Last week, the U.S. Treasury released a report criticizing the peer-to-peer (P2P) lending business, recommending it be more tightly regulated.
Events surrounding leading P2P financier Lending Club highlight the industry’s troubles.
CEO Renaud Laplanche was recently forced to resign after the company revealed that it had provided mis-assessed loans to Jefferies and Co., which was distributing the loans to institutional investors.
The P2P lending business is yet another product of the “funny money” bubble, and when the bubble bursts, it’ll largely disappear.
The Problem With P2P
The P2P lending business grew rapidly after 2008, as banks reined in their lending operations.
The idea is straightforward enough: With bank capital scarce and banks more strictly regulated, these new lenders could use the internet to match borrowers and lenders. That’s because bank capital restrictions are a major barrier to individual and small business lending.
Initially, individuals and businesses made a high percentage of the loans, as intended. But as the industry grew, hedge funds jumped in.
And this is where the Basel III capital restrictions are muddying the waters.
They focus primarily on “risk assets” in which various loan categories are multiplied by a fraction before the capital requirement is calculated. In the case of government debt, this is zero.
This pushes banks towards lending to governments and other assets defined by Basel as “low-risk.” Thus banks tend to de-prioritize small business lending in particular.
This restriction – not the capital requirements themselves – is why there’s an opening for new participants in consumer and small business lending – an opening that P2P lending was designed to fill.
Unfortunately, in an environment of easy money, rapid credit source expansion is a recipe for disaster, just as it was in the subprime mortgage bubble of 2006-07. Individual lenders have no expertise in assessing credit risk, nor do they have access to the information that a bank does.
While new data-driven credit models have been set up, they’ve only been tested in the current easy-money environment, and haven’t faced an economic downturn or credit crunch.
Hedge funds may have credit expertise, but in an environment where hedge funds are clamoring to enter the business, the incentives are high for participants to push loan volume at the expense of credit quality.
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Another problem is that the industry no longer consists of lenders taking individual credit risks on borrowers. Instead, the loans are securitized in packages.
Lending Club itself aimed to take no risk on the loans it made, selling them off to others instead.
As we know from past experience, the ability to securitize and package loans doesn’t make loan losses go away. It merely dumps them on unsophisticated buyers – often asset-hungry institutions such as German regional banks in the subprime loans case.
As investors, we don’t want to find ourselves the equivalent of a dozy landesbank.
In an easy-money environment, there are also temptations to play games with the loan structure.
For example, Lending Club and its CEO both appear to have invested in a company set up to buy Lending Club loans. Like hedge fund “funds of funds,” this doubles the fees paid and enables all kinds of conflicts of interest.
The P2P lending business is thus a product of misguided bank regulation and ultra-easy money. In this environment, it attracts higher-risk borrowers whose needs aren’t met by the conventional financial system.
The U.S. Treasury notes that the P2P lending business “expands access to credit,” but from subprime mortgage experience, such expansion tends to involve making loans to people and businesses that can’t repay them.
In the real world, banks are keen to make loans to creditworthy minority borrowers, because doing so enables them to tick boxes with the regulators. So I regard “expanding access to credit” as a bug, not a feature of the new business, and it’s certainly an additional risk for P2P lenders.
Since individual P2P lenders have difficulty assessing credit risk, and hedge funds are seeking to profit by securitizing the loans generated, there are essentially no forces in the business maintaining credit quality.
In such an environment, there’s a high risk of loss in the next business downturn. Lending Club’s experience suggests that loan losses may be appearing already, before the next credit downturn has hit us.
The P2P lending business might appear to provide relatively high income returns, but like many other such opportunities in the current high-liquidity environment, it’s more likely to lose us money than make us additional returns.
We would therefore be wise to avoid it.