It was an interesting investment concept, made possible by a combination of the Internet and low-cost electronic payment processing. People with money to lend, as little as $25, got together with people who wanted to borrow money, up to $25,000. If enough people kicked in cash, the loan was funded and the borrower got the money; and the principal and interest from every payment were divided among all the people investing in that loan, which could number in the hundreds.
At least that’s the way it started at Prosper.com, the first of the big peer-to-peer lending markets; and the kindest way to phrase it is investor returns were mixed, as initially the loans were not reported to the major credit bureaus and the skip rate was brutal. The rise of the more structured Lending Club put pressure on Prosper to tighten up its program, just as state banking regulators took an interest in both companies. Today Prosper and Lending Club are regulated in the states in which they operate, all loans are reported to the major credit bureaus, and peer-to-peer lending has gone corporate as big banks and hedge funds step in for a piece of high-return action.
The new structure, and competition from deep pocket investors, are changing the nature of peer-to-peer investing, and make my list of why small investors should be wary, at least for the moment. By way of disclosure, I have a Prosper investment portfolio.
You’d Be Missing Better Returns In the Stock Market
On March 9, 2009, the stock market closed at 6626; this Friday it closed at 16,064, an astounding recovery of 41%. My Prosper investments over roughly the same time frame returned an anemic 8.05%. Ironically, the two seemingly unrelated trends are connected. Companies are achieving good returns by not hiring back employees who were trimmed during the market crash. Instead of hiring, big corporations are using the bonanza of free cash to buy back their own stock. That’s good for the stock market, but not so good for the larger pool of consumers, many of whom are struggling to get by on jobs that pay a fraction of what they used to make.
Big Players Are Elbowing In
Prosper and Lending Club have both made deals with large, institutional investors, and anyone who works in the investment world knows the big money always comes with a price tag. Big investors get theirs first, and everyone else comes second. While Prosper insists the loan portfolios are totally separate, it’s hard not to notice the default rate on small investor pool loans went up around the same time the institutional investors moved in. That is more likely related to the continued weakness in the job market, but as an investor it’s hard not to feel like institutional investors are cherry-picking, and the rest of us get what’s leftover.
Late Payments Stay Stubbornly High
If you’re very thorough in reviewing lenders and picking loans, you’re still going to have between 3-5% of your lenders late on payments every month; and I’ve had 11 notes that were charged off, which means the unpaid principal is a loss. The late payments and charge-offs take a big bite out of returns, reducing mine by nearly a third. Some borrowers are using Prosper and Lending Club loans to pay off high-interest credit card loans, which are harder to discharge in bankruptcy. It can’t be a coincidence when a borrower pays off $10,000 in credit card bills, and files for bankruptcy protection four months later. Prosper loans are uncollateralized personal loans, and while the default is reported to the credit bureaus and the balance turned over to a collections agency, personal loans get short shrift in bankruptcy court.
The Risk Sharing Is Pretty One Sided
Prosper pays itself first and you second. The loans are structured so the Prosper fees are higher the first two years of the loan, the most likely time for loan defaults. Considering Prosper gets a percentage for just being the middleman, they’re not very willing to share the risks when loans go bad. Prosper gets loan origination fees from the borrower up front, but the lender doesn’t get a cut of those fees, only the P&I on payments. The costs and expenses when loans go bad fall in your lap. Prosper is sort of like the house at a casino — they always win.
Because of the inequities in the relationship, I cut off putting any new money into peer-to-peer lending some time ago, and shifted those investments to equities, a move that paid off big-time. Sooner or later, market returns are going to return to earth, and there’s a building movement for better pay for rank-and-file workers, especially in the service sector. Those trends will converge to reduce corporate profits at some point and, when we get there, an 8-10% return on Prosper might start to look pretty good. But right now peer-to-peer lending is high risk for the reward and investors should approach with caution.
