The even cloudier future of peer-to-peer lending

In early 2015, we expressed skepticism about the prospects for peer-to-peer (P2P) lending. Like other efforts to slash financial transactions costs (think “block chain”), P2P was all the rage. The notion was that the lenders and borrowers could cut out the middle man, “disrupting” traditional finance.

For that to work, for P2P investors to get an attractive risk-adjusted return, it would have to embody a technology that can screen and monitor borrowers at a lower cost than do existing intermediaries in the long-established sector of consumer credit. That seemed especially doubtful in a competitive industry like credit card lending, which is what P2P lending often turns out to be. While pre-2015 returns looked good (compared to the opportunity cost of funding), we argued that the effectiveness of screening and monitoring could only be assessed over several complete business cycles. Yet, P2P’s entire brief history has been during the post-crisis recovery. It hasn’t yet experienced even one recession. This led us to conclude that the future of P2P lending is much cloudier than many investors seemed to believe.

What a difference a year makes! Skepticism about P2P has suddenly become widespread. With a combination of reduced willingness to purchase P2P loans (see here), deteriorating profitability (see here), and the recent dismissal of the prominent chief executive of the largest U.S. P2P lender, Lending Club, (see here) investors have soured.     After peaking at nearly $28 in late 2014, Lending Club’s stock price dropped to $11 at the start of 2016, before plunging as low as $3.48 following the leadership change in early May. At the same time, following a decline of lending in the first quarter of 2016 (its first quarterly drop),, number 2 in the U.S. industry, announced plans to lay off one fourth of its employees.

All of this comes against the background of the February collapse of Ezubo, China’s largest P2P lending platform, in a Ponzi scheme that reportedly defrauded 900,000 people out of $7.6 billion (see here). It is no wonder that P2P firms in the United Kingdom—where such lending also has grown rapidly—recently rushed to assure investors that their activities were safe (see here).

As we emphasized a year ago, much of P2P lending is for credit card debt consolidation. So, it is worth keeping in mind that credit cards have been around for a very long time. Oil companies and department stores introduced them in the early 20th century, Diners’ Club and American Express followed in the 1950s, and banks got into the act with MasterCard and Visa a decade or so later. Even credit card securitization has been around for decades, starting in the mid-1980s. What this means is that there is a massive amount of data that allows issuers and investors to gauge the ability of borrowers to repay. The implication is that this is a mature, efficient business with substantial competition and narrow profit margins. Even more important, the return on consumer credit debt has been and likely will remain closely linked to cyclical developments.

As the chart below highlights, this relationship is amazingly tight.  For each percentage point change in the unemployment rate, credit card default rates move 0.8 percentage points in the same direction. If we restrict ourselves to the period since 2007 (those are the red dots), the scale of the change in credit card default rates for each percentage point change in the unemployment rate rises above 0.9 percentage points.

Credit Card Default Rates and the Change in the Unemployment Rate (quarterly, 1991 to 1Q 2016)

Source: FRED.

Source: FRED.

Stated baldly, the inception and initial growth of the U.S. P2P industry (and presumably that of the U.K. industry as well) has coincided with an episode in which consumer credit performance should excel relative to the long-run norm. Back in 2010, Lending Club and Prosper created loans totaling a mere $0.15 billion. As of 2015, that combined figure had surged to $10.08 billion (see here). Over the same interval, the average annual unemployment rate plunged by 4.3 percentage points. And, on a year-over-year basis, it continues to decline—by 0.7 percentage point in the first quarter of 2016.

But even with this enormously supportive tailwind, performance now appears to be slipping. For example, as of this writing, the net return on Lending Club’s 2015 vintage of loans has declined to the lowest level since 2011 (see here). With limited data, it’s difficult to know precisely why. Yet, we suspect that U.S. P2P firms tried to expand rapidly by tapping into credit markets—rather than just individual investors—for their funding. Much like pre-financial-crisis private label mortgage securitizations, the P2P platforms may have put themselves into a position where the only way they can meet growth expectations is to create supply (new loans) that matches the rapid expansion of capital market demand (that recently has receded).

Other credit fundamentals don’t appear to account for this slippage. Credit card interest rates (on accounts charged interest) have barely changed, while the average default rate is down by 1.4 percentage points. And keep in mind that P2P lending remains less than one-half of one percent of the $3.6 trillion in U.S. consumer credit. (By comparison, credit card debt accounts for over one-quarter of the total.) Consequently, if the businesses were merely siphoning off typical credits from the large pool of borrowing consumers, why would returns suffer?

One possibility is that there is adverse selection—that the rush to find borrowers has diminished the quality of the pool. As we already noted, P2P sites are filled with borrowers consolidating credit card debt. Both are uncollateralized and face information asymmetries that are costly to overcome.

P2P lenders can surely screen potential borrowers using credit histories and FICO scores, and they can set interest rates high enough to encourage speedy repayment. But, when financing conditions are favorable, banks also may rush to create new credit, only to regret it when employment and income start to fall. That risk must be even greater in a new business like P2P lending, where growth has been astronomical and past experience provides little guidance about the industry’s limits.

This brings us to our primary concern: the developments we have seen to date don’t capture what will happen when business cycle conditions turn less favorable. Based on the experience of credit card debt, default rates rise in a mature expansion when credit conditions have relaxed beyond long-run norms. And, in a downturn, they could surge. Over the period 2011 to 2014—the latest available data—the return on assets of large U.S. credit card banks averaged 4.94%, compared to the average loss of 2.73% in the 2008-2009 episode when unemployment soared by 5½ percentage points. If anything, since they are likely to have a more difficult time obtaining (re-)financing elsewhere, P2P borrowers probably face a greater risk of default than the norm for bank borrowers.

Where does all of this leave us? Mostly with the same conclusion we offered last year: “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 remain 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.”