More problems with peer-to-peer lending


[The first post of this series described the general concepts and issues with peer-to-peer lending and the borrowing process. If you’re coming here from a search engine then you should read that first post and the P2P borrowing calculator post before you read any more of this one.  Understand the companies and the borrowers you’ll be dealing with.]

It’s the new hot way to make money. It’s really different this time. The Internet makes everything better. All the cool kids are doing it. Don’t get left behind. You know you want to be part of the peer-to-peer lending group, too!

Hmm, maybe not so fast. The last two posts explained why P2P loans can be a bad idea for borrowers, but lenders might have it even worse. The individual investors and venture capitalists who funded P2P lending companies have certainly earned whatever their shares might be worth someday, and the employees of the P2P lending business have created an innovative model with impressive websites that are starting to scale. Some of them have even managed to generate revenues with it.

I’ve done a lot of P2P reading in the last few months, and it seems as if every person who’s written about P2P lending has made some money at it. A few have made quite a bit of money at it. One or two may be able to retire early and live the rest of their lives from this income stream. I should also point out that nobody seems to be blogging about “I lost a fortune on P2P lending”, although you can find some entertaining articles by searching on the phrase “P2P lending sucks”. Of course, P2P’s survivor bias suits my personal confirmation bias, and I’m experienced enough (or at least old enough) to recognize that as a danger signal.

Don’t link your checking account to a P2P lender just yet. The end of this post will point you to some excellent bloggers who can show you how to do that, but first, let me share what I’ve learned.

The P2P business sector

Before we talk about the P2P lending companies, let’s put their business into perspective.

This FDIC statistical summary says that in the first quarter of 2013 there were 7019 FDIC-insured banks, down nearly 300 banks from 2012. During the last year, the surviving banks made new loans that amounted to $248 billion.

During the entire tenure of America’s two biggest P2P lenders, Lending Club and Prosper, all of the loans that they’ve facilitated amount to just over $2.3 billion. It took both businesses over five years to lend out that much money, and it’s still less than one percent of the money loaned by the entire banking industry in just one year. Although Lending Club and Prosper have come up with a creative and disruptive business model, they’re barely an asterisk in the national database. If both companies manage to grow by 100% over the next year then they’ll still have less than one-half of one percent of the American loan market. If they double again in 2015 then they’ll still be a “<1%” footnote on that PDF.

I don’t think that the executives of Wells Fargo and Bank of America are laying awake at night worrying about the next moves of the P2P industry. If either group of execs really cared, they wouldn’t even try to compete. They’d just set aside a few days of their cash flow to buy the two biggest P2P companies. If you’re lending money through a P2P company, how would you feel when you read the headlines about their acquisition by a corporate monolith like BofA?

The American P2P companies

Prosper Marketplace Inc. actually took an early lead in the sector by starting operations in 2006, followed by LendingClub Corporation (yeah, that’s one word) a little over a year later. Both companies had to “pause” in 2008 to register their lending activities with the SEC, but both have grown steadily since then. It’s worth noting that both companies survived the Great Recession, an accomplishment failed by a significant number of extinct banks on that FDIC statistical summary. Both P2P lenders also survived without taking a dime of government money.

[Let me add a quick note about the links in this post. The information in that last paragraph was taken from the latest Lending Club prospectus and from the latest Prosper prospectus. (Both of those links will open PDF files.) I’ll include more links throughout this post, but if I don’t specifically link a statement then it’s from one of these two documents. However both P2P company’s websites and blogs and some SEC filings are updated more often than the prospectus, so please let me know if you find a conflict. I’ll do more research and update the info from the current source.]

Each one of those PDFs is over 120 pages long, and they’re written in typical turgid accounting prose. You don’t have to be a CFP or a CPA to comprehend the text, but it helps to understand a little about accounting and about how companies operate. I’ve read through both documents several times, and I think I understand the contents, but I’m not an investment professional. You have to make the time and the effort to read at least these two documents, or else you should not be acting as a lender with either company. You have to understand the risks you’re taking or you’ll get surprised by something that’s already part of the company’s rules.

If you feel that you know enough about the business “just” from reading some of the excellent blogs on P2P lending then you’re gambling & hoping– not investing.

Lending Club is so much bigger than Prosper (in terms of loan volume), and Prosper is so much bigger than the third-largest P2P lender, that I’m only going to talk about these two companies. There are smaller American P2P lenders, and there are several overseas P2P lenders, but Lending Club and Prosper are effectively the American P2P lending market. Keep in mind that even though these two are the “giants” of P2P lending, they’re still a very small part of the lending industry.

Lending Club overview

Lending Club’s latest 10K SEC filing describes a fairly encouraging status for a startup company. During six years of operations, they’ve raised $102.5M through several rounds. A 2012 funding round valued Lending Club at over $500M, so they’re making great progress through the startup minefield. They lost over $4 million from March-December 2012 but the last three months of that showed positive cashflow from operations. The technical terms in that last sentence mean that Lending Club took in more money than they spent (and they made employee payroll) but the company is still not profitable. However, they’re headed in the right direction, with both rising loan volume and rising revenue. April was Lending Club’s best month ever, with over $140M in loans. They issued $780M in loans in 2012 and expect to reach $2B in 2013 so that 100% growth target looks “reasonable” and is certainly achievable.

Tech investors love it. Last month Google and Foundation Capital purchased $125M of shares at a price which values Lending Club at over $1.5B– a tripling of value in less than a year. The money was paid to existing shareholders (who sold some or all of their shares), not to Lending Club, and it gave Google an observer seat on the company’s board. A Google exec will be joining a group that already includes Mary Meeker, John Mack, and Larry Summers. Lending Club might even file for an initial public offering during 2014, although that’s strictly a rumor.

Enough of the good news: Lending Club is also a victim of its own success. The real reason that they loaned out $140M last month is because they screwed up– they couldn’t approve the applications fast enough to lend out even more. They’re just not scaling fast enough yet.

Their standards mean that they approve fewer than 10% of their “quality borrower” applications, and existing lenders are snatching up the available applications even before Lending Club has finished verifying them. (This is despite the fact that Lending Club only checks the borrower’s credit score and credit report. They verify the income statements on just 60% of their applications– they don’t even try to verify all stated income.) There are so few approved borrowers relative to lenders that the lenders have to manually click on the loans at specific times of the day before they’re gone– Lending Club hasn’t even fully implemented an automated tool yet. Lending Club actually admits that they’re “prudently reducing their investor acquisition efforts”… because they can’t keep up.

The weak link in Lending Club’s approval process is that they need too many employees. As of the end of 2012 they had 89 people working in sales, marketing, & customer service. This includes their employees in collections, credit, operations and “member support”. However Lending Club customer (and Forbes blogger) Marc Prosser has noted that even if each employee could make a decision on an application within 30 minutes, LC would still need over 150 people just to review January’s borrower volume.

Yeah, I know, it’s good to have growth problems. But when your money is sitting in a holding account instead of being loaned out to a “qualified” borrower, your ROI is zero.

Prosper overview

Compared to Lending Club, Prosper seems lucky to be in business. Their first-mover advantage turned out to work against them, and as pointed out by Peter Renton’s LendAcademy.com they’re practically rebooting the whole operation this year.

In early 2012 it looked like Prosper had raised about $40M in funding. As near as I can tell from the balance sheet in their 2012 10K, by the end of that year Prosper had raised about $83M and burned through nearly all of it. In early 2013 they raised an additional $20M which their 2012 10K describes as a “recapitalization” (always a touchy word for a startup finance company) led by Sequoia Capital and their existing shareholders.

As part of that funding, the new investors cleaned house. Prosper’s new CEO, Stephan Vermut, is part of the new team of execs and board members. The old CEO and a founder have left the company. A couple of months ago Prosper’s new President, Aaron Vermut, also joined the company. (Yes, he’s the CEO’s son, as previously noted on LendAcademy.) The new board members might not have the name recognition of Lending Club, but they’re all professional financial managers and experienced venture capitalists with experience and access to help. While a father-son team may seem a little odd, they’ve worked together before at a previous company for several years. It looks like Sequoia was only willing to invest if Stephan Vermut was available to take the reins, and his team has already built a successful company before coming to Prosper.

The turnaround is in progress. Prosper has been reworking the company structure to offer more protection to lenders and implemented a new API to make the borrower data more accessible. April was their biggest loan volume ever, and up nearly 75% from a year ago. The loan volume is particularly impressive in this chart at the end of this LendAcademy.com post showing Prosper’s stumbles in the last quarter of 2012 and their turnaround in the first quarter of 2013. However, the Lending Club chart in the same blog post shows that Prosper has a long competitive slog ahead of them.

Unfortunately, Prosper’s new team inherited some old legal baggage for this new era. Prosper has been litigating a class-action lawsuit since late 2008. Their earliest lenders allege that the company’s initial business model violated a number of state and federal security laws. What the plaintiffs really want, however, is damages to help replace the capital they lost. Nearly 20% of the loans from Prosper’s early days were delinquent, and nearly a third of the loans from one particularly bad month were delinquent. Prosper has already charged off most of these loans but the lawsuit may require the company to pay additional capital to the plaintiffs. I can’t find any more credible information on the progress of the lawsuit, but the new team of execs knows that it’s in their best interests to settle this one quickly. Prosper has already successfully staved off a potential brush with bankruptcy, and I think they’ll minimize the lawsuit liability as well. With their rising loan volume and their improved management, they may even be able to afford to pay for it out of revenues.

Now that I’ve laid out the differences between the two companies, I’ll describe their similarities.

P2P company lending process

Not only do the P2P companies have similar lending processes, but they both use Wells Fargo and the online bank WebBank. Prosper and Lending Club act as loan processors, moving your money between accounts to fund the loans and collect the payments.

When a borrower files an application on either P2P company’s website, their FICO score and credit report are checked. Once the company is satisfied that the borrower meets their minimum criteria and has a valid ID, the application is posted for lenders to purchase.

When a lender links their checking account to a P2P company, their funds go to an escrow account held with Wells Fargo. The escrow accounts are FDIC-insured up to $250K for each individual, so your money is still safe before you lend it out. Although the account might be earning interest, you don’t get any of it. Your money sits there, losing to inflation, as long as it takes you (or the P2P company) to put it to work on a loan.

A typical lender will diversify their assets by only “buying” $25-$50 of each loan. Applications from high-quality borrowers may be funded in a matter of minutes, but some low-quality borrowers are also attractive. (Aggressive lenders think that low-quality borrowers will pay a disproportionately high-interest rate with an acceptable percentage of defaults.) In addition to individual lenders (the “peers” of P2P), some financial institutions invest their corporate funds through a P2P company. Prosper and Lending Club will also automatically invest the (larger) accounts of qualified individual lenders. The theory is that every lender, individual or corporate, has the same opportunity to fund a loan. However, the P2P companies may make selected “entire loans” available to institutions or accredited investors, while other loans may be funded through automated programs. The P2P companies claim to make roughly the same percentages of all loans available to all of their customers, and you’ll have to trust them on that.

If you’re an individual investor with a Lending Club account, it may also mean that you’ll be lurking their website at 6AM, 10AM, 2PM, and 6PM Pacific Time hoping to beat out your fellow “peers” for the loans that meet your criteria.

At some point, a borrower’s loan has enough demand to be funded. When that happens, the P2P companies deduct the money from the lender’s accounts send it (minus the P2P company’s fee) to WebBank. WebBank actually sends the money to the borrower in exchange for the borrower’s promissory note. WebBank then assigns the non-recourse promissory note back to the P2P lender, who uses it to distribute principal & interest payments to lender accounts (minus the P2P company’s fee).

Although this promissory-note process seems cumbersome, it meets the SEC’s requirements to track the funds and to protect investors. Here’s a block diagram for Lending Club from their prospectus:

A diagram of how borrowers and lenders use Lending Club to process loans

Lending Club loan diagram

 

There’s a similar diagram on page 14 of Prosper’s prospectus.

Lender commitment: 3-5 years

The non-recourse promissory note stays with the P2P company, not the lender. This is a good thing. The P2P companies earn their revenues from the fees on servicing the loans, but they can also charge additional fees to borrowers. If the borrower stops making payments then the P2P companies hold the legal paperwork to start the delinquency and collection process.

If a borrower is late on their payments, the P2P companies charge late fees. Late fees (minus the P2P company’s fee) go to lenders, but this is still a sign if impending trouble. If a loan defaults (usually more than 120 days late) then the P2P companies charge additional collection fees. However the lenders don’t get any of these extra revenues, and they’re losing interest while hoping that the borrower will bring the loan current. If the borrower declares bankruptcy then the lender gets nothing.

At this point, a lender has committed their money for a minimum of three years. If the borrower makes their payments on time then the lender receives a stream of income, and they can withdraw that income at any time. (Most lenders re-invest in more loans.) If the loan is paid back on schedule then the lender has received their principal & interest. If the loan is paid early (which seems to be rare) then lenders get less interest. However, if any payments are late then the loan may revert to a five-year note. If the borrower defaults then lenders lose some principal and interest. These are unsecured loans so there’s no collateral for lenders to seize.

So how many loans go into default? That’s a difficult question, and it doesn’t have a credible answer. The riskier the loan, the higher the interest rate, but the higher the chance of default. The current lending programs have only been in effect for about five years, and that’s not enough history to make a valid statistical prediction. In addition, the P2P companies keep improving their criteria so it’s difficult to compare loans across the years and programs. Overall, only 2%-3% of the loans have defaulted. However Lending Club assumes that at least 5% of their riskiest loans will default, and Prosper assumes that over 15% of their riskiest loans will default. Yet Prosper also had a very bad month in 2007 when over 30% of their loans defaulted.

Another problem with the default statistics is that both lenders are making up the metrics as they go along. (Hey, they’re creating the business model, so they get to choose most of the parameters.) Lender’s returns are projected into the future with assumed default rates, not the actual ROI. Loans aren’t formally written off until long after the borrowers have stopped paying. If a three-year loan becomes a five-year loan, now two statistics databases have to be updated. Lenders don’t have easy access to the real-time performance data, let alone the rights to audit the results. The whole system is ripe for data-mining and cherry-picking, even before the marketing committee puts together their campaign.

As equity investors know all too well, history is next to useless at predicting the future. Both Prosper and Lending Club were just getting started when the 2008 financial crisis hit, and they were “paused” by SEC injunction for much of that time. Nobody knows how borrowers will behave next year, or during the next recession, or whenever interest rates start rising again.

“Unsecured” also means that the lender has a low-priority claim on collection efforts. If the borrower declares bankruptcy then the lender gets nothing more. If the borrower dies then the estate executor has the discretion to pay the loan– or not. It’s the executor’s decision, not the lender’s.

Can lenders get their money back before the loan is paid off? Sort of. Both Prosper & Lending Club use FOLIOfn to provide a secondary market for trading the promissory notes. However, the notes in the secondary market are heavily discounted because most of them are delinquent. Other lenders can buy new notes from the P2P companies, so lenders on the secondary market will only buy your note at a discount. Selling your loan here means that you’ll wipe out your profits and even some of your principal.

One more time: lenders have to commit their principal for 3-5 years in exchange for monthly payments. Liquidity is very limited. Although lenders can sell their notes on a secondary exchange, the discounted price will almost certainly result in loss of interest & principal.

P2P company bankruptcy

Another reason for this complicated lending process is a legal protection that nobody wants to talk about: bankruptcy. The P2P companies will survive only if they eventually earn more in fees than they spend in processing the loans (or collecting on them). After more than five years of effort, and ~$200M in expenses between them, only Lending Club has succeeded in this goal— and only for the last three months of 2012. Prosper actually came within a few months of going bankrupt. Eventually, the investors are going to stop coughing up the cash and expect these two companies to execute on their business models– or the investors will pull the plug and start fighting over the carcasses.

If either P2P company goes bankrupt, then what happens to the lenders and the borrowers?

Both Lending Club and Prosper hold the notes in trust for their lenders, much like stockbrokers and mutual fund companies hold shares for their customers. Each P2P company has contracted with a backup to take over the loan processing during their bankruptcy. This is an accepted practice in the financial industry, and it happens more often than you might expect. However, it does not happen instantly or flawlessly. There will inevitably be computer glitches, customer service lapses, disgruntled (unpaid) employees, regulatory interference, media hype, and uncertainty.

Borrowers might be tempted to stop paying money to a bankrupt company, but they’d be wise to continue paying their loans right on time. They signed a non-recourse promissory note, and the holder of that note can come after them with the full force of the law. However, if there’s enough chaos (or if the backup customer service screws up their payments) then borrowers might just walk away.

How many borrowers will default if a P2P company goes bankrupt? Nobody knows. There’s just not enough history to make an intelligent guess.

Lenders should continue to receive their principal and interest payments from the borrowers, as soon as the backup processing company has taken control. Both P2P companies have done their best to make sure that their bankruptcies would go through the courts without their legal issues affecting the promissory notes. (Good luck with that.) However, the lenders are a mix of financial institutions, accredited investors, qualified investors, and retail investors. Nobody knows whether the notes would continue to pay out per each lender’s share, or whether some lenders would claim a higher priority. Institutional lenders have the assets (and the legal expertise) to perturb this process for months. I’m not sure who’d stick up for the retail investors… certainly not the FDIC or the SEC.

How long will it take for lenders to receive whatever funds they have on deposit with the loan processor? Nobody knows. It’ll be a minimum of the remaining term of the loan, unless the bankruptcy is tied up in the courts for longer. If borrowers default en masse then it’ll be a lot quicker, but nobody wants that type of answer.

Should you invest through Prosper, given their shaky finances and their legal issues? The only reason to do so would be if you feel that you can boost your returns with their riskiest loans. Those loans (at APRs as high as 35%) will almost certainly have a higher default rate, which means that lenders will have to be especially vigilant about selection and diversification. I’m not sure that the additional return is worth the very real default risk and the huge additional lender labor to screen the loans. Everybody loves an underdog, but Prosper is very thinly capitalized and still has the legal liability hanging over their financial future.

P2P lending company execution

I hope the last 4000 words have given you a perspective of how difficult it can be to execute an innovative idea with a good business plan. Lending Club and Prosper didn’t just have to break the old rules– they had to write the new rule books and defend them to the regulatory authorities and their investors. As horrific as their finances might seem today, they’re among the top 1% of startup companies.

However, the survival skills that got them here are irrelevant to their futures. Founders of successful companies are great at getting them to revenue, but they mostly suck at the only metric that counts from now on: growth. Both companies have to add as many borrowers as quickly as possible, and as cheaply as possible, without buying more infrastructure. They’re already spending millions of dollars on marketing and other “customer acquisition” costs, and now they have to figure out how to scale that effort along with their lending software.

Prosper has limped along for years of uneven performance, but today they might actually have a better executive team climbing the growth curve. The “new guys” have considerable Wall Street and banking experience, have already built at least one successful business, and are presumably ready to do it again. Hopefully, there aren’t too many surprises lurking from the founder’s era.

Lending Club is already discovering the limits of their system. Their software is too slow, or it requires too much human intervention to approve borrowers, or it’s too hard for the lender users to automate. Maybe it doesn’t scale from 10,000 lenders to 10 million. Maybe they can tweak it, or more realistically (like Facebook) they’ll have to scrap it and rewrite it.

In the meantime, I’d hate to be a worker-bee in either cubicle farm. Management is surely squeezing the staff to move as fast as possible with as little as possible. It’s all too easy to start cutting corners on the borrower applications. It’s all too tempting for the risk committees to change interest rates to please their customers instead of to adequately compensate for the risk. It’s all too expedient for the statistics & probabilities (what few there are) to get trampled in the rush to move more money out the door. Anyone who raises a caution flag, let alone tries to hit the emergency button on the assembly line, will receive way too much of the wrong kind of supervisory attention. I’m sure that their talent can command a high price in their area, and the compensation metrics might not necessarily be aligned with the best interests of the lenders.

Even without the temptations of fraud & theft, good people will end up taking risks that they don’t truly comprehend. I wonder how much they learned from the 2008 mortgage-lending crisis.

Loan default rates could double during 2013 just from these execution issues.

Your weaknesses as a lender

Unless you’ve worked in the loan business, then I’m pretty sure you also suck at figuring out whether an anonymous borrower is likely to pay back your loan.

Both P2P companies try to avoid outright borrower fraud, but let’s face it: they make their money from moving more borrowers faster with more money. It’s up to you to choose the right borrowers, and you have no idea what you’re doing.

“Luckily” both Lending Club and Prosper recommend that you “diversify” by doling out a little money to each of a lot of different borrowers. The statistics start to work in your favor when you rise above 400 loans. (Every Lending Club lender with at least 800 loans has made money– so far.) Are some borrowers more likely to pay than others? Sure, that’s pretty easy to figure out from credit scores alone. However, you can’t tell whether borrowers are stating the truth about a lot of other parameters. You certainly can’t tell whether the interest rate they’re promising to pay is adequately compensating you for the (unknown) risk that you’re taking.

I don’t know about you, but this situation would paralyze me with indecision.

Unfortunately, Lending Club and Prosper have been thinking about this customer acquisition paralysis issue for a lot longer than we lenders have.

“Illusion of control”
Their marketing solution is to give you the illusion of control. You’re fooled into thinking that your hard work pays off.

Each company’s website lets you look at every loan– right down to the borrower’s personal appeal reason for borrowing your money. Each website has a plethora of screening tools to help you choose the perfect borrower. It has everything except levers, switches, knobs, and flashing lights. If you don’t feel comfortable screening on your own then there are dozens of blogs and third-party tools to crunch the existing data, backtest it, and extrapolate it. You have tremendous control in choosing where you put your money, and there are many powerful tools for analyzing the loan portfolio. The only problem is that nobody really has enough data to know whether any of it works.

But that thinking shouldn’t distract you from the fascinating tools: Excel spreadsheets, pivot tables, backtesting algorithms, proprietary screening tools, lender discussion forums, and borrower’s personal statements. You could spend hours tweaking each of the parameters and never have to consider whether you’re working with gold– or garbage.

I should point out that personal-finance bloggers (and nuclear engineers) are especially susceptible to this weakness. We’re all about the control, and our hard work is the critical factor behind accelerating our wealth.

“It’s not luck, it’s skill!”
Every existing P2P lender would respond to that last paragraph with “Yeah, but my model works better.” How do you know whether your screening tools are skill or luck? One possibility is that you’re a brilliant loan analyst. Another is that you’ve built a diversified portfolio which happened to weather the last storm of defaults. A final possibility is that you’re just freakin’ lucky. How much data does it take to know which possibility applies to you?

Jason Hull has already crunched some of those numbers, and the short answer is “for the riskiest loans, over $18,000 and 3-5 years”. For the high-quality loans (with a lot more borrowers) the number is more like $180,000. If you just want to know whether you’ll break even, then the answer is only about $2750– but you’ll still have to wait until all the loans are paid back (or defaulted). Those Lending Club members with their 800 loans who have all made money? At $25 per loan, each of them has committed at least $20,000 for 3-5 years. Each of these companies has only been lending money through their current process for five years. Where will they be in another 3-5 years?

“An exclusive club for very special members.”
We all want to belong to a place that appreciates us, but we’re not just anybody. Both companies warn their potential lenders that their services may not be available in your state. Both warn that you need to be “qualified investors” who are presumably smart educated enough to understand the rules and the risks. Both have extensive disclaimers and risk disclosures and a whole highway filled with signs claiming “Danger– excitement ahead!!” It’s almost as if they can tell that you have money.

Oh, and you can get a discount with access to special tools, too. What’s not to like?

“I’m doing this with my friends. All five million of them.”
Another marketing issue is the social proof aspect of peer-to-peer lending. (Note that the author of that linked article is a partner at one of Silicon Valley’s biggest and most successful VC firms.) It’s so high school, but it works so well. You’re not only one of the cool kids again– you’re helping people just like you overcome their debt problems. Better yet, you’re doing it with an awesome team of lenders who are also coincidentally just as charming, analytical, and successful as you. We’re all brilliant investors, too!

“Chasing yield”
Whether we’re brilliant or not, there’s still those righteous double-digit returns. If some of your asset allocation is in bonds, or more of your money is sitting in a low-yield savings account, then how can we pass up P2P lending?!?

Chasing yield is a major behavioral psychology problem. Those assets are in your portfolio to lower its volatility and to help you ride out a bear market. If you’re a value investor then your cash is sitting idle (losing to inflation) for several years while you wait for an asset dollar to go on sale for 75 cents. The advantages of your low-yield bonds and your spare cash are lower overall volatility and the liquidity to quickly buy a bargain when it goes on sale. You get a big discount for paying cash, but until the next recession surprises us then you can’t tell whether you’re the next Warren Buffett… or just another hypercautious idiot.

If you’re saving up a down payment to buy a home in five years, but it’s only earning 0.6% in a money-market account… hey, don’t even go there.

“It’s not that hard, and they’ll do it for you.”
P2P lending is too much work, especially if you’re deployed to the desert. Not only is P2P too much effort, but you’re slaving away (admittedly on a great website with fascinating tools) at minimum wage. Just like gambling, it’s mostly entertainment: the more work you put into it, the less money you’ll lose. You might even make money, but you’d make far more money by (as Jason writes) investing in yourself.

Lending Club has a PRIME program that automates much of your effort. For a minimum portfolio of $25,000 (and an additional 0.8% fee) you’ll choose a risk level and they’ll do the rest. Even before Lending Club’s latest loan-processing challenges, it took nearly three months for PRIME to invest one (very experienced) lender’s $52K. Prosper attempts a similar automation with their “Quick Invest” tool. However these helpful conveniences just make it even easier for you to hand over your money without doing any due diligence on the compensation you’re receiving for the risk you’re taking. More brilliant marketing by both Lending Club and Prosper.

“But we can afford it!”
There’s another aspect of P2P lending for my older readers (especially military retirees). If you’re barely surviving your retirement budget on your pension & savings then P2P losses (like a Prosper bankruptcy with accounts frozen for three months) can destroy your portfolio. But many military retirees (especially dual-military couples) have found that they have more assets than they need. When that happens, you stop hustling for a buck and only do things that bring you fulfillment without sacrificing your autonomy. At a minimum, you (*ahem*) do more surfing & traveling. Otherwise, you spend time on enjoyable projects where you feel your efforts will be more rewarded, like writing & philanthropy. If you can afford to lose the money then P2P lending becomes just another speculative asset class without a track record. It’s just as much an entertainment expense as a part of a diversified investment portfolio.

“But what if we…”
I’ve written nearly 13,000 words over three posts on this subject, and the investor psychology still almost sucked me in. I’ve tremendously enjoyed this research project (and the challenge of explaining it), and nearly every aspect of P2P lending plays to my financial vulnerabilities. Every day when I read or wrote, I was looking for the secret that would give me an incentive to sign up. I have to admit that I’m still a nuke– I’m still tempted to “give it a try” and “do it right”. Surely it’ll be different this time!

Luckily, I’ve been investing long enough to recognize the addictive signs and to know my weaknesses. Over the years I’ve turned into a lazy highly efficient investor, and I don’t feel that P2P’s results will help me distinguish luck from effort. It would become yet another project in an already busy life.

Minimize your risk

So after this ringing three-post endorsement, why would any investor in their right mind even consider peer-to-peer lending?

Oh, yeah, the chance to get in on the ground second floor and chase double-digit yields– before all the good deals are gone.

Not that any of us brilliant investors would be swayed by that type of P2P behavioral psychology marketing.

I hope I’ve shown that you can’t quantify the risk– and you don’t know whether you’re being paid enough to take the risk. Even the companies might not stay in business. Everything else is marketing & sales pressure playing to your psychological vulnerabilities.

If P2P lending is important to you, then treat it like any other single-asset allocation risk. I’d urge you to put no more than 10% of your investment portfolio into the entire sector– and kiss it goodbye for at least 3-5 years! I’d suggest that you split it between Prosper and Lending Club, so that one bankruptcy won’t (temporarily) freeze all your P2P assets.

I strongly recommend that all prospective lenders read the risk factors on Lending Club’s prospectus and on Prosper’s prospectus. Both of those disclosures start on page 13 of the PDFs. (If your culture ascribes bad luck to the number 13, then… eh, I’m sure that’s just a formatting coincidence.) Don’t trust the fancy graphics & charts on the P2P company’s websites. Read the legal documents. If you don’t understand something in those risk factors then please ask your financial advisor or post a comment– we’ll figure it out for you.

If you have TL;DR syndrome and can’t be bothered to read a prospectus, then don’t engage in P2P lending. You’ll be much happier at a gambling casino, and the drinks might even be free.

Here are a few websites with more details on executing a P2P lending plan:
Peter Renton’s Lend Academy. Peter’s the leader in the field, with many contacts at both companies. He’s also built up a six-figure portfolio for both himself and a relative.
MrMoneyMustache’s Lending Club experiment. He’s using the money generated by his blog’s revenue.
Military Money Manual Lending Club report. He’s done it even while deployed to a combat zone.
Mike at Live The New Economy. He’s exploring both Lending Club and Prosper.
Rob Aeschbach on two types of risks with P2P lending

Thanks to poster “Footenote” on Mr. Money Mustache for the Economist article “Crowdfunding in America:  End of the peer show”!

Related articles:
The problems with peer-to-peer lending (the first post of this series)
Chasing yield
Save or invest?
Where to put your savings while you’re in the military
Tailor your investments to your military pay and your pension
Retirement planning: “Just tell me what to do!”
Military retirement with low savings
Retiring on multiple streams of income
Asset allocation considerations for a military pension
Education of an investor (“Black Monday”)
Do you really need $2M to retire?!?



WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

10 Comments
  1. Nearly 3 years have elapsed since you wrote your post and that’s another 3 years of p2p experience.
    How have things evolved since? Does any of your analysis require updating? Do you conclusions still hold?

    • Thanks for asking, George! I think we need a nasty bear market before we gain enough data for a good followup post.

      My biggest concern about P2P lending is that we still can’t tell whether investors are being adequately compensated for their risk. If anything, the large corporate lenders are encouraging more risk by snapping up loans and encouraging lower interest rates.

      Small P2P lenders still haven’t loaned enough money to tell whether their lending criteria are better than random chance. It takes thousands of loans (and hundreds of thousands of dollars) to distinguish skill from luck.

      We haven’t had a bear market in the last three years, so we don’t know how borrowers will behave when they lack the money to pay an unsecured loan.

      The only “evolution” has been in the growth of the lending platforms. I haven’t plowed through any Lending Club or Prosper 10Ks or 10Qs lately, but I bet they’ve added more knobs & levers to allow investors to “analyze” borrowers. I also suspect they’ve made it even easier for lenders to give money to borrowers, despite the trend of large corporate lenders to snatch up the loans faster than the smaller investors. I’m sure that their future growth rests more in creating more loans rather than in creating “better” loans.

      I also suspect that the large corporate lenders have the experience (or at least the loss reserves) to survive the next bear market (and P2P lending defaults) better than the smaller lenders.

      I think borrowers would only do better with a P2P loan if they possess the assets to pay off the debt in such a short term. I think it’s better to use debt counseling and consolidation services (and changing their money behavior) rather than paying high funding costs for what is probably going to be a subprime loan rate.

      I think the average investor is still much better off in a classic passively-managed index fund with low expense ratios. P2P lending could be 5%-10% of their asset allocation for “shoot the moon” investments (or at least a testosterone-poisoned outlet) but I think a healthy degree of skepticism is still appropriate. Until an investor’s 10% asset allocation grows to fund thousands of loans with a six-figure dollar commitment, they’re simply speculating.

  2. Congratulations for a very well written article on P2P Lending. We try to address two of the major problems you mention with our LendingRobot.com service: one, the requirement to lurk their websites four times a day, two the deluge of filtering criteria. But in any case, you’re absolutely right in explaining peer lending should not be seen as a philosopher’s stone, but rather an asset diversification venue.

  3. Uhhh – I skimmed the three posts – you are working way too hard here (was each of these about 10K words?) !!!! (Did your wife remind you about your over zealous nuclear engineering analysis tendencies coming to the forefront ;-)) And based on a few of the things I picked up in my skim, I would be working too hard figuring out how to do this…I know I’m not that sophisticated, and frankly, it just seems like the same thing as lending family or friends money – better just to give it to them as you probably won’t ever see it back…..nevertheless, kudos to you….how’s the surf?

    • Thanks, Deserat!

      I’ve been stalking this subject since last October. WordPress claims that those three posts are 4033, 2836, and 6414 words respectively. They’re among my ten longest posts, and that 6414-word one is probably the longest. As you can tell, I had a lot on my mind. This weekend I’m trying to boil all three down into a summary for a guest post on a personal-finance blog to be named soon.

      When I gave my spouse the 10-minute pitch, she was not impressed with this asset class. With your engineering background, you’d be frustrated by the unquantifiable and uncompensated risk. And then when you started working on the websites, you’d be at least as frustrated by the process. That’s how I feel now. My research has only nudged me closer to value investing.

      The surfing has been most incredibly excellent. My daughter’s home from college, and we’ve been out 20 of the last 24 days. Two weeks have been 8-12 footers, and the rest of the days have been “just” 3-5. This is the best south shore surfing season kickoff that I’ve had in my 11 years of surfing, and the old-timers say that it’s the best in at least 20 years!

  4. These posts have been absolutely first-rate Doug! Bravo! I’m going to link to them. Thanks as well for the mention… I know I’m “chasing yield” with my $20,000 investment, but I can afford to take risk and, for me, I find the entire sector too darned interesting to not explore with some of my actual cash. In fact, I’ve dedicated a new tab to the site where I’ve placed a running summary of both our LC and our Prosper loans. I’ll continue to show the full numbers in the monthly reports. Again, great post!

  5. Wow what a great conclusion to your series of posts on P2P lending Doug. Very informative stuff and a clear message here to prospective lenders to do their homework and due diligence.

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