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John Spiers: The perils of peer to peer lending

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John Spiers: The perils of peer to peer lending

Peer to peer (P2P) lending is a hot topic. The government has announced a consultation to allow this type of investment within Nisas and it has already become available through at least one Sipp platform.

Meanwhile, Santander, in a quite remarkable move, has agreed to start to channelling some of its corporate lending requests to Funding Circle, one of the prominent P2P platforms.

The government-owned British Business Bank has also made £40 million of investment available. It all looks too good to be true and in the investment world we know what that usually means.

I started dabbling in this sector a couple of years ago. At first glance it looked pretty tempting, with headline rates of interest well above bond yields and returns likely to be only loosely correlated to the stockmarket.

We all love to hate the banks so it’s easy to think that they are missing out on lucrative business through their cumbersome lending criteria and high margins. However, they have been in this business for a long time and it would be surprising if they were closing the door on a cash cow.

Losses are inevitable

Nothing in the investment world is simple and the first thing to realise is that those tempting headline yields are simply the absolute maximum you can receive if all goes implausibly well. Bad debts are a fact of life and this is going to be one of the biggest bugbears of P2P lending.

Loan loss rates vary depending on economic conditions and right now we are in a pretty benign environment that will not last.

Another problem is spreading risk. There is no Financial Services Compensation Scheme (FSCS) payments available in this sector.

When a loan goes sour you will probably lose most if not all, so you must have a wide spread in order to benefit from the law of averages. I’d say at least 20 separate loans, preferably well diversified across business sectors, should be the target of private investors; 100 would be better. A bank will have thousands.

If you try and build a loan portfolio by making your own selections be prepared to put aside a considerable amount of time to do your analysis. Once you have found a candidate you may be outbid at the last moment – very frustrating.

Alternatively you can allow some platforms to make the choices for you under predetermined criteria for risk, which brings us to the next issue. 

Who’s looking after your interests?

The P2P platform is only risking its reputation and not its own money when it puts a rating on a loan. I’m sure these businesses regulated by the Financial Conduct Authority (FCA) will have proper controls but you can’t ignore the fact that the interests of them and their customers are not well aligned.

That’s an issue in terms of the initial rating given to each loan (platforms may be competing for business) and even more so when it goes sour.

How much effort will be put into chasing down the guarantors and any other possible sources of redress? Remember these are exactly the same issues that led to the bubble and collapse of securitised lending. 

The tax trap 

Finally you need to consider a tax regime that provides no incentive for taking risks. Loan losses cannot be offset against interest income for tax purposes.

It can usually be used to create a capital loss but that will only be of value to a small number of investors who pay capital gains tax. The table below looks at the potential numbers:

Lowest Risk

Moderate Risk

Typical Interest rate

8.0%

10.0%

Platform fee

(1.0%)

(1.0%)

Bad debts*

(2.0%)

(3.0%)

Gross return

5.0%

6.0%

Tax (@ 45%)

(3.2%)

(4.1%)

Net return

1.8%

1.9%

Gross equivalent

3.3%

3.5%

A net return of less than 2% is clearly inadequate given the illiquidity, opacity, lack of FSCS cover etc. You can see why the platforms are excited about the potential ISA relief since that would radically improve the position. The table also demonstrates that there is very little incentive to take on higher risk loans. 

The bottom line 

For taxpayers I believe the current net returns from P2P lending are unappealing. If that disadvantage can be overcome by making them Nisable then I’d say the sector is worth a dabble but the critical issue then will be the quality of the platforms’ due diligence and debt recovery teams.

We are in the early years of this activity so we can expect their learning curves to be steep. I also suspect that lenders are being too generous with their terms at the moment.

John Spiers is the founder of Bestinvest.

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