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Why I Stick to Low-Risk P2P Lending
At 4thWay® we write all our views, both positive and negative, about P2P lending.
We don't shirk on our responsibility to tell it like it is.
With this in mind today I'd like to tell you about why I stick to low-risk P2P lending instead of high-risk, or even medium-risk, lending.
Indeed most of the time throughout my long P2P lending lifetime, I will be confining myself to safer lending.
Why low-risk P2P lending is a highly suitable investment
The main thesis behind P2P lending is that we stop banks profiting tremendously at our expense and we keep most of the profits for ourselves.
Instead of just taking a safe low interest rate through a cheap savings account, we can now take the vast majority of the profit by lending our savings for ourselves.
Effectively, we run our own money lending business, with most of the operations outsourced to highly talented, low-cost organisations that allow this to happen. (Quality P2P lending companies.)
Two good examples
A well-run bank that sticks to the basics can make good money every year, even in poor weather, by lending to responsible borrowers at a good margin.
I'd like to take a couple of examples of such banks.
Although actually, my examples are both well-run building societies.
Most building societies just do savings and loans (with the loans usually being predominantly residential property mortgages). Most don't have current accounts and they tend to have a minority in other products, such as insurance. So they're more similar to P2P lending websites than typical high-street banks.
They also don't partake in all the debt swapping and other highly complex financial casino strategies that have helped get banks into serious trouble.
Building societies suffer some structural disadvantages to banks, and they don't have the lower costs that P2P lending companies have to compensate either.
And yet they still manage to do fine through both good times and bad – if they stay disciplined.
What a good lending operation looks like
Skipton Building Society has £14 billion in assets. Aside from a very lucrative estate agency division and a few other products, it is a pure savings and loans operator. No fancy banking. It doesn't even do current accounts.
It's style: just take in savings from its members and lend that money out at a higher rate to responsible borrowers, while not lending to more than a third of its customers above 75% of the value of their properties.
The building society grew all through the financial crisis and beyond, being profitable every year. It always kept plenty aside for bad times but it didn't need it anyway, even during the horrendous time for banking of 2008/9.
Principality Building Society is another example that remained profitable all through the financial crisis and beyond, growing its assets considerably to £7 billion. Its average loan size compared to property values has been below 70% throughout the period.
Moving on to higher-risk lending
Examples of banks that lost their way with 100% mortgages, self-certified loans and complicated debt-trading include: all of the major banks.
Yet, just because it has the name “building society” it doesn't mean it's safer than a bank. The West Brom Building Society also took on higher-risk customers it didn't understand, including, especially, commercial property borrowers.
It thought it was going for “sustainable growth” but that push to grow every year nearly destroyed it. It had to do some fancy accounting to save itself.
Yet it, too, was sticking to traditional saving and lending for its profits.
But not conservative saving and lending. It took more risks than it should.
Why do I mention this? Because not all P2P lending companies are equal either. Your own little lending business could be the next The West Brom if you don't stick to safer lending. Only no fancy accounting or bail outs will save you.
Once we go down the slippery slope of doing slightly higher-risk lending, then even more risk, and then finally high risk, we need far greater knowledge and ability.
It could go swimmingly well for many years and then we could make substantial losses every year for half a decade – like The West Brom.
Like The West Brom, we might then be asking ourselves what happened to our plan for sustainable growth.
And we have to attempt this higher-risk lending with very little information indeed.
At 4thWay®, we collect and collate P2P lending statistics, but we still haven't acquired enough to know when to take higher risks on any solid statistical basis. And I currently don't expect to have enough data to achieve that for many years to come.
We know that conservatively run banks and building societies make money in any weather.
We know that banks that take risks need bailing out. And we, with our own little lending businesses, won't be bailed out.
Where do we draw the line? How much interest is enough to compensate you for future catastrophes when taking greater risks? I don't know yet. And I think you need more a magician than a statistician to figure that out.
Look for a high margin for error
That is not to say I will not consider any medium- or higher-risk lending at all over the coming years. There will be times when the rewards are obviously right to those of us who keep our heads.
One of the most profitable times to lend is when there has just been a terrible catastrophe.
A recession, say, has just seen lots of loans go bad. Lenders who haven't stuck to safe options have made losses. They have then panicked and all tried to get out at once by selling their loan parts to everyone else.
The lenders who waited patiently can then buy up those loan parts at super-cut prices. At these times, you might find that you can buy £1,000 of loans off someone by just giving them £700. Combined with very high interest rates, and provided you spread your money across hundreds of loans, you're very likely to come out of the deal with an extremely large profit.
The margin for error will be so large that you won't need decades of statistics to so precisely price the loans; with more moderate quantities of information we'll be able to see that the prices are clearly right.
We'll be letting you know when (not if) such opportunities periodically arise, and at which P2P lending companies, if you sign up to our newsletter.
Read more: Why I Prefer Shares to Higher-Risk Lending.