Peer-to-Peer Investing a Bust in Michigan

A few weeks ago a reader emailed me and said he was looking for peer-to-peer (P2P) lending information on FMF and couldn't find anything. He wondered if he was missing what I'd written or if I simply hadn't covered the topic.

I told him that I write about topics that I know something about or am interested in. Since I have never tried P2P lending, I don't have much to say about it.

In his email the reader pointed to Lend Academy. He said had been reading that site as he was working on what he was going to do. I decided to check it out for myself.

The site was quite informative and gave me pause a bit because it said people were earning 10% back on their money through P2P lending (for example, here are the results from the site's author). I was skeptical but was intrigued enough that I was willing to use a bit of my own money to see if I could replicate these results myself. If I could, P2P would be a nice complement to my real estate investing efforts as I moved towards setting up my safest retirement scenario plan.

As I dug deeper, I found that some states allow P2P investing and others don't. Unfortunately, the information I discovered said Michigan did NOT allow it. Not sure if this was accurate, I sent Lending Club (the largest P2P company, the other is Prosper) an "Is this true?" email.

They responded promptly that yes, this was true. The wonderful State of Michigan (my sarcastic words, not theirs) limits my rights to lend/invest in this manner. So do many other states. They pointed me to this page for details.

However, I did have some options. The non-participating states prohibit investing in primary markets -- the original issuing of notes/loans. But they allow secondary investing, which is basically buying loans that others have made but want out of for some reason. I wasn't too excited about investing in notes others were trying to bail on. In addition, this market is MUCH smaller and likely couldn't give me the diversification and investment choices I would want. So it wasn't a viable option for me.

They also noted that if I was an accredited investor, I might have some additional options. Since I do meet the criteria, I called the contact they provided to see if I could make something work.

He reiterated the info above (no primary but secondary investing for Michigan residents). We talked about what I was looking to accomplish (10% return on my money) and he confirmed I met the definition of an accredited investor. Then he told me that accredited investors could invest in Lending Club’s "private offerings." From what I could tell, this is a group of combined loans that is managed as a hedge/mutual fund. Different people buy into it, Lending Club manages the loans/investments (for a fee, I'm sure), and income is paid out as the funds earn money. I believe he quoted an 8% to 10% range of average returns.

I was interested in this until he told me the minimum needed to invest in the private offerings: $500,000. Yikes! I was interested in testing P2P lending and proving that I could earn 10% returns with it. If I could, I would then add more of my portfolio to the effort. But there was no way I was going to start the process with $500k! That's too big of a "test" for me.

So that's where we left it -- me wanting to invest and him wanting to help me -- but there was nothing they offered that worked for me. I'm hopeful that the state of Michigan will wise up and let its residents begin investing in P2P lending (Governor Snyder, do you hear me? You should -- I sent you a note regarding this.) But for now, I'll have to watch from the sidelines.

Are any of you P2P investors? What sort of returns are you getting?

Comments

[CW]

As the saying goes "If it's too good to be true.. " :)

[Noah]

I have about $3K at Lending Club and their ROI number (probably slightly inflated) for me is 15.8%. This will obviously dip a bit as the principal balance of the loan diminishes but I find it hard to believe I'll end up anywhere south of 10%. The secret is to come up with a good filter and not choose just any loan. If I get a bonus his year I'll probably throw in another $1K.

[Travis]

I'm in MI and started w/Prosper when it first came out...then MI put the kabosh on it. I earned 10% the first year but then as the economy crashed I lost money w/a final return of -13%. However, I firmly believe I lost the money because I could no longer manage my loans, add new ones or sell existing ones so I was stuck with a small pool of ~ loans which is a far cry from the 100 loans I had intended on making in order to spread out the risk.

[tim]

I was looking into P2P lending a few months ago but decided against it because Prosper had less than 300 loans to choose from. To me this didn't seem like enough loans for me to selectively choose from, so I decided against it.

[Daniel]

I bought into Lending Club with a total of about $3,000 over 125+ notes, with a weighted average interest rate of 13.5%. My actual Net Annualized Return as LC reports it is currently 3.62%. I started investing in 2009, and I cut back on additional investments as a I noticed my default rates rapidly rising. My belief is that they are bringing in enough new investment that it masks some of the high default rates that lead to overall mediocre returns.

I followed a few finance blogs that were also invested in LC over the last few years, and there sentiments seemed to have soured on LC as well. Another major issue is the tax treatment of these notes. Each individual note is considered a separate security. You will be issued a 1099 for each note you invest in that earns more than $10 in a given year. That's a lot of 1099's. And the average $25 investment does not meet this threshold, which means you're on your own for doing the math/reporting your taxes fairly.

[Mike B.]

I started about a year and a half ago with $3K on LC and they are reporting a 9.87% return. I didn't do the math to see if that is accurate.

Agree with Daniel, the taxes are awful. Not only do you have to do your own income calculation, but also the bad loans are subtracted somewhere else (not straight off the gains) and again aren't reported to you--you have to go find them. And it's not 100% clear where to put them.

I really want to put more in. I just don't always have the time to go back and do the re-investing (though it really doesn't take that much, I just have to remember to do it). I love the whole principle of the thing: why should the big banks only get that 20% CC interest rate? Offer a better rate than them, and give the profit to just everyday people with some extra money to invest. It seems win-win to me. And my impression is that LC has had a lot more loans to invest in lately, hopefully not because they've loosened up borrowing requirements or something else that will drive up the default rate.

[retireby40]

Oh man, $500,000! That's crazy for an individual investor. I'm getting about 12% from P2P right now. I think that will go down a bit over time, but I'll be happy with anything close to 10%. It's unsettling to see loans default, but I'm getting used to it.

[Noah]

@Mike B

You can set up a reminder that will email you once you hit >= $25 of available funds. Also, it takes about 5 min to pick a few loans. Maybe you are took picky? :)

[Jim]

I would not say that some states just "don't allow P2P" lending. The P2P companies don't adhere to the laws in some states. I'm sure theres a variety of reasons across the states. The Ohio law for example requires that anyone selling securities to verify the information given and the P2P companies do not do that, so they can't sell securities in Ohio. Thats not the same as saying Ohio outlaws it in general. If a P2P lender verified the claims of the borrowers then they' probably be legal in Ohio.

I haven't done P2P lending / borrowing myself. Theres a reason those people are paying ~10% interest and its not cause they're awesome credit risks. P2P sounds so much nicer than 'junk bonds' though.

[Nicole C.]

I just started to invest on Prosper few months ago.
They are reporting 11% return or so. Don't know about seasoned return yet, since the notes are still quite new.

[Brooklyn Money]

I've been doing LC for a few years. I like it and my returns are like 8% but that's only because I often fail to reinvest in a timely manner. Am thinking about opening up a Lending Club Prime account.

[[email protected]&More]

I am seriously considering investing in P2P but haven't made the jump yet. I may put that on a to do list for 2013...

I hope it is allowed in Florida.

[Bad_Brad]

I had a friend turn me on to P2P lending a few years back. I didn't take the plunge, but thought it was an interesting concept. I would tend to agree with the notion that if someone is trying to borrow money at 10% or higher on a P2P site, that person is probably not a great credit risk. With that said, there may be exceptions on that site that are pretty good deals from a risk/reward standpoint. I just didn't feel comfortable enough with it. Might be worth looking at now, given the pathetic returns you get from lower risk lending these days.

[Bo Manry]

I don't quite know what this is exactly. What exactly are you investing in with this type of investment. A little clarity would be great.

[Jim]

Bo, simply put : peer to peer (P2) lending is where a company like Propser makes loans to individuals which are then funded by other individual. So if you "invest" in P2P then you're loaning money to other people via the P2P company. Its a fixed investment with a fixed % return. So for example if I have crappy credit but I need $1000 to pay for a broken car I might borrow from P2P site. Then the investors might each throw in $50 or more to fund my loan. I then pay back the money with 10% interest and the investors get the laon and interest payments. Until I default and they get nothing.

[Noah]

@Jim

Most of the people I select to loan money on LC are in the 700 credit score range. There are also plenty of filters so you can find borrowers with good scores, lengthy employment records, and no prior defaults.

Also, if banks/credit card companies can make a fortune off loaning money to individuals, why would you believe it's not good enough for us?

[Matt]

I tested the water at Prosper about a year ago with about $1k. I stuck mostly with lower risk loans, which I'm told isn't necessarily the way to go. I just wanted to beat my credit union. I'm returning about 10% and have 35 current loans, 10 paid in full, and one that defaulted after 2 months meaning I lost nearly all of the principal. Obviously, if you can avoid those, it's a pretty good deal. They key is setting up the filters to weed out those.

I find those with homes and those who have had previous Prosper loans that were paid on time are a good place to start.

[Noah]

Matt is correct. Setting up good filters will help keep your defaults low. In order to set up good filters, you need to visit a site like LendStats.com and spend some time looking over the statistical data. Then you create your filters based on past trends. For example, I weed out all CA loans because Californians are more likely to default. I am happy with my default filter and have 140 loans with 5 paid off and 0 defaults. I know this will eventually change and I'll get some defaults, but the bulk of my loans are almost a year old.

[Jim]

Noah, I didn't say it wasn't good enough for you or anyone else.

But in general if people want high returns it comes with high risks. Right?

With due diligence you can make good bets and lower your risk. Or you can have bad luck and lose money.

But people need to be aware that this is not a guaranteed or safe investment in general. You have a significant risk that people will default and I dont' think theres any recourse if they do.

[Noah]

@Jim

You are absolutely right. I believe that with smart filtering, the risks are lowered greatly. If you are not willing to filter smartly, you are likely to be disappointed in LC investing. It's not for everyone. I get excited about peer lending because the 0.80% rate from a savings account is next to nothing :)

[Bill]

You make a major mistake assuming that the secondary market is not an attractive way to invest. You are not purchasing notes from people looking to dump them, not necessarily, you are buying them from people who want liquidity. If this were not true you would never invest in any financial market as primary issuance is a tiny fraction of the trading that occurs.

I live in Massachusetts which also prevents investors from participating in the primary market but allows secondary trading. I began investing 5/23/11, making a total investment with Lending Club of $5,000 and have garnered an annualized return of 34.87%. This is my own calculation as the LC calculations are not done correctly. This also includes loss reserves for small portion of my portfolio that is delinquent which LC doesn't allow for. I've bought and sold over $50,000 in notes during that time. The secondary market is alive and well and provides ample opportunities for motivated investors.

[Noah]

@Bill

How much of a discount are you usually buying up the loans for and which site are you doing that on? 34.87% seems awfully attractive if your calculations are correct!

[Andrew]

Interesting topic FMF. Perhaps this could turn into a series by one of your commentators, just like Alex did with real estate. I.m sure there are many sides to this topic to be explored.

[Al]

@Jim

You do realize Lending Club has a minimum Fico of 660 and Prosper 640, among other criteria such as DTI and recent inquiries that makes them only accept 10% of Borrowers? Both these companies report to credit bureaus, so these borrowers do have an incentive to pay back, especially those with good enough credit to get approved.

Instead of just looking at the numbers and automatically assume something is rotten, why don't you do some actual research for a change?

[Al]

@Jim plus, both companies would be stupid not to know that their long term survival depends on approving only the best loans and keeping default rates low.

[Peter Renton]

Thanks for linking to my site. It is too bad that many states like Michigan choose to not allow p2p lending as an investment in the primary market. There is some good news on the horizon though. The CEO of Lending Club, which just surpassed $1 billion is total loans issued last week, has indicated that IPO is in their future. Now, it is not imminent and my guess is it will be 2014 or 2015 but when that happens investors in all 50 states will be able to invest.

[Bad_Brad]

@Noah - question ... does Prosper or Lending Club verify things like FICO scores, employment, liquidity, etc, or are these things just self-reported?

[Noah]

@Bad_Brad

I'm assuming they do check the FICO because in their terms it says they can terminate the registration if your score dips below 660. I've heard that the majority of applicants to LC are rejected, so I'm certain they do actually check an applicants financial information before approving.

"Under WBK's current credit policy as of April 2010, your Fair Isaac Corporation ("FICO") score must be greater than or equal to 660 and you must meet other credit criteria in order for you to be eligible to apply for any loan. If for any reason you do not qualify or you later cease to qualify for a loan from WBK, if, for example, your FICO score from any consumer reporting agency falls below 660, we or WBK may terminate your loan request and deny your ability to make additional loan requests. Even if your FICO score is higher than 660, we or WBK may nevertheless terminate your registration or loan request based on WBK's other credit criteria such as debt-to-income ratio or other information in your credit report."

[Peter]

I've been investing in Lending Club for a couple of years now, and while I don't have a ton in - about $3000 right now, I do plan on adding more down the road after saving up a home down payment. Right now I'm getting about 12.22% returns on my money, which is probably closer to 10.5% or so when taking other things into account.

[Bill]

@Noah

I'm using Lending Club, my calculations are correct for the assumptions I've made which are more conservative than LC's. The problem with LC's ROI calculation are two-fold.

First, they don't haircut the value of delinquent loans until they have been charged off. My calculations assume a below par value for these notes. For example my entire delinquent bucket is priced at an average of 70. I'm including loans in their grace period in that number which aren't even contractually delinquent yet.

LC also doesn't properly handle trading profits, they don't include capital gains from buying and selling loans in their ROI calculation. Their calculated return for my account is 9.49%. The weighted average investment date for my $5,000 was 9/13/2011. As of 11/14/12 I had $6,704.79 in notes and $602.71 in cash in my account, clearly a return well above the ~10% they calculate.

I don't buy notes at a significant discount, instead I do active relative value trading, selling overprices notes and buying under priced ones. This is a strategy the majority of investors won't have the patience for. I look at it as a fun hobby.

[Jim]

Nowhere did I say P2P is "rotten" or anything similar.

There is risk. Right? Thats my point. Do you agree theres risk or not?

Mid 600 credit scores are not great. In fact that has a historical delinquency rate of 10-20%. The P2P lenders are seeing 10%+ default rates.

You don't get >10% returns without risks.

I'm not going to keep defending myself about things I didn't say.

[Jim]

BTW, I don't think junk bonds are awful either. THey have relatively high returns but theres default risks involved.

[Catherine]

Who among the P2P fans has read "Thinking Fast and Slow" by Kahneman? Here's a good intro, but read the whole book. http://www.bloomberg.com/news/2011-10-24/bias-blindness-and-how-we-truly-think-part-1-daniel-kahneman.html

There is alot of willfull blindness in comments endorsing a business model that advertises mathematically unsustainable average returns. The risks are huge.

[Noah]

@Catherine

Can you explain how the average returns are unsustainable? I have accepted the fact that on average 5-10% of my loans will default. I'm perfectly happy with that average as it still means I'll be earning over 10%. If this model did not work, then credit card companies and banks would not be in business.

[David Waring]

We have done a lot of research on P2P investing and it is a great thing however there are some caveats we have found:

1. Lending Club, Prosper and other P2P lenders are pretty new so a large percentage of the loans have been made in the last year. This makes returns seem better than they are because loans are not as likely to default early on.

2. Prosper tightened their lending standards in 2009 so people who invested after that time have better returns as a result. Lending club didn't really get started until 2009 and had the benefit of hindsight.

3. You can juice your returns significantly by going into riskier loans but just as with anything else this makes your returns much more volatile and your investment is going to fall in value much more if the economy goes South.

When you take these factors into account, our research shows that a more realistic return after defaults are taken into account is around 6 to 7%. In today's low yield environment thats still really high so we have started putting our money where our mouth is and making some pretty sizable investments.

Hope that helps.

Dave

[Jim]

Here's an article that figured overall ROI on a batch of loans at Lending club from 2009 to 2010 came out at 5.5%
http://www.lendacademy.com/lending-club-prosper-default-rates/
Prosper was higher at 8.7%. Of course thats just a snapshot in time and I think they looked at all loans so you could do better or worse.

[Noah]

@Jim

That's where the use of filters come in. Filtering our loans that match certain criteria can dramatically change the outcome. Lendstats.com does a good job of presenting the data and allowing you to see which borrowers are much more likely to default. For example, I filter out all borrowers from CA because they were 1 or 2% more likely to default. I also filter out people who haven't been employed by the same employer for less than 4 years.

[Jim]

Noah, Right, good screening of borrowers is important for success. But on the other hand poor screening will end up in a big failure.

[Bill]

One important feature of these sites that hasn't been discussed it that these notes are uncollateralized. You are not actually making a loan to the person on the other end. The notes are only an unsecured obligation of Lending Club and not of the borrower.

What does that mean? If Lending Club goes bankrupt you have no claim on the borrower. Your note is a unsecured "bond" issued by Lending Club and if Lending Club can't or won't pay you have no recourse to the borrower. You can only get money from Lending Club and even then your claims are uncertain.

And as Lending Club repeatedly tells you they are a negative cashflow negative company at this time, they are not profitable unless they continue to grow to a large enough size. So you are buying notes issued by a highly risky company with no actual collateral backing them, you only are entitled to proceeds from highly risky unsecured loans while Lending Club continues to operate. It is vital for people to understand they are not simply taking the borrower risk but also Lending Club's risk. If either fails you lose. They have no backup servicing system or rundown mechanism in place. If LC goes you sit alongside all the other unsecured creditors waiting for a tiny slice of the recovery pie. This is the reason I have limited my investment in this product. I'm happy to take the borrower risk but the company itself is arguably a bigger risk to your return.

Excerpts from the Note Prospectus.

"The Notes are special, limited obligations of LendingClub only and are not secured by any collateral or guaranteed or insured by any third party. The Notes will not represent an obligation of borrower members or any other party except LendingClub, and are special, limited obligations of LendingClub. The Notes are not secured by any collateral and are not guaranteed or insured by any governmental agency or instrumentality or any third party."

"If we were to become subject to a bankruptcy or similar proceeding, the rights of the holders of the Notes could be uncertain, and payments on the Notes may be limited and suspended or stopped. The Notes are unsecured and holders of the Notes do not have a security interest in the corresponding member loans or the proceeds of those corresponding member loans. The recovery, if any, of a holder on a Note may be substantially delayed and substantially less than the principal and interest due and to become due on the Note. Even funds held by LendingClub in trust for the holders of Notes may potentially be at risk."

"In a bankruptcy or similar proceeding of LendingClub, there may be uncertainty regarding whether a holder of a Note has any priority right to payment from the corresponding member loan. The Notes are unsecured and holders of the Notes do not have a security interest in the corresponding member loans or the proceeds of those corresponding member loans."

[Al]

@Bill

Actually, Lending Club just announced they have become profitable, with an IPO not far down the line. They also have more than 50 million in cash in the bank.

They'll be here a long long time.

[Dan B]

Bill......Actually both LC & Prosper do have "backup servicing systems" in place & have had it for years now. The rest of your post is technically correct & covers points that I've brought up as far back as 3 years ago. However it is also prudent to note that the risks continue to diminish over time.

Also, even in a worse case scenario, as you've laid out, it is far from certain the extent in which "lenders" will or will not be hung out to dry. There is simply no legal precedent for this scenario, since it's very likely the matter will ultimately be decided in a courtroom. But again, all that you point out & all that I've suggested would only be put to the test in a worse case scenario..........& there's little to suggest that we'll ever have to face that scenario.

[Bill]

I'd like to see a link to LC's profitability announcement, they haven't filed any reports with the SEC saying that. Third quarter 2012 they lost almost $1mm. They've got $50mm in cash because they've continued to do capital raises. Equity of ~50mm after raising ~100mm over their life. That's a cumulative loss of $50mm since inception.

I'll have to go back to their servicing arrangements Dan, I could very well have misunderstood. The risk I'm referring to isn't necessarily that you will be entirely wiped out in a bankruptcy, but that you face substantial losses. In either case you are a very sad investor. I've been involved and continue to be involved in litigation with financial firms, over defaulted bonds, and with asset backed security trusts and trustees. If you have to go to court you've already lost, it's expensive, time consuming and nobody wins except the lawyers.

I don't think either of you guys are evaluating this investment in a fundamentally sound way. Actually you probably are and it's just not coming across clearly in a 100 word internet post, so don't take that as an insult.

Statements like "They'll be here a long long time" and "there's little to suggest we'll ever have to face that scenario" should never come out of an investor's mouth. There's plenty to suggest LC might go bankrupt, they very likely could cease to exist before a long long time has passed. LC is not a safe company because there are no safe companies. If you lend money to anyone you taking the risk that they won't pay you back. Every risk has a price and it's our job as investors to figure out if that risk is priced appropriately. To imply LC's continuation as a viable business is not a substantial risk is as silly as saying that these loans are poor investments because their interest rates are so high. Both of those things are just facts that go into an analysis of the investment.

There is some probability, which is not negligible that LC goes under and you lose a substantial portion of your investment. My point was only that this risk is embedded in the notes you buy, you are not simply taking the credit risk of the borrower but of LC too. This is a pre-IPO internet/financial startup, it's going to be risky. They wouldn't be continuing to raise capital if they were able to borrow money at reasonable rates through other means. Just for comparison the CDX HY 19 is a credit index referencing 100 below IG North American companies, it's trading at a spread of 5.32% today. That means you could take 5 years of "average" sub-IG corporate risk for approximately 6.10% yield. IF that's a good proxy for LC risk then you have to subtract that yield out of the returns you get from your Lending Club portfolio to find out how much you are making on these loans. The first 6% is just compensating you for the risk that LC goes poof.

Having said all that I actually think Lending Club and Prosper are good ideas, I genuinely want them to succeed. I have a small amount of money invested and will likely increase that in the near future. I think it's very likely that LC continues it's growth and becomes a viable business that makes everyone a lot of money, however there are substantial risks. I think that you are compensated for that risk but it's vital that the readers here fully understand them. It's too easy to focus only on the borrowers credit risk.

[My Money Design]

FMF, I was just at Lend Academy and read the same thing in their book. Thanks for confirming what I was afraid of = because I live in MI, I can't invest in P2P lending. That's too bad because I was looking forward to giving this a shot. It looks like I'll have to shift my passive income efforts to something else.

[Miggy]

Well stated Bill. I appreciate your insight.