Is Lending Club or Prosper a Risky Investment?

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

That's not to say P2P investing is without its risks. It certainly does have risks. What Todd fails to mention is that all investments — including those that are traditionally called “risk-free investments” — have risks.

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 it was not available to the retail investor until recently.

I recently 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 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 professional 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 Todd's article are default risk and interest rate risk.

Default Risk

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

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

More importantly, the second issue is true when directly referencing Lending Club's 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's and Prosper's notes are almost exactly the same as revolving unsecured credit cards offered by commercial banks.

In fact, I invest only 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 judgment.

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 five-year anecdotal experience with Lending Club, my default rate is slightly over 3%. This is in line 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 and 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 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 interest rates is huge — around 1,300 basis points (at the time of this article). P2P rates, while slightly lower than credit card rates, still boast an 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 with other fixed-income investments.

From 1994 till now, the average interest rate has decreased only about 700 basis points. Credit card interest rates, even in this low rate environment, remain stubbornly high.

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 makes for 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 of 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 buy in to 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 has over five years investing with Lending Club, I do have some insight into what works in the P2P investment space.

P2P investing isn't perfect, nor is it without its 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 with a 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.