Marian Dreher
PP loans in a financial crisis Marian Dreher

Over the past years, investing into p2p and p2b loans has been giving us stable returns north of 10% per year. At the same time we are seeing a tremendous growth of traded loan volumes and many new investment platforms emerge month by month. But how about the performance of p2p loans in a financial crisis?

I would say that we are right in the middle of a p2p loan boom. It’s nice to enjoy the ride but it is also crucial to keep our eyes open for what might come afterwards. There will certainly be changes and issues which are specific to the p2p loan market but there is one thing which is likely going to affect all types of investments and certainly the p2p loans: it’s the next economic depression.

This is not some apocalyptic post that proclaims that the next crisis is imminent. I don’t know when it will come and what will eventually cause it. The point of this article is more to look at how p2p loans as a relatively new type of investment opportunity might perform in such a crisis. Is the loan market somewhat decoupled from the stock market?

There were two financial crises in the past 20 years. P2p loans emerged shortly before 2007.

We cannot look into the future but we can take a look into the past. When the last financial crisis hit back in 07/08 there were already two p2p loan platforms active on the US and UK market, respectively. I will use data from these platforms to analyze how the p2p loans performed during the crisis.

The economic depression that started in late 2007 and lasted well into 2010 was actually not caused by stock market speculations but to a large extent by rotten “subprime” mortgage loans in the US. When the interest rates started to increase in the years before 2007, many people could not pay back these loans anymore. This started a landslide that brought banks to collapse, drove people out of their houses and out of their jobs. The stock market was also affected and major indices dropped by up to 50%.

The US stock market started to fall in Septmeber 2007. Unemployment started to rise in early 2008.

When we look at the p2p loan performance in a financial crisis, the ability of the borrowers to pay back these loans is a key factor. Unemployment and part time work will severly affect this ability. Looking at the US unemployment rate and at the S&P500 index it becomes clear how severely the US economy and the job market were hit durign the subprime crisis.

Naturally, this affected the performance of loans and the rate of loan deliquency began to rise together with the unemployment rate. Essentially all types of loans were affected from credit card debt to mortgage loans.

US consumer debt deliquency around the 2007 financial crisis. Payments on credit card and mortgage debt started to drop.

The essential questions is now: how did this financial crisis affect the performance of p2p loans?

Lending Club was the first US p2p loan platform and started its business in 2007 during the final buildup of the debt crisis. The dataset that we are going to look at here is therefore not perfect since the years before the crisis are missing (this would have been some sort of baseline).

Nonetheless, the data that is available on the Lending Club website already reveals some interesting details. The graph below shows the effective return on investment per loan risk category (with A loans being the least risky and FR the highest risk loans). Even during the crisis, the low risk loans managed to generate a positive return on investment. Only the higher risk loans lead to losses. The overall loan portfolio performance was just slightly negative in 2007 and reached profitability again in 2008.

Performance of the Lending Club p2p loan portfolio per risk category.

So, while the stock market kept crashing and the unemployment rate kept climbing, Lending Club investors were already making a profit again, particularly the ones with lower risk loan portfolios! This data shows that the p2p loan market is somewhat decoupled from the stock market and can generate profits even during an economic depression.

Let’s take a look at another platform, this time from the UK.

Zopa got started in the UK back in 2005 and claims to be the oldest p2p loan platform worldwide. Be that as it may, Zopa provides us with the perfect dataset to study the performance of p2p loans before, during and after the financial crisis in 2007.

Loan default rate at Zopa from 2005 to 2013.

Above graph shows quite impressively how the loan default rate started to increase with the unfolding debt crisis. After reaching a peak in 2008 it started to go down again and stabilized in 2011.

Now, I put all the important data into one graph: loan default rates, portfolio profitability, UK unemployment and the UK’s FTSE100 stock index.

Zopa loan default rates and portfolio profitability. UK unemployment and the UK’s FTSE100 stock index.

Similar to what we have seen in the case of Lending Club, Zopa maintained an overall positive return on investment despite increased loan default rates, rising unemployment and a 40% drop in the UK stock market. Moreover, it is important to note here that 75% of the delinquent loan volume could eventually be recovered by Zopa and were paid back to the investors.

So, what are the lessons learnt?

First of all, we saw that the p2p loan market is to a certain extent decoupled from the stock market. Of course, rising unemployment does affect the repayment of loans but apparently not to such a large extent that the loan portfolios turn completely negative. This is particularly true for loans with lower risk classes.

The Lending Club portfolio had about 1% loss in 2007. This is essentially nothing compared to the losses seen in the stock markets which were between 40% and 50%. Most importantly, investors at both Zopa and Lending Club were back to positive returns already in 2008 when the crisis was still in full force.

Therefore, investments into p2p loans can be a good option during economically instable times and might be a good addition to an investment portfolio.

Concretely, investors who are interested in p2p loans should look for high diversification and have a solid basis of low risk loans. Platforms that offer such opportunities are mainly Mintos and Bondora.

In the case of Mintos, the risk rating of the individual loans is less important but attention needs to be paid to a solid track record and high profitability of the loan originators. On Mintos, everythings stands or falls with the stability of the loan originators. Therefore, I avoid using the Invest&Access feature of Mintos but instead use external ratings (such as for choosing solid loan originators and to build my own investment strategy.

On Bondora, a portfolio with low risk loans (e.g. AA-B loans) will probably get investors through a crisis much better than higher risk loans. The highly diversified Go&Grow feature is also a good choice in my opinion. Bondora might reduce the currently advertised interest rate of 6.75% but not making any losses durign a crisis is already a big win.

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