Peer-to-peer lending is one of the fastest growing markets in the UK as savers who are sick of derisory interest rates on offer at the banks rush to secure better rates online. The returns are certainly attractive but are they enough for this high-risk form of lending, which places all of an investor’s capital at risk?
Dangerous times
It is a nice idea cutting out the banks and creating a truly egalitarian funding network that connects lenders and borrowers in a low-cost environment.
The problem is that as the growth of the sector accelerates, it is taking on more risk. In a normal credit environment higher risk would demand higher returns, but we are not operating in a normal world of credit. Demand from desperate investors scrabbling for returns is driving down the rates on offer from all asset classes.
These are dangerous times, when risk can be horribly mispriced. Lending money is easy; it is getting it back that is the tricky part — and that is only seriously tested during a downturn.
What is peer-to-peer?
Peer-to-peer lending has grown rapidly and provided £1.6bn in loans at the end of June, according to data from the peer-to-peer finance association. The industry is filling the gap left by banks as they cut back on credit after the financial crisis.
The biggest providers that are offering loans are Zopa, Ratesetter and Funding Circle. The websites allow investors to earn a rate of interest typically between 5pc to 6pc. The funds are then lent to hundreds of people.
This is not banking and these are not savings accounts. The peer-to-peer lending websites are typically providing unsecured credit for car loans, home improvements and to pay off other credit card debts. There is no guarantee that the money will be repaid and any funds lent through the websites are not covered by the Government-backed Financial Services Compensation Scheme, which protects bank savers up to £75,000.
Solid track record
The risks are clear, but so far the track record has been excellent. Zopa, the largest provider of loans to consumers, has a 10-year history of successful returns for investors. Giles Andrews, chief executive of Zopa, explained that it was the firm’s experience through the financial crisis that informs its thinking today. Zopa managed to navigate the credit crunch with no losses to investors’ capital and only a small dip in returns during 2008.
Ratesetter has a record stretching back to 2010, which obviously doesn’t include the same 2008 period, but the default rate on its loans has remained safely below 2pc. Only once has it gone above the expected rate, and that was in its first year of operation. Ratesetter has been able to return all the funds that investors have put into the service so far.
Safety funds
The peer-to-peer websites also offer a degree of protection from funds of reserves. Zopa has established something called the Zopa Safeguard Trust, which currently holds £9.6m to cover any losses. This may sound enough for any eventuality, but putting it in perspective, the company has almost £500m of loans currently outstanding. The safeguard trust therefore represents 1.9pc of the loan book, and the highest default rate experienced was more than double that, at 5.54pc, in 2008. A crude measure, admittedly, but simply applying a default rate of 5.5pc to the current loan book would imply losses or about £27.5m, or more than twice the current safeguard fund.
Mr Andrews said that Zopa has ensured that investors have never made a net loss, even in 2008.
The Safeguard trust was introduced in 2013 and currently covers £344m of the almost £500m in loans outstanding.
Spreading risk
Much is made of the fact that investors are reducing their risks because the funds they invest are spread over hundreds of borrowers.
So, while it is very possible that one borrower could get into financial difficulty, the chances of hundreds failing at the same time are much lower.
This is all true during a period in which credit markets are functioning normally. The past six years have been anything but normal, however. Those borrowing money have been supported by record low rates and financial markets have been flooded with easy money.
As the peer-to-peer industry grows and more money is on offer, it is a rational decision for a borrower paying a 19pc interest rate on a credit card to take out a peer-to-peer loan at a far lower rate and repay the card.
The issue being that when another downturn hits, as it surely will, then borrowers with similar credit profiles will tend to all fall over at the same time.
Cherry picking
The defence of the industry is that it has developed systems to select only the credit risks the lenders want.
Peer-to-peer platforms have built records on thousands of lenders and when taking on new business, they use this experience when cross-checking application data against other credit information to reach a decision.
The system sounds robust, but in order to expand the industry has had to take on ever more risk. The peer-to-peer industry had lent a total of £75m in early 2010, and that has soared to £3.15bn at the end of June this year, according to the association data.
Zopa credit history data show that the loans it had outstanding during the 2007 to 2008 period totalled £7.2m – the figure is now closer to £500m.
Should you invest?
The development of the peer-to-peer industry is a good thing for both investors and borrowers.
The greatest issue is that the industry in its current form and size has not been tested through the worst of a recession.
It is only then that investors will discover how easy it is to access funds, how much the safeguards cover and what the maximum potential loss could be.
The product also needs to be compared against similar alternatives. These are not bank savings accounts and should not be compared against the rates on offer there.
This is an investment product and should be compared against corporate bonds that offer between 4pc and 5pc, and shares that currently offer between 3pc and 6pc.
The nightmare scenario would be a pensioner drawing down their funds and placing a large portion into one of these products believing it to be as safe as a bank.
Any peer-to-peer investing should sit in a portfolio which includes cash, bonds and equities.
A sensible starting point would be to not invest more than 5pc of any savings pot. After the ravages of a recession, perhaps that can be increased.
