Peer to Peer Lending

Red Flag - peer to peer lendingPeer to Peer Lending raises a ton of red flags during my due diligence process.

Fear is an investor’s constant companion.  We are supposed to be greedy when others are fearful and fearful when others are greedy.  However, fear seems to loom largest when the markets are down and fades away when markets are up.  Pain of past losses gives birth to new fears that what happened in the past will happen again.  While fear was helpful to our ancient ancestors, it is less helpful in investing.

One of the most insidious fears is fear of missing out – sometimes abbreviated as FOMO.  Fear of missing out is why everybody and their brother threw money at any stock with ‘.com’ in their name in 2000.  Fear of missing out is why your brother-in-law suddenly got into the house-flipping game in 2007.  Fear of missing out tells us that this is a once in a lifetime opportunity and if we get in on the ground floor, we will be living fat and happy without having to do too much work.  Unfortunately, what we mistake as the ground floor is often the top.

I’ve recently been pitched several different portfolios of peer to peer lending products.  The idea behind peer to peer lending is that some people need to borrow money while others want to lend money.  The peer to peer lending firm acts as a broker of sorts to match these two parties together.  There are different flavors of this, but they end up at the same place.  The peer to peer lending firm offers potential lenders/investors/chumps access to borrowers lumped together according to credit quality.  The firm might offer high quality, moderate quality, and ‘high yield’ (LOL – it’s never called high risk) portfolios.  The investor/sucker gives the peer to peer lender money and gets a piece of the portfolio without having to do any research or due diligence.  The peer to peer firm does all that for you, supposedly.

So many red flags come with these pitches that they should just be delivered through the mail wrapped in a red flag with Soviet postage.  The very first thing I notice is how little live history these products have.  One firm told me its fund had 5 years of performance.  When I read the fine print, it had 6 months of actual performance and 4.5 years with a similar strategy.  ‘Similar strategy’ covers a lot of ground, but usually means a smaller portfolio with different investments and different investors.  There is a huge difference between managing a $50 million portfolio and $500 million.  The bigger the portfolio, the harder it is to achieve the returns touted on the glossy brochure.  Even assuming the portfolio really does have live performance going back 5 years, this doesn’t show us how it will act in a down market for either stocks or bonds/credit.  Of course the peer to peer lending company’s model shows that they pass a 10,000 iteration stress-test with flying colors.  They also perform their own due diligence and credit checks on borrowers rather than relying on a third party like Experian or Equifax.  I am told, “Trust me/believe me, our credit algorithms and stress testing programs are much more robust than that other stuff.”  Being told to trust or believe the person trying to sell something is a red flag.  When someone tells you, “Believe me” or “Trust me”, the BS alarm should be going off.

The peer to peer lending salespeople I have talked with conceded my red flags, but brought up what they thought was a trump card – performance.  This is where they looked to play on the fear of missing out.  What if peer to peer lending is the next big thing?  Lots of institutional investors already got in.  Interest rates are zero!  Where else can you get yield like this?!?!?!

Where else can you get yields like this in a zero interest rate environment?  What about junk and distressed credit?  While they do provide high yields, there is a reason behind why an investment pays x% above Treasurys.  If peer to peer lending firms’ portfolios are of such high quality, why do they pay so much?  Maybe the market is just mispricing these assets.  Or maybe, as Bloomberg reports, there is trouble in peer to peer paradise.

If you’re truly investing, you’re not concerned about tomorrow, the next six months, or even the next two or three years.  Investing is a process with a long time horizon.  If ‘the next big thing’ really turns out to be good, an investor will be just fine missing out on the first 5 years of performance and participating in the next 20 or 30 years.  It pays to be patient.  Turn fear of missing out into fear of blowing up.  The early bird gets the worm, but the second mouse gets the cheese.


Photo by rightee