarded for lending to higher credit risks since D-rated borrowers yielded 6.1%.
Zumwalt made 4.9% on his Prosper loans net of fees between 2009 through 2016. This is better than the five-year performance of the high-yield corporate bond category (3.24%), and represents an intriguing and legitimate portfolio category for clients. The duration of loans ranges between three and five years, and loans can be laddered to control portfolio duration. The main disadvantage is that these loans are relatively illiquid, although a secondary market does exist within the sites to dispose of loans for cash. These secondary market loans tend to sell at a deeper discount.
It can also be fun to read about the people who are borrowing your money to pay off high-interest credit card debt or start a new business. But, as Zumwalt notes (and researchers have confirmed) “if you think you can do better by reading people’s stories and looking at their pictures, you don’t have a chance.” A good strategy is to set lending criteria, such as a range of risk levels, and automatically fund loans that meet these requirements without spending the time reviewing individual requests. Researchers note that photos and descriptions that borrowers add to their loan requests aren’t vetted by peer lenders, so you shouldn’t really pay attention to them.
Of course, some still do. Younger, beautiful looking women tend to have an easier time getting funded. According to research conducted by my graduate students, it appears that photos of attractive females can be relatively easy to obtain on the Internet. So attaching them to a loan shouldn’t provide much value.
Both Prosper and Lending Club allow borrowers to invest in loans through a tax-sheltered account. Investing in peer-to-peer loans through an IRA makes a lot of sense as a way to add yield to a bond portfolio since much of the bonus in returns above other high-yield bonds appears to come from illiquidity. And since most investors won’t be touching assets held in IRAs for a while, why not stash your illiquid (and high yielding, tax-disadvantaged) peer-to-peer loans in a retirement account?