A downturn will cause a shake-out of the poorest peer-to-peer lenders, but that isn’t necessarily a bad thing, argues Iain Niblock.
The peer-to-peer (P2P) lending sector may not have been fully tested in an economic downturn, but that doesn’t make it weaker than any other investment.
P2P as an asset is still in its infancy. Only P2P consumer lending giant Zopa, which launched in 2005, has been through a downturn and its investors came out relatively unscathed with positive returns continuing despite a rise in defaults.
The impact of an economic downturn in P2P will be slower and not the same as one in the stockmarket. A drop in equities can quickly push down the value of your shares or fund portfolio, but the process won’t be as immediate in P2P. One of the strengths of P2P is that it is uncorrelated to other investments, such as equities, but there are still risks.
The P2P sector now spans the consumer, property and business markets. These are all sectors that, over the long term, could get hit by an economic crash.
You can expect higher unemployment rates in a downturn, which will increase the chances of defaults on personal loans on consumer P2P platforms. However, P2P lenders are typically lending to prime or super-prime borrowers who may be less likely to lose their jobs in an economic crisis.
In business lending, you may see an increase in insolvency rates, more businesses going bankrupt and their customers may hold back on spending. This may mean some firms struggle to repay loans.
There may also be issues for P2P platforms lending to property developers or bridging and buy-to-let borrowers, or those taking bricks and mortar as a security.
An economic downturn could cause a reduction in property prices, meaning that the assets that many P2P loans in this sector are secured against will be worth less than previously.
Typically, there will be a cushion against this within the loan-to-value, so the worst thing that could happen is liquidity dries up and it is more difficult to sell the underlying asset.
Of course, the reaction of the end-investors will be key to how P2P platforms fare.
Many will remember seeing images of customers queuing outside Northern Rock branches when the bank collapsed. There will hopefully not be anything of that magnitude for P2P, but investors may worry about receiving their interest repayments in an economic downturn.
Currently, there is a buoyant liquid secondary market, where lenders can sell their loans easily and convert them to cash, But, if economic conditions get worse and everyone panics and tries to sell, then these markets could soon dry up. No one would want to purchase the loans if confidence disappears, or they may have to be offloaded at a knock-down price.
While the wider financial markets may panic in a crash or economic downturn, I believe that P2P will fare favourably. It will shine a light on the strong characteristic of the asset class as being stable, predictable and uncorrelated to the stockmarkets.
Just because most P2P lenders haven’t been through a downturn, it doesn’t mean that they aren’t preparing for one. Lenders such as Funding Circle and Landbay have conducted stress tests of their loan book based on Bank of England modelling to see what would happen in various scenarios, and they have found that investors will still get a decent return, albeit slightly reduced.
Platforms planning ahead is a good sign, but investors can also prepare by keeping an eye on default rates among P2P lenders, doing their due diligence on how stable and secure a provider and its loans are, and building a diversified portfolio themselves or through a third-party.
You need to look beyond the rate and understand where, and how, your money is lent, if there is any security, and how easily you can exit if you need to. Understanding this should keep your P2P portfolio flowing in both good and bad economic times.
Iain Niblock is chief executive of Orca Money, the peer-to-peer investment aggregator.