Is Lending Club or Prosper a Risky Investment?

A recent article by Todd Tresidder of Financial Mentor mentions the “dangers” of peer-to-peer investing. From my experience P2P investing is not risky, and I have evidence to prove otherwise.

That’s not to say P2P investing isn’t without it’s risks, it certainly does have risks. What Todd fails to mention, is all investments have risks: including what are traditionally called “risk-free investments”.

To put it simply, there’s no such thing as a risk-free investment. With any investment, you have to understand all of the risks, and put them into the correct context.

Let’s discuss the context of these risks with P2P investing.

In reality, this type of debt investing has been around for many years. The problem is that it was not available to the retail investor until recently.

Last week, I attended the peer-to-peer investment conference LendIt in NYC. It was very informative, and featured some interesting developments in the P2P space.

It’s my belief that we’re still in the early stages of P2P investing, and when I first started investing, it was retail investors only. According to Peter Renton of Lend Academy, only 15% attending were retail, the rest were institutional. This speaks volumes when professionals investors get involved. But I digress…

Todd’s argument against P2P investing goes something like this:

Your investment profit is determined by mathematical expectancy (most simply understood as probability x payoff). Expectancy = (Gain on a Winning Bet x Probability of Win) + (Loss on a Losing Bet x Probability of Loss).

When filtered through that lens the problems with peer-to-peer lending are immediately obvious:

  • Your gain is strictly limited to the interest rate; whereas, your loss can be 100% creating a negative risk/reward ratio.
  • Your probability of gain or loss is impossible to define because the system is too new to have been adequately stress tested.

The two primary issues in the article are: default risk, and interest rate risk.

Default Risk

Let me discuss the first point mentioned. This statement could be true with any fixed-income investment. So I’m not sure I fully understand why this argument is exclusive to P2P investing.

In addition, if you invest in hundreds of notes, statistically I’m not sure how you could ever have 100% loss of your deposits. This would mean all notes invested would default.

More importantly the second issue is true when directly referencing Lending Club and Prosper’s data, but there is much longer-documented history in which it’s exactly the same investment class as P2P investing. The comparison isn’t against high-yield bonds either.

Both companies offer unsecured credit for up to five years. Lending Club and Prosper’s notes are almost exactly the same to revolving unsecured credit cards offered by commercial banks.

In fact, I only invest in borrowers who are consolidating or getting a better rate from credit cards. So we can agree a comparison to the default rates with credit cards would be a great judgement.

Fortunately we have well-documented data available from the Federal Reserve for credit card default rates. The data from the Federal Reserve goes back to 1985.

We’ve experienced three recessions in that period. Readers will also agree during 2008 we experienced the worst recession since the Great Depression. Since 1985, the credit card default rate has averaged 4.7%. In the fourth quarter of 2010, the default rate peaked at 10.59%. In the recession before that, the default rate went as high as 7.79%.

So far, in my four-year anecdotal experience with Lending Club, my default rate is slightly over 3%. This is inline with the averages seen by the Federal Reserve for unsecured debt.

So based upon this data, it is more than possible to achieve positive returns with Lending Club or Prosper. Lending Club’s data during this period (Prosper had a different lending model at the time) also concurs with this statement. Collectively pooling all Lending Club notes during this period, shows the returns were still positive. So if we experience another severe recession — like we did recently — your returns should still be pretty decent.

Todd’s article doesn’t concur with my findings.

Interest Rate Risk

The current gap between the 10-year Treasury note and credit card rates is huge — around 1,000 basis points (at the time of this article). P2P rates, while slightly lower than credit card rates, are still attractively high rate of return for an investor.

Even as interest rates eventually rise, investing in unsecured credit card debt will remain an attractive investment. Interest rate risk isn’t really a factor with P2P investing until we experience a much higher (say 5% or higher) Federal Funds rate.

P2P investing should remain an attractive investment for the foreseeable future compared to other fixed-income investments.

From 1994 till now, the average interest rate has only decreased 400 basis points. Credit card interest rates, even in this low rate environment, remain stubbornly high.

Credit Card Interest Rates

With the Dodd Frank regulations and an overall heavily regulated banking industry, the rates for credit card debt have barely budged during this low Federal Funds rate period. With $850 billion in outstanding revolving debt, individuals still have a lot of debt to reduce and consolidate.

This means individuals are looking to refinance their higher interest rates to something lower. P2P companies Lending Club and Prosper are perfect candidates to take advantage of this gap, even if they get a small percentage of the total revolving debt.

All of this is now a ripe time for the P2P investor to take advantage of the interest rate gap, and help borrowers get a lower rate in the process. All the while generating a steady return on your P2P investment.

Is P2P Investing Risky?

All of these counterpoints do not completely eliminate the risks investing in the P2P space.

For the retail investor this is really a new asset class, but it’s an asset class that’s been available to commercial banks for many years. Previously the only way a retail investor could invest in this investment class was indirectly through owning banking stocks.

P2P investing now bypasses the middleman.

Lastly, the only negative articles on P2P investing I see are from individuals with no direct investment experience. As someone who’s coming on four years investing with Lending Club, I do have some insight into what works in the P2P investment space.

P2P investing isn’t perfect, nor without it’s risks, but it’s an investment that should be seriously considered. I’ll even make the bold statement that P2P investing is less risky than many other high-yield fixed-income investments.

For now I am investing in Lending Club and Prosper notes until other fixed-rate investments become more attractive.

At the current interest rates and commitment by the Federal Reserve to keep pumping liquidity into the marketplace, it might be many years before conditions change.

For high return, low risk and low duration investments, P2P is hard to beat at the moment.

Comments

  1. says

    Time tells all truths.
    We can banter all we want, but it is clear we see things differently.
    Hopefully I’m wrong (for the sake of investors) and get to eat my words. The would certainly be best for all concerned.
    In the end, only time will tell…

  2. says

    Excellent article Larry and one that should be a must read for all p2p lending skeptics. I am not sure how much time Todd Tresidder is talking about when he says, “time tells all truths”. We already have some data from Lending Club and Prosper as to how they performed during the worst recession in the last 75 years.

    If p2p lending skeptics want to wait on the sidelines for another decade or so that is ok. Meanwhile, I will continue to enjoy my 10% returns compounded every year. Eventually, I am convinced they will see the light and join the party. The evidence of p2p lending being a great risk/reward investment will only continue to grow.

    • Dan B says

      “Eventually, I am convinced they will see the light and join the party.”

      Perhaps, but the vast majority number of those people will arrive at the party so late that the food, liquor & profit potential will not be flowing as easily & abundantly as it did before. Of that, I am convinced.

  3. Dan B says

    As a whole Todd’s article presents a number of reasonable & sober points. Unfortunately, imo, they are overshadowed by the rather fantastic scenario presented which describe potential TOTAL losses at some future date. Though it is easy to imagine such scenarios as they apply to say a specific stock or even a group of stocks within a sector…………………it really is a tremendous stretch to suggest 100% total losses as even a remote possibility in a reasonably diversified p2p portfoilo.

  4. Hrant says

    Actually Todd’s viewpoint is quite intriguing, and valid, but.
    Out of curiosity, how long has he invested in LC? w/how many loans?
    As far as Larry’s article, I find it very well balanced, and apropos to the fact that I also have been investing in LC for approx 4+ years, and still can’s believe in the returns of approx. 10-11% range am attaining. Just takes a lot of time for me to manage and choose loans, as I have micro diversified (approx couple of thousands of loans), yet am very happy w/the results, and am expanding as going forward on a regular basis.
    Like any investment, one should allocate to different investment types and strategies, and diversify as much as possible.
    Keep up the great work Peter, Larry and all else who have been the pioneers of this nascent retail industry. The results bear the fruit of my labors, although wish it were a little less time consuming to pick and choose loans to get a statistically higher rate of return, w/consistency.
    I am looking.
    Good luck to all in their investments, and stay the course.

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