The cloudy future of peer-to-peer lending

Peer-to-peer (P2P) lending is all the rage. The idea is that individuals can bypass traditional financial intermediaries and borrow directly from investors at lower cost (or obtain credit that banks would not provide). Improving the lot of borrowers would be great if it works. But the key question is whether lenders can efficiently screen and monitor borrowers to get an attractive risk-adjusted return on their investment. In effect, individuals would be beating the technology that traditional lenders use. It’s far too early to tell, but there is plenty of scope for skepticism.

Browsing through the loan listings on www.prosper.com – the second-largest U.S. P2P lender – you will find all sorts of things. For example, Prosper rates the borrowers, with those rated A having the greatest likelihood of repaying their loans (and, therefore, receiving the lowest interest rates). Many people are trying to pay off credit card balances or consolidate their debts to reduce the interest rate they pay. Credit card rates are currently something like 13%, which is higher than the rate borrowers with a B rating pay through Prosper.

Other potential borrowers are looking for car loans, home improvement loans, loans to go on vacation, or money to pay medical bills. We even found one spendthrift romantic seeking to borrow $12,000 in order to purchase an engagement ring. The interest rates on the loans range from 5% for the most highly-rated borrowers to more than 25% for the poorest. (The engagement ring borrower has a C rating and will be paying an interest rate of 14.55% over 3 years if lenders fully subscribe the request.)

P2P lending has grown dramatically over the past few years. Lending Club, the largest P2P lender in the United States, originated over $3 billion in loans in 2014, more than 10 times the amount just four years earlier. And if you examine the data on returns, things look pretty good. After adjusting for losses, investors appear to reap over 10% on loans like the one to the engagement ring borrower.

What should we think about all of this? It looks like a rousing success. Borrowers are getting loans they couldn’t otherwise get, and lenders seem to be reaping returns higher than what is available elsewhere. What is the future of this new financial technology? Is peer-to-peer lending really taking off? Will it replace traditional sources of consumer finance?

In our view, P2P lending is likely to remain a tiny fraction of the $3.25 trillion in U.S. consumer credit. We doubt that the system created by P2P companies will overcome the information problems that traditional financial institutions are designed to solve. And, until these new intermediaries experience a few complete business cycles in which unemployment goes up and then down, there won’t be sufficient data to compute accurately the expected returns or assess their risk.

Perhaps the most critical function of financial institutions is to address the information asymmetries in lending. Lenders have a difficult time finding out about the willingness and ability of borrowers to repay. Prior to lending, it is costly to determine who is creditworthy; and once a loan is made, it is difficult to confirm that the borrower uses the funds as intended. To overcome these adverse selection and moral hazard problems, banks screen potential borrowers prior to lending and monitor their behavior after the loan has been made.

We suspect that U.S. P2P lenders can manage the screening process reasonably well. If you look at the websites of the largest P2P firms, you see that they have credit histories and FICO scores for their borrowers. And repeat borrowers who repay their previous loans get discounts, which makes sense.

But what about monitoring of borrowers after they receive the loans? How can P2P firms assure lenders that the borrowers don’t just take the money and fly to Tahiti? There is a reason that banks are only willing to make certain types of loans, and that they tend to favor borrowers with whom they have established relationships. Where possible, they seek collateral to limit their exposure and contain moral hazard. Auto loans are the classic example of a secured debt – if the borrower fails to pay, the lender takes the car. (Technology now even allows lenders to track the location of the car using GPS, and to make it impossible for you to move the car.)

It is not surprising that credit card borrowers are relatively common on P2P sites. Credit card lending faces similar information asymmetries. Like P2P loans, it is uncollateralized. Also like P2P, banks can screen using credit histories and FICO scores, and they set interest rates high enough to encourage healthy borrowers to pay quickly. But even banks face difficulty in preventing the use of a credit card for a big expenditure that is unlikely to be repaid. To limit that risk, they set usually set spending limits on each credit card – just like the limit on a P2P loan. Consequently, the question is whether P2P technology for screening is really superior to that of banks, lowering the cost of lending over time.

That naturally leads us to look at investment returns. According to Lending Club, of the $121 million of A-rated loans made in 2012, 84% of the principal has been repaid, while 3.2% was charged off as lost. The resulting return is 4.34%. Compare this to a U.S. Treasury rate of roughly 0.25% and you can see the appeal.

However, the screening and lending process is not free of cost and – unlike a Treasury instrument – the resulting loan is not free of default risk.

Building a portfolio of loans yourself – putting a chunk of money into a P2P firm and then lending it out in small increments – would be quite a bit of work. Some people will enjoy this. For others (probably the overwhelming majority of potential investors), mutual funds that invest in P2P loans may facilitate the process. If the returns are really so great, a 1% fund fee would be a small price to pay. So, we might expect to see these sorts of investment vehicles to pop up. And, they are doing so.

This brings us to the primary concern regarding investment returns and risks: does past performance predict future performance? Is the default experience of the P2P lenders over the past few years a reasonable guide to what we are likely to see in the next decade? Our answer is no. We expect that default rates will rise over the course of a business cycle, possibly by quite a bit.

This conclusion follows from looking at the default experience of credit card debt. As indicated, the risks associated with P2P debt seem very similar to that of credit cards. In fact, the risks are probably higher for those who are unable to obtain a low-cost consolidation loan from a bank. Fortunately, we have substantial historical data to help us assess the cyclical risks associated with credit card debt.

The accompanying chart plots quarterly credit card default rates on the vertical axis against the change in the civilian unemployment rate over the previous year on the horizontal axis. We have data starting in 1991, so it includes two full business cycles.

Credit Card Default Rates and the Change in the Unemployment Rate (quarterly, 1991 to 2014)

Source: FRED.

Source: FRED.

The message is clear: when people lose their jobs, they are far more likely to default on their loans. The relationship is amazingly tight.  For each percentage point change in the unemployment rate, credit card default rates move 0.7 percentage points in the same direction. If we restrict ourselves to the period since 2007 (those are the red dots), the change is almost exactly one-for-one. 

Other evidence reinforces this conclusion. Consider, for example, the Federal Reserve Board’s annual report on the profitability of credit card operations. In the years prior to the financial crisis, banks’ credit card operations enjoyed an average return in the range of 3¼%. That return plunged to -3% in 2009 as the unemployment rate rose by more than 5 percentage points.

To see the implications for P2P lending, take a look at the returns for the 2012 Lending Club loans that we mentioned before.  For the entire $718 million of originations, returns over the next 2 years were 7.15% after charge-offs of 8.6%. Over the same period, the unemployment rate fell by roughly 2½ percentage points. The credit-card evidence suggests that this decline drove the returns up by 2 percentage points, so that a better estimate of the return in normal times is something in the range of 5%. Taking this as a baseline, we can then ask what we would expect to see happen to P2P investors’ returns following an economic downturn. In a mild recession, unemployment typically rises by between 2 and 3 percentage points. This would increase default rates and cut P2P loan returns in half to something like 2 to 3%. A deep recession, like the one just experienced, could eliminate the return entirely. And, if you’re also paying a 1% mutual fund fee, the return could be negative. In other words, once we have more experience, investment returns may prove significantly less appealing than they appear today.

Where does all of this leave us? Well, if you have a good credit rating and are looking to reduce the burden of your existing debt payments, obtaining a P2P loan could be very attractive. But if you are looking to invest, we are skeptical. Financial intermediaries have been around for a long time, and there is tremendous competition in the consumer lending business. If websites are to have a big impact on lowering credit card financing costs, perhaps they could better do so by directing borrowers to the lowest cost card providers – much like some mortgage lending sites do today. It would be nice if replacing the most competitive card providers with a website would result in consistently higher returns to investors and lower costs to borrowers, but we doubt it.