Ex banking chief: crowdfunding losses will be huge

A friend of mine has been trying to get me into peer to peer lending (AKA P2P lending, AKA crowdfunding). I still haven’t taken him up on it. Here’s why.

A friend of mine has been trying to get me into peer to peer lending (AKA P2P lending, AKA crowdfunding). He says he’s making 7.2% interest on it, with low risk. Easy money!

I still haven’t taken him up on it. Partly because 7.2% just seems too good to be true, partly because there’s something about the whole P2P lending thing that seems a bit sketchy to me.

Recently the former head of the FSA, Lord Adair Turner, was on the radio warning about the dangers of P2P lending. He told the BBC’s Wake Up To Money programme “The losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses.”

So who’s right – my mate down the pub or the former head of the FSA?

Let’s have a look.

Breaking banks

P2P lending is a clever idea cooked up by the financial technology industry. It’s all about connecting borrowers directly to savers – no bank required.

Normally, the banks act as the middleman between savers and borrowers. The saver stashes his money in a bank account paying 2% interest, the borrower applies to the bank for a loan at 5% interest, and the bank keeps 3% for itself.

P2P “platforms”, as they call themselves, are websites that connect borrowers directly to savers. Savers can choose how much risk you want to take, and be rewarded with an appropriate interest rate.

For example on Funding Circle, one of the popular P2P platforms, you have a big range of options as an investor. You can put your money into one particular business you like the look of – I was offered a chance to lend to a local property renovation company, for example.

If that’s too risky for you, you can spread your money around different businesses. You can put your money into a big pool of loans, 100 or more. And you can choose the amount of risk you’re willing to take.

For example, the riskiest loans – the P2P equivalent of “junk bonds” – pay 18% interest. But Funding Circle warns you’re not going to see that 18% – bad debts will likely shrink your returns to around 9%. The safest loans pay a headline rate of 8%. But your realised returns, minus bad debts, are estimated at around 6.4%.

Funding Circle keeps 1% for itself. And to be fair, you wouldn’t begrudge them that – the banks charge far more! The important difference though, is that the bank guarantees the depositor will get their money back. The bank takes on the risk that its loans won’t work out. P2P lenders don’t take any risk. If their loans go sour, the savers lose out – not the platform.

“Internal risk models”

So it all boils down to whether companies borrowing from P2P platforms are a good credit risk. Funding Circle estimates that for the least risky loans – those offering an 8% headline interest rate – 0.6% of loans will go bad.

As Funding Circle describes it, “This is the estimated annual level of bad debt to expect for this risk band. Estimated bad debt rates are based on internal risk models which estimate the probability of default, exposure at default, and loss, or unrecoverable amount, given default.”

And that’s the problem. As an investor, you’re relying on these guys’ “internal risk models” to tell you how safe your money is. If they’re roughly right, my mate and all the other P2P investors are quids in. If they’re wrong – as Lord Turner clearly seems to think – he’s going to get burned.

I’m going to keep tugging the thread tomorrow. I want to explore this idea a bit further – why Lord Turner is so suspicious, and why the government is throwing its lot in with the P2P companies.

Until then….

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