The growth of the peer-to-peer lending industry may fly in the face of logic for some, given how tightly guarded the lending industry has been in the aftermath of the financial crisis. However, some of the major P2P platforms not only survived this credit crunch, they appear to be thriving, offering consumers cheaper loans and investors better returns.
Peter Renton is an expert on the growing peer-to-peer lending industry and the founder of Lend Academy, the leading source of educational materials on the industry. With the rapid growth of peer-to-peer lending at home and abroad, Peter sees a real investment opportunity that can provide steady returns in good times and bad.
He talked to us on the phone about the current state of the peer-to-peer industry in the United States, where it appears to be headed, and why every investor should consider devoting a portion of their portfolio to peer-to-peer loans.
EQ: In your book, you observe that the tight-fisted practices of banks after the financial crisis helped create the opportunity for something new in the lending industry. Do you think we’re seeing a permanent shift away from banking institutions participating in this space? Or will enough success for P2P lenders eventually draw back the bigger players?
Peter Renton: There are some very big banks today that are still lending, they’re just not lending in the same way the P2P platforms are doing it. But I think they’re watching this industry, looking at how it’s going to develop. I suspect the banks will take a role going forward. We’re already seeing it to some extent, both Lending Club and Prosper have banks that are investing on their platform. So it’s like they’re making loans without any of the underwriting costs involved.
If online lending gets as big as projected, tens of billions or hundreds of billions of dollars, banks will be involved, whether they purchase a platform or start their own. They’re not going to want to cannibalize their high-margin business like credit cards, but they are going to want to participate in this industry.
EQ: Who benefits more from P2P as compared to the options available 10 years ago: investors or borrowers?
Peter Renton: The investors. You’ve got, for the first time in history, a way for individual investors to easily access the consumer credit asset class. You can make loans to complete strangers using the algorithms created by these platforms. That has never been available to individuals.
And it’s becoming more prevalent among institutional investors. Basically, if you’re a hedge fund and you want to deploy $25 million into the consumer credit asset class, there’s now a relatively easy way to do that. This provides a way for all kinds of investors to access consumer and small business credit that was unavailable ten years ago.
On the borrowers’ side, they get an easier application, lower interest rates, they’re benefiting. But the big winner here, the driving force behind this industry, is the investors.
EQ: How confident should investors feel when investing in P2P as opposed to other, more traditional asset classes? How does the level or risk compare to other bonds or equities?
Peter Renton: The official word from the platforms is that you should not invest more than 10 percent of your net worth. That’s probably a good rule of thumb for people getting started. I know a lot of investors that don’t do that, some are putting half of their life savings into this, and that’s probably not the greatest idea. But there are some people, particularly retirees, living on fixed income and they’ve been hammered. They’ve seen an 80, 90 percent reduction in their income, a $1 million nest egg and it’s yielding $10,000 a year. That’s unacceptable.
And I really think that, while the risk is still there, this is a much lower risk investment than it was three or four years ago. These companies are established; the two leaders both have long track records, and these businesses are pretty stable.
I’ve been investing for approximately four and a half years, and this is my most stable investment. I’ve got a diversified portfolio with stocks, bonds, real estate, even commodities. This has been my overall most consistent investment.
Now, we’ve had a lot of drama in the stock market, people will say “I got a 30 percent return on my stock market investments last year and I got 10% at lending club, why should I devote more money to that?” Well, we all know what happened in 2008 and we all know that could happen again. If you keep your money in equities, you’re always at risk of that 20, 30, or even 40 percent drop.
At Lending Club and Prosper, you’ve got a consistent investment that’s low volatility that increases in value pretty much every month. You’re not going to get a 30 or 40 percent return every year, but you’re not going to get that downside either.
EQ: So you’re not as concerned with increasing default rates during market downturns?
Peter Renton: I think the most correlated number to P2P lending returns is unemployment. These borrowers are all people with jobs, and a spike in unemployment could mean a spike in defaults.
But keep in mind, both Prosper and Lending Club went through the financial crisis in 2008 and 2009. Lending Club came through the crisis quite well, but Prosper struggled due to their low underwriting standards. For Prosper at that time, their minimum credit score when was 520. That’s in the thick of subprime, but their drop in 2008 and 2009 was still just in the single digits. Since then Prosper has tightened their underwriting standards and now have a 640 minimum credit score.
If there were another 2008 or 2009 now, I feel very confident that my returns would remain positive. I’m earning close to 12 percent right now. If there were another 2008-9 right now, I might go down to 6 percent, but I know my stock market investments are going to drop precipitously. And that’s what you don’t get with P2P. I truly believe that it’s the best risk/reward investment out there across all asset classes.
EQ: How do you see peer-to-peer lending fitting into the portfolio of a retail investor? Is this something average people can take advantage of? Do you envision this becoming a regular part of the average 401(k) at some point in the future?
Peter Renton: Right now, you can’t invest through your 401k. You can invest through an IRA, but if you go to your 401k provider at your work and say “I want you to add Lending Club to the list of offerings,” it’s just not going to happen. It’s not set up for that retail type investor yet. We are still at least a couple of years away from that option being available to the average 401k plan.
You look at the stock market, it’s obviously a very mature asset class. It’s been around for hundreds of years. There are investors who choose individual stocks, do their own research and stock picking, but the vast majority are investing through the mutual funds in their 401k or IRA. Most investors don’t want to pick stocks, they want someone else to do the work for them. I think the same thing is going to happen in this asset class. You’re going to see a minority of people who are self-directed, who want to do everything themselves, and you’re going to have the majority of people who want to use a third party.
That’s something that’s still in its early days. There’s no mutual fund or daily liquidity in this asset class yet, but that’s coming within 12 months. The big guys aren’t going to get involved, you aren’t going to get Vanguard or Schwab mutual funds launching in the next 12 months, but you’ll see a mutual fund launch, almost certainly, before the end of next year.
I think this will be an asset class that people are going to want. You’re going to have investment advisors say “you should put 10 percent in P2P lending. It’s very consistent.” You’re going to have some people who want to get aggressive and might put 25% of their portfolio in there, spread across multiple platforms.
It’s not going to be as big as the stock market, not in the next several decades, maybe never, but you’re talking about a pretty big opportunity. With consumer and small business credit, not including mortgages or real estate, you’re looking at a $3-3.5 trillion market. You include real estate and you go up to $10-12 trillion. The industry’s going to evolve and we’re going to have a way for millions of investors to access this asset class.
EQ: What parallels do you see to bond markets in the P2P space? What lessons can P2P investors potentially take from investing in bonds?
Peter Renton: If you look at junk bonds, they’ve got high yields and relatively short duration compared with investment grade bonds. Peer-to-peer lending has higher yields, lower defaults, and shorter duration than junk bonds.
Bonds are large businesses borrowing money. If you buy a bond fund, you’re effectively lending money to businesses. You have that opportunity with the large businesses, but you haven’t had that same opportunity for small businesses. Now, you can lend money through the P2P platforms doing small business loans. So, you’re going to have your bond portfolio lending money to big businesses, and your online small business portfolio lending money to smaller businesses. It’s something that every investor should have.
People say you should diversify between bonds and stocks, and I totally agree with that. You could even put in a few REITs or some sort of real estate exposure, that’s a real smart move. You should also diversify into small business loans and personal credit. That’s how I see it. And it’s not going to be that long before that becomes the norm for investors.