What impact does the ‘youthfulness’ of the sector’s loan book have on defaults and returns?
Ageing is a wonderful thing. Truly it is. Depending slightly on how you look at it perhaps. Certainly when it comes to the peer 2 peer sector ageing is incredibly flattering. At least for the time being anyway. Let me explain…
Amongst the panoply of emerging terms in this new sector ageing seems to be the descriptor generally given to the combination of two important trends.
First comes the statistically and intuitively obvious reality that an older portfolio of loans will tend to have more defaults than a younger portfolio of loans. Whilst still true for amortising loans this is even more clearly the case for bullet loans. As one would expect, after funds have just been drawn down, and before the dreams embedded in those spending plans have been realized or dashed, the loan is highly unlikely to default. The precise time line is a topic that merits a column all of its own – and this is where the distinction between amortising and bullet loans really kicks in - but what is clear is that a cohort of comparable three year loans in the first quarter of their second year are more likely to default than a cohort in the first quarter of their first year all other things being equal.
Second comes an even simpler, and indeed more wonderful reality, namely the impressive growth of the sector. At the last count the P2P segment of the Liberum AltFi volume index recorded the sector growing at 7.76% month on month in June, year on year growth of 160.9%, putting the sector on track for 170% growth over the course of 2014. Borrowers and investors alike are responding enthusiastically as the margin hitherto consumed by the inflated cost base of the high street banking sector is shared between both as an improved rate of interest.
This impressive rate of growth alone means that the sector has far more loans on its books that were extended very recently than were made longer ago. The skew is in fact most pronounced amongst both the youngest and fastest growing platforms. But whatever the split the sector, as a whole, is very over-weight young loans.
As explored above young loans default less. So the sector has more of the type of loans that are unlikely to default and relatively fewer of the loans that default more often. This is not a function of good luck, or good judgment, or indeed some grand corporate strategy – this is simply a function of the sector's impressive growth rate.
The trouble is, we all know that - a few notable exceptions aside - ageing does not tend to be flattering. Whilst the sector continues at a prolific rate of growth it is this youngness of the sector's existing loan book which will mean that over-all default rates are likely remain depressed by the ever increasing volume of freshly originated loans coming through the door. But what happens when growth slows down? Given the current growth momentum, and given the huge market opportunity that exists, there is absolutely no reason to call time on the sector’s growth. But at some point the rate of growth will slow. Initially this will simply result in a more uniform distribution of loan ages. But so pronounced is this effect at present that it would only take a deceleration in the rate of growth for this to begin to occur. And beyond that at some point the sector's loan book will start to get ‘old’. That is to say the loan book will contain more old loans than young loans and as such more loans that are more likely to default.
So why does all this matter? Well clearly defaults are important. They represent losses and any increase will be closely watched. On top of that the sector is increasingly measured by its net return - i.e. the return after defaults and recoveries. Indeed the P2P FA has recently announced a standard methodology for calculating default rates across the sector. As such it will be increasingly possible to calculate meaningful standardized net returns across all platforms. This is a huge boost to the transparency of the sector and should further boost the burgeoning confidence of investors. But defaults are a key factor in the calculation of net returns. In turn these impressive returns are a key part of the sector’s attraction versus other asset classes. It is therefore worth understanding that net returns are in fact very likely to be sensitive to the sector's over-all growth rate.
For now the sector remains firmly on the right side of this trend. Young loans hugely out-weigh old and will continue to do so for as long as the sector is growing. But growing up can’t be put off forever and from an investor's perspective - forewarned is forearmed.