P2P Bad? Really?

By AltFi on 13th December 2013

At AltFinanceNews.com we’ve been warning for many months now that the backlash against alternative finance generally, and P2P lending specifically, is on its way. Governments and regulators may be looking very favourably on the sector at the moment as a way of funnelling new credit lines into SMEs and consumers, but sooner or later broader questions about the nature of internet based platforms were bound to raise their ugly head.  

P2P Bad? Really?

The curious thing is that we had been expecting the first strike to come from the more established banking sector, disseminated through off the record briefings but yesterday we saw a much more serious attack delivered by Dan McCrum at the FTs Alphaville, helped in large part by a more detailed blog from Stefan Loesch, a former investment banker and quant, who now runs oditoriumuniversity.

I’ve pasted in the links for each article below and included what I think are the relevant bits for anyone in the AltFinance space – they are both essential reads!

The first and perhaps most important thing to say is that both Loesch and McCrum raise some incredibly important points, not all of which I think are entirely justified. McCrum’s starting point is a spirited appraisal of a Liberum report on Swedish listed P2P platform Trustbuddy. As a (small) investor in Trustbuddy I’ll refrain from making any observations on this line of attack.

Yet it strikes me that both McCrum and Loesch are spot on when they worry about pro-cyclicality or the serious likelihood of increased losses as platforms head into a recession. It seems to me that there’ll be an obvious sequence of events which will go thus:

  • Sector keeps expanding at a super fast rate as interest rates stay low
  • Sector attracts ever more newer players who will boast lower levels of credit risk analysis
  • These newer players will not only help push down rates of return to investors (over time though not initially) but they’ll also start to lend to riskier entities simply as a result of flow questions
  • Credit risk models built on backwards looking data may not be robust enough to deal with a slowdown sparked by rising rates and defaults spike
  • Defaults spike killing investor returns stone dead during a business cycle slowdown
  • Investors chase higher risk in order to overcome increased defaults and losses spiral. Regulator steps in.
     

Talk to the major platforms today and they’ll quite rightly tell you that their credit risk analysis is top notch, as evidenced by low default rates. And I believe them, but it’s not these platforms I worry about. I worry about newer platforms who will relax their criteria in order to attract customers.

For this observer, every one of the networks has to be brutally honest with its investors and say up front that the probability of an economic slowdown in the next 3 to 5 years is almost certainly above 50% and that in a slowdown the quantum of increase in defaults will probably be at least 5 to 7 fold, and I think that’s true in even the most robust risk systems.

Contingency and protection funds are a perfectly sensible next step and I applaud the idea but they are not the same as a guarantee or putting the platform’s own money in the game – as suggested by both Loesch and McCrum. Credit risk data is necessarily backward looking and there is no reason to believe that the current estimates used to inform the funding of a contingency reserve will be sufficient to deal with the challenge. Platforms should offer robust analysis of past default episodes in other sectors and then cross reference that to their contingency reserves. I also think that putting their own capital in play is an interesting concept although we wouldn’t want to stifle innovation by forcing massive capital requirements equivalent to a bank. An alternative might be to say that a platform puts at least 25% of its net profits into capital that is placed on the platform.

McCrum and Loesch are also surely right when they say that the whole sector is in effect a form of shadow banking introducing a host of agency and behaviour-induced risk related issues, not least that platforms have a direct incentive to scale up as fast as humanly possible.

Yet admitting that P2P lending is part of shadow banking is not the same thing as saying its bad. Hedge funds, infrastructure funds and existing asset backed finance houses are all in effect shadow banking but no-one bats an eye lid. Equally these existing players have their own agency issues – as do the big integrated non-shadow banks who have been exposed as riddled with agency and incentive challenges that destroy customer wealth!

P2P networks may have an agency risk to expand their loan books but big high street banks have traditionally had an agency problem with cross selling crap to customers and then duping them into believing they have protection which they don’t.

In sum agency issues are legion with any financial intermediary or disintermediating platform for that matter. The challenge is to manage the transparency of information flows so that the customer knows what they are letting themselves into. On that score the AltFinance sector wins hands down as transparency is at the very core of what it does. Could it do more? Of course, but the sheer quantity of data available to an investor to make a qualified judgement about the risks they are taking is immense – whereas with banks that information is patchy and obscure.

But if we’re truthful even investors equipped with all that transparent knowledge face an additional, very real hazard – that they’ll ignore the data and simply chase after the highest return regardless of the risks. Let’s be honest, no-one is really worried that smart, wealth advisers and hedge funds are ploughing money into online invoice funding platforms, largely because we assume these players will do their due diligence….and if they don’t that’s their look out.

But mass market investors will chase high yields or the possibilities of backing tomorrows crowd funded Facebook and no amount of data will stop them from making stupid mistakes. It’s this concern that has powered the FCAs own view of the crowdfunding equity sector which they think (mistakenly as it happens in my view) is only for smart, knowledgeable investors. By contrast I’m not entirely sure that the average retail investor really has the knowledge to judge a P2P commercial loan book, especially when the allure of big double digit returns are hovering at the top of the page. They probably won’t think about that pro-cyclicality point and they probably won’t check on the contingency fund’s underlying default assumptions. Hopefully they’ll only think about putting a small amount of money into the proposition in which case I suppose one could argue that they’re not taking a dissimilar risk to anyone who invests in penny shares – we don’t ban these equity based investments and nor should we ban risky P2P lending!  But we need to make investors realise that P2P lending isn’t a surrogate for saving nor a near cash financial instrument. It is risky, and it can destroy your wealth but that’s the thing about risk capital…if you don’t take some risk, you’ll never get a return!

Which brings us nicely back to the real agency issue here, which is access to capital and the failure of the existing financial structure – and the role that regulatory agencies and central banks are playing in pumping up various asset class bubbles.

P2P lending is booming in part because of financial repression by the central banks – what on earth do the regulators expect savers to do when faced by negative real yields? Equally borrowers, especially from the SME sector, will use P2P platforms precisely because their access to credit is so impaired in the mainstream banking sector (in large part, driven by regulators increasingly draconian judgement on appropriate levels of risk).

And these agency related issues (driven by central banks and regulators) aren’t going away anytime soon. Financial repression is with us until at least the end of the decade and the big banks are going to carry on deleveraging like crazy, especially around stuff like SME banking which is intrinsically risky. These two forces will continue to power growth in the AltFinance space come what may, which means that P2P platforms have an obligation to be as transparent and honest as humanly possible about the risks that their investors are taking.

Anyway, here’s the two articles, first from the FT Alphaville site – also check out the excellent string of comments below the main blog.

FT Alphaville Blog

http://ftalphaville.ft.com/2013/12/11/1719452/a-lending-buddy-needs-capital-as-well-as-trust/

“Peer-to-peer lenders are nothing but middlemen, an incentive structure at the heart of the last crisis. Brand is important when building a business, but at a certain point — trying to list, under stock market pressure to grow — there will be pressure to loosen lending standards in the pursuit of sales volumes and more fees.

This could happen naturally over time anyway, as those expert loan officers you start out with are gradually spread more thinly, or cash in stock options and retire. There will also be competition from all the other new peer-to-peer lenders, not to mention the existing banks.

The companies will say they are cautious and responsible lenders, but that assertion is all that stands in the way. They have no “skin in the game”, no exposure to losses from an overenthusiastic lending boom.

There is an illusion of safety

Some lenders, such as the UK’s largest, Zopa, have set up schemes to deliver “safe” lending through thinly capitalised backstops. There is also much made of transparency, the ability to see the hundreds or thousands of borrowers an investor’s money goes to.

Investors could, of course, have read the listing documents for subprime mortgage backed securities. In reality small investors — the actual lenders in a peer-to-peer scheme — will rely on the skill, assumptions and brand of the lending platform, the middlemen mentioned above.

Comparison with deposit-protected bank accounts, something the UK regulator has indicated it will frown upon, also serves to create that impression of safety.

Losses will be bigger than expected

Maybe not in the next cycle, but the bigger peer-to-peer lending becomes, the more likely it is that loss rates will exceed the limited history for the industry.

Those many thousands of small investors, who by the way bear all the credit and liquidity risk, may be surprised to lose money. We also wonder about the resources of the lending platforms to pursue a wave of small debtors in default through the courts.

Which brings us to the final point…

Pro-cyclicality

Peer-to-peer lending will be a happy source of lending for individuals and businesses right up to the point when it is not. It might be fraud, a savage downtown, or perhaps much larger than expected losses at a particular platform.

But the expensive offices and staff of banks mean that they have to at least try to carry on doing some business through a recession, or after a shock. What happens if peer-to-peer lending just stops, overnight?”

Oditorium  Blog

More at http://www.oditorium.com/ou/2013/02/why-p2p-lending-is-a-bad-idea-and-what-to-do-about-it/

“Wrong incentives

If all of this wasn’t bad enough, the incentive structure of the P2P marketplaces is awful – think investment-banks-rating-their-deals-themselves-awful: as an intermediary with no ‘skin-in-the-game’ it profits from any increase in the numbers of deals closed, regardless of their ultimate profitability. This gives a clear incentive for the raters to make the ratings of their (potential) borrowers as good as possible, so that the maximum number of (potential) lenders can be enticed. Now one could argue that any company that is in there for the long-term has an interest to get its ratings right, and this is true. However, as the example of many of the fly-by-night subprime mortgage originators has shown during the crisis, riding the wave, extracting the profits and eventually going bankrupt can be a very profitable strategy.

For the avoidance of doubt, I have absolutely no reason to believe that any of the current operators is in the market for anything but the long run and/or that their underwriting criteria are unsound. I am certain however that as soon as the size of the P2P lending market becomes such that it can be of any relevance to the real economy then those operators will appear.

highly procyclical

The hope that the P2P market is countercyclical strikes me as highly naive. It might be at the moment, because it is a new, growing market that has been created in a downturn, so almost by definition it is counter-cyclical. I find it very hard to believe however that when the first downturn strikes an existing P2P lending portfolio – ie when the ‘expected’ losses for the lenders become realised losses – that then lenders will happily continue lending as if nothing had happened.

If anything I would believe that they’d withdraw from the market even faster than the banks – after all, banks have an institutionalised lending structure in place, with credit officers which can not all sit idle etc. P2P lenders on the other hand are just one click away from investing their money somewhere else.”

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