Peer-To-Peer Lending

Reader Question

My wife and I have been hearing a lot of hype about peer to peer lending sites like lending club.com. What's your take on the investments?


My Reply

That's a great question. I've been meaning to look into this area in more detail for awhile, but I'm more strapped for time than ever these days. I will give you a Cliff's Notes of my thoughts on peer-to-peer lending.

First off, as you said, there's a ton of hype in this field. Hype is never a good sign when it comes to finance or investing. Hype takes A LOT of money and effort to generate and which means the company selling this financial service decided that it's smarter to spend money on selling its product as an investment to others (you) than on investing in it directly (which would've been a lot simpler to do). Not exactly reassuring. Of course the same is true of most investment "services" out there, not just peer-to-peer lending. As I never tire of saying, this is one crooked industry.

Second, the United States is blessed with (though for the last few years it seemed more like burdened by) an exceptionally well-developed retail banking industry. These banks, from giants like Bank Of America to  small local credit unions, are experts at weighing risks and rewards of lending to individuals and small businesses. The fact that these expert lenders -- who, by the way, are currently sitting on immense cash piles looking for a profitable investment -- are not willing to lend to these borrowers (at least not at rates as low as available on peer-to-peer sites) should give you pause. Bankers are not ones to pass up good opportunities, especially when they have cash to burn as they do now.

Third, my first attempt to gauge peer-to-peer lending performance resulted in finding this chart at Prosper.com:

Ignore the top table for now and focus on the bottom one. These are the actual results of  loans made on Prosper.com from November 2005 to June 2009. As you can see these results are pretty terrible, averaging -5.42% (negative 5.42%) annual return! Even the highest quality Prosper.com loans only managed 4.05% return in that time period. Compare that to some of the more conventional fixed income investing in the exact same period 11/2005 - 6/2009:
Vanguard Total Bond Market Index fund: 5.4% annual return
Vanguard Short-Term Investment Grade Index fund: 5.3% annual return
Vanguard High-Yield Corporate Index fund: 1.0% annual return

As you can see pretty much all conventional fixed income investments easily beat comparable Prosper.com's results over the same time frame of 11/2005 - 6/2009. The junkiest of conventional investments (Vanguard's High-Yield Corporate fund) eeked out a small positive gain for this time period compared to the terrible -9.72% managed by the junkiest of Prosper.com's investments. The higher-quality Prosper.com's investments didn't lag by nearly as much but still trailed high-quality Vanguard fixed income funds by about 1.4% annually. This is very much an apples-to-apples comparison, using exact same time frame and very similar maturities of loans. Conventional fixed income invesments as represented by low-cost Vanguard mutual funds easily beat Prosper.com's returns.

I've been assured that since 2009 Prosper.com raised its borrower screening standards to ensure such poor performance does not repeat. Pardon my skepticism, but I don't buy that assurance one bit. First, the chart above clearly shows that the average borrower credit scores were actually higher in the early period than in the later one -- and those credit scores are the only decent, albeit imperfect, measure we have of individual borrower's credit-worthiness. Second, what happened in 2005-2009 period had little to do with screening standards and everything to do with economic downturn that hits overleveraged consumers and companies alike the hardest. These are the types of individuals that make up the borrowers on peer-to-peer lending sites and the types of companies that make up the high-yield bond market. If the economy is chugging along these individuals and companies can make ends meet and pay off their high-interest loans. But once the economy takes a downturn (or, worse, a nosedive) they simply have no fallback plan or rainy day funds to make ends meet. And they default. And as a lender to individuals you have essentially zero recourse to recovering your funds -- unlike a lender to corporations that almost always recovers some, though certainly not all, of the principal.

Now the 11/2005 - 6/2009 timeframe obviously ends squarely in one of the worst recessions of all time. But that's all the more reason to take these numbers seriously. The whole point of fixed income investment is to be relatively safe even in bad times. By lending at a fixed interest rate you cap your upside. You better expect that your downside is similarly protected or else you get all pain, no gain. It's undoubtedly true that peer-to-peer lending results have been much higher since 2009 than in the period we just examined. But so have the returns of our best comparable -- Vanguard High-Yield Corporate fund. That fund delivered full 14.2% annually in the period of 6/30/2009 to 6/30/2012! That's much higher than the average claimed returns on either Prosper.com or LendingClub.com (which are somewhere between 8% and 12%, depending on which statistics you view).

To recap, peer-to-peer lending is analogous to investing in borderline investment-grade bonds at the high end of the quality curve and the junkiest of the junky bond funds at the low end. Available statistics are limited, but based on what is available it seems pretty clear that comparable conventional fixed-income investments handily beat peer-to-peer loans both during the bad times ending in the 2008-2009 recession and during the (relatively) good times since. This holds true both at the high and low ends of the quality curve. Furthermore, it is very clear that an average peer-to-peer borrower is far less equipped to ride out bad economic times than a junk-bond corporate borrower. And, on top of that, lenders to such individuals have far smaller chance of recovering their funds in the event of a bankruptcy than do lenders to corporations.

If you feel that peer-to-peer lending is a great investment, you should jump all over high-yield corporate bonds (and perhaps high-yield municipal bonds) which have much more appealing returns both in the past, and, I suspect, going forward. Look at ETFs like HYG, JNK, and even HYD for a tax-exempt municipal junk bond -- though I admit that last one scares me. Viewing high-yield bonds as some sort of middle ground between the very safe but fairly low-yielding investment-grade bonds and the not-safe-at-all but potentially high-return equities is not unreasonable. Instead of a, say, 50/50 stocks-bonds split, you could do a, say, 35/30/35 stocks/junk bonds/investment grade bonds split. Of course, doing this makes much more sense in a tax-sheltered account since high-yield bonds are extremely tax-inefficient (unless we are talking about high-yield munis like the aforementioned HYD).

I wouldn't follow such a strategy myself, but it's not ridiculous and it makes more sense to me than abandoning either stocks or investment-grade bonds for peer-to-peer lending which, so far, appears to have combined the worst of both worlds -- high volatility with low returns.

There is one big positive aspect to peer-to-peer lending that's absent from conventional fixed-income investing. It is at least somewhat charitable. You do get to help some cash-strapped individuals to get by in tough times. Few people would care to provide charity to Sprint Nextel whose bonds are often present in high yield funds and ETFs. But a lot of people would want to help out a single mom in Wisconsin struggling to pay off high interest credit cards. So there's that. But I'd rather keep charity and investing as separate endeavors or else risk get sucked into horrible investments camouflaged as charity, such as this gem. Make your investments as lean and profitable as possible and then use the proceeds to donate to the charitable cause of your choice.

I have to give peer-to-peer lending sites their due for making their investments fairly transparent and easy to analyze. Unfortunately the results still say that these simply aren't very good investments compared to more conventional alternatives.

I do hope to revisit this topic in the future and drill down into the detailed data made available by the Lending Club. But, unfortunately, I can't make any promises since my schedule is so full these days.