As I said yesterday, something important is happening. In the last few years there’s been a big surge in interest in that stuff. Do a Google trends search for fintech to see what I mean!
For once, the government is ahead of the curve. A couple of years ago Osborne allowed peer to peer lenders to write off their losses against income tax. And in less than a month’s time, the wraps come off the “innovative finance” ISA, which will allow P2P lenders invest tax free up to £15,240.
It’s all been good news. And judging by the emails I’ve received (more from them later) and what I’m hearing from friends, the P2P lenders are a happy lot.
But as I’ve been threatening to do over the last couple of days, it’s time to talk about the risks from peer to peer lending.
Note: strictly speaking, crowdfunding refers to buying equity stakes in companies, and peer to peer lending refers to making loans to companies and individuals. But the terms get used interchangeably. When I’m talking about equity investing, I’ll make sure to spell it out.
The two worries
Peer to peer and crowdfunding sceptics have two big complaints. The first is that it’s never been tested by a big, systemic credit crunch. The second is that, because of something called “adverse selection”, it’s much riskier than people think.
I’ll take the first one first. Peer to peer lending sites diversify loans in order to reduce risk. On Funding Circle, for example, you might loan your money to 400 borrowers with a similar credit profile. Another big peer to peer lender, Zopa, has set up what it calls a “safeguard trust” of 1.9% of its loan book to protect against a bust.
That protects lenders to a degree. It means a bust in any one lender, or even any one industry, won’t ruin their loan. The problem of course is that if there’s a credit crunch across the entire economy, like we had in 2008, the lender would be exposed. Given that P2P loans typically are used as unsecured credit for car loans, home improvements and to pay credit card debts, P2P lenders should be under no illusions about what’d happen to their loans if the credit market took a hit.
Peer to peer’s second big criticism is based on something called “adverse selection”. It’s based on an idea put forward by an economist called Gary Akerlof – the husband of none other than the Chair of The Fed, Janet Yellen.
Akerlof realised that markets don’t tend to work very well when one side of a transaction has more information than another – asymmetric information in microeconomics jargon. He used the example of the market for used cars. The dealer knows which cars are “lemons” and which aren’t. But the customer doesn’t. So the customer is only willing to pay the lower, “lemon” price, since he doesn’t want to overpay.
The net result is that only “lemons” get sold. The mere presence of inferior goods destroys the market for quality goods when one side of the deal has more information than the other.
How does this apply to peer to peer lending? It’s similar to the used car market, where only the crappy cars get sold. The people who’ll most want to apply for a P2P loan are those with the biggest risk. They might have been turned down for credit elsewhere. And because it’s difficult to know exactly who you’re dealing with in the P2P market, bad credit risks get extra “cover”.
So those are the chin-stroking theoretical arguments against P2P lending and crowdfunding. They have a certain logic to them. But on the other hand, most people’s experience of crowdfunding has been very positive. Loans have tended to perform just as expected (on the bigger platforms at least). And the returns have been good.
Here’s just a sample of the email I got on this subject this week. All very clued-in, and happy with their experience.
Hi Sean, I’ve just read your ‘risk and reward’ piece today about P2P lending.
I have been a member of funding circle for about 16 months having taken my first precautionary steps with its lending model. I have made a return. In the 16 months – only one of my loans has failed and I have lost £13.42, but by the same taken I’ve made over £95 in returns on my 1st grand of investment. They’ve lent over £1BN to small business now and their predictive run rate of failure is generally higher than what reality is bearing out. Yes they had higher failure ratio initially but then what business doesn’t have to go through a fine tuning process to iron out the bugs in its trading model.
Disruptive change is always viewed with scepticism of course and early adopters have to take some hits. Funding circle is certainly a more refined and maturing animal now and I am confident enough to increase my investment in its mechanism. With ISA wrappers coming to P2P hopefully soon, I expect it will become more mainstream. We will also then get the rafts of legislation, regulation and above all protection being applied as a matter of course.
My view is that as with anything concerned with investing, you have to take measured risks. You do not put all your eggs in one basket. Just as you do not buy only one stock. My money is not even held in any one bank. I’ve even gone so far as to hold multiple currencies. I am also confidently recommending P2P to my friends and family. Not to put all their life savings in there, but just as a portion of a diversified portfolio. So what’s the harm?
Invested just £5k 3 years ago and had no ‘problems’, normal lenders going bust and some repayments – Funding Circle seem to be on top of that.
But last spring re-evaluated; not too easy to liquidate one’s position so, not wishing to leave the problem to my loved ones, have been taking out accumulated monies. £3.2k out £2.6k remaining so some taxed profits.
– John S
Yep I use P2P and to a much lesser extent crowd funding. The thing you must have clear in your head is that this is not saving, it is investing, it is not a direct alternative to a bank, it is not a safe place to stash your cash, having said that a bank isn’t either it has only been perceived to be so, there have been throughout history banking runs and crashes, your money is not in a nice safe vault waiting for you but lent out and you are just as much at risk from the banks internal risk model (and boy have they got that wrong before) and the government backed £74K safety net is only backed by a politician’s promise, is open to political risk and the premise that the Government won’t be bankrupted by the crash of banks “too big to fail”. That of course is always assuming that the EU bureaucrats don’t step in and mandate a “haircut” for depositors as well (as they did in Cyprus). What bank safety!!
As with any investment it boils down to a risk/reward assessment.
I must admit, four days ago when I started looking at this I was more sceptical than I am today. For all the risks, peer to peer lending looks like a relatively safe bet. Especially at a return of more than 6%.
I’d like to thank everyone who wrote in on this. Tomorrow, I’ll finish up with a closer look at crowdfunding – specifically, taking an equity investment in fledgling companies. If you’ve anything to add, especially if you’ve done any equity crowdfund investing, do let me know. [email protected]