| Sep 29, 2014
No offense to Hamlet, but the question is not "to be or not to be", but whether to go "P-to-P". And Polonius, who "neither a borrower nor a lender" wanted to be, was equally mistaken.
Today, with the advent of big data, integrated web services, and service-oriented platforms technologies in the cloud, a more relevant quote may be:
"neither a lender nor a borrower be, unless through a platform that provideth both parties with contractual certainty and a better deal than hadst they used an intermediary such as a bank".
Admittedly, back in Shakespeare’s day, you couldn’t get access to a diverse pool of borrowers via the Internet - you were pretty much stuck with the rabble at the playhouse. You also couldn’t assess those borrowers based on multiple data sources in real time. You couldn’t slice and dice the loans easily into small slithers, enabling lenders to diversify risk and apply the law of large numbers at the sub-atomic level to build a portfolio made up of many small loans.
This capability is what allows investors to gain access to asset classes that have previously been the domain of the banks. In Australia, personal loans are one of the most profitable business lines within the major banks. The major banks collectively earn about $2 billion annually from their Consumer Finance portfolios, which by and large consist of credit cards and unsecured personal loans1. These returns have doubled since 2007/08 placing return on equity for the banks on par with retail mortgages. To put that into perspective, for a large bank like CBA, Consumer Finance in 2013 made up 20% of its Retail Bank Net Profit After Tax (NPAT), despite being only 3% of its balance sheet.
The profitability of Personal Lending has been increasing due to improving Net Interest Margins (which are about 10x the level of home loans), income approximately two thirds that of their mortgage books2 and losses that are low and stable.
Investors have only been able to access this asset class directly with the advent of Peer-to-Peer (P2P) lending platforms, also known as online consumer lending. In Australia, the only platform available today is SocietyOne, although it is expected others will follow their lead in years to come.
A Growing Phenomenon
P2P platforms have been expanding rapidly around the world as first individual investors, and now venture capitalists and institutional investors are pouring hundreds of millions of dollars in equity funding to the burgeoning industry. Over 200 companies worldwide are now building online marketplaces for consumer credit using different models and different methods, pushing into new markets and developing asset classes in exciting new directions from medical loans to solar energy.
The sector is now “supercharged” with loan volumes to borrowers increasing at very rapid rates. The US and the UK (and arguably China) are the world’s largest P2P lending markets. Lending Club and Prosper, the two biggest P2P lenders in the US, are growing at close to 200% a year! It is estimated that they will collectively originate US$6.25 billion in 2014, with Europe to contribute another $4 billion to that number3. At this rate, the sector is predicted to become a US$1 trillion industry globally by 2025(4).
Lending Club has filed its IPO in the US and will list with an expected market capitalisation of circa $5 billion. Early shareholders of the company include Google, Blackstone and other notables. Its board is a veritable who’s who of industry personalities like Larry Summers (former US Secretary of the Treasury), John Mack (former CEO Morgan Stanley) and Mary Meeker (respected technology venture capitalist). The loan origination growth for Lending Club has been exponential and now exceeds $1 billion per quarter.
Understanding the risks
With a proven track record overseas, the P2P lending model for personal loans is poised to get traction here in Australia as well. In a continued low interest-rate environment, investors continue their search for yield. While RBA rates have fallen over the last few years, personal loan rates have remained stubbornly high at circa 14-14.7% with margins for the banks in this product quite impressive, while defaults have been well contained around 2-3%.
P2P lenders collect a platform fee in the same vein as eBay, Uber and other platforms, enabling investors and borrowers to share the margin that banks would otherwise keep as profit for themselves. The investor takes the credit risk and hence takes the majority of the margin.
But as with any investment, interested investors should first understand the risks involved in P2P lending. The key risk to investors is the exposure to loan defaults that diminish the returns and potentially the capital if they are not well diversified. Typical gross returns on unsecured personal loans are 11-12% before defaults, with the overall default rates across the platforms typically 2-4%. It is important to diversify across as many loans as possible to approximate the platform default rate.
It is also important to note that although the investment takes on many characteristics of traditional fixed income products with consistent, predictable and regular cash flows (probably daily if there are hundreds of loans in a portfolio), investors are locked in for the term of each loan, which are generally 36 months. It took 5 years in the US for a secondary market in loans to emerge and one does not exist yet in Australia. Many investors treat P2P loans as an annuity type product giving them similar regular cash flows at attractive rates.
When building a fixed income portfolio and selecting term deposits, bonds, bond funds and hybrids (if one considers hybrids fixed income), investors could potentially also consider P2P lending to gain further diversification in loans that are arguably less correlated to other common assets in your overall portfolio.
New asset classes
As P2P lending becomes more mainstream, investors will be able to get access to other asset classes previously unavailable to them. An example in the U.S. is small business loans, a new segment that Lending Club has recently also entered. Other online fintech companies like Kabbage are also increasingly using big data to tie merchant finance to B2B commerce sites like eBay, PayPal and Amazon. This gives the platform real time access to sales, inventory and other data to assist the retailers with lines of credit. The continuing and evolving access to big data will enable more lending products on these platforms, sometimes in niche areas where returns are good and volumes are too small for the big banks to be interested.
A home-grown example of a niche SME loan product is SocietyOne’s P2P Livestock Lending Program developed in partnership with Ray White Rural. The program was developed for the purpose of purchasing livestock secured by the cattle. An unintended consequence of mandated RFID tags on cattle for biosecurity reasons is the fact that a lender can register an interest on cattle in the government tracking database and record these tags on their interest in the PPSR security register. SocietyOne provides a structured program with a robust settlement processes giving investors access to an agricultural related investment with very low correlation to equity or property markets.
In summary, P2P lending platforms give investors the opportunity to access asset classes that have previously not been widely available. Over time, the range of asset classes available will only increase as innovation and competition reveal opportunities in other areas characterised by mispriced risk. As always, investors need to do their due diligence and understand the business model, the companies and the products being offered. But in this low yield environment, P2P lending is definitely worth considering.
1. Industry Annual Reports for Financial Year 2013 for the main banks CBA, ANZ, Westpac and NAB.
2. JP Morgan Research Paper – Australian Banking Sector, Getting Personal: Small Balances, Big Profits. Scot Manning, 17 March 20143. LendIt Conference 2014
4. “A Trillion Dollar Market By the People, For the People”, Charles Moldow, Foundation Capital, 4 May 2014