2019 11 08
If you’re looking for a short answer, it’s “Yes”. But that’s not the full story.
11 years after the collapse of Lehman Brothers, and the financial turmoil that followed, the world economy seems to have turned a new page. For now.
As misery gave way to opportunities, the financial crisis of 2007-08 has been followed by one of the longest economic expansions on record. America’s economy, the source of previous financial troubles, has now been growing for more than 122 months straight – the longest run since record-keeping began in 1854.
But there are signs that the world economy is not in rude health anymore (see “Strange times we live in” section below). A fierce debate has thus ensued among economists whether we should expect to read “Economic Crisis” in print soon.
Whatever the outcome, what you won’t see in the papers, is what a recession would mean for your investments in peer-to-peer (P2P) lending. And if you don’t have yet, is it even a worthwhile investment in times as such?
What would happen to P2P lending in a time of crisis?
The inconvenient truth is that no one knows for sure. Relatively recent innovation that it is, P2P lending is yet to go through a full business cycle (the boom and the bust).
During the previous financial meltdown of 2007-08, only one European P2P lending platform was in existence – the UK-based Zopa. But it has shown encouraging results under pressure. Even during what is now considered to be the worst financial crisis since the Great Depression, Zopa’s investors made a net positive return of 4% – at a time when almost every other financial player was in the red.
Investors will take comfort in the thought that if we were to experience a similar financial disaster, P2P lending industry is not susceptible to the evils that have exacerbated the last. In stark contrast to the “too big to fail” banks – P2P platforms are not leveraged and do not use fractional reserve banking. P2P lending platforms are 100% equity-funded, which means that for every €1 put in by a lender, €1 is lent out to a borrower.
Furthermore, “P2P loans” – as a broad asset class – are far less volatile than stocks. And P2P loan rates don’t overreact to small fluctuations in central bank interest rates.
Lastly, P2P loans are an excellent diversification choice, because they don’t reverberate too much to the shocks in other asset classes such as stocks or bonds. In case of a financial meltdown, they wouldn’t be dragged down by other assets and would thus be an outstanding counterweight to other investments in a portfolio.
Effects of an economic downturn
Nevertheless, a spike in default rates seems unavoidable in times of difficulty. And whether P2P lending industry will survive and thrive will depend on the severity of the downturn and how well individual platforms have prepared for the worst.
In case of a small downturn, credit demand will most likely remain intact. But – jumpy about the prospect of more defaults – banks might overreact, cut-off lending, and become too risk-averse. If that’s the scenario, P2P borrowing would increasingly look like an attractive option for households and firms deprived of capital and looking for alternative forms of credit (especially for debt consolidation and refinancing purposes). Despite more defaults, an increased number of P2P loan requests would look like P2P lending industry discovering the bright side of an economic crisis.
If, however, the recession continues to get more and more severe – things will get worse. The overall credit demand in the economy would fall as households and firms respond to an economic downturn by delaying their purchases and cutting down on debt. As banks panic and further restrict lending, P2P investors might not have the stomach to step in their place. Fearing more defaults, many would respond by fleeing to other safe-haven assets.
With fewer lenders, P2P loan markets would freeze-up. To stay afloat, P2P lending platforms would need to survive by drawing on the financial cushion they have built up during the good times. Weaker platforms – which have no such buffer – would be forced to increase loan interest rates to attract investors and compensate them for the higher number of defaults.
Without some constraints, the weakest P2P platforms could become trapped in a vicious cycle. If platforms offer loans at above-market interest rates, that motivates the most creditworthy borrowers to shop around for a better price. To retain credit demand, P2P platforms would face pressure to lower their acceptance rates and, in turn, increase their exposure to the subprime borrower segment. Such a move would push up risk even higher. More defaults would follow. Investors would demand even higher interest rates to compensate for the losses. And so it goes.
What’s the aftermath?
Even the worst-case scenario sketched above, would not mean a collapse of the whole P2P lending industry. But it could spell doom and gloom for the smaller, unprepared, individual platforms.
From the perspective of an individual investor, in this brutal game of survival-of-the-fittest, backing the winners would become increasingly important.
Financially robust P2P platforms not only limit immediate risks but also promise higher future pay-outs. If the lending platform survives the crisis, a number of defaulted loans (stuck in the hands of overworked debt-collectors and bailiffs for the time being) will eventually be recovered.
Choosing a reputable and strong platform is vital. But there are other ways one must prepare.
Avoiding liquidity issues
In case of a severe financial turmoil, a financially robust platform and diversified investments will not be enough. As your investments become locked in – liquidity drying up might easily become a way bigger problem.
Your loans might be performing well, but if you find yourself short on cash, it might be difficult to find a willing buyer on the secondary market. To avoid having to sell your loans at an eye-watering discount, make sure your investments are staggered – that there’s a regular and continuous flow of capital for you to be able to withdraw or reinvest.
Among the ranks of seasoned investors, anxiety is surprisingly common. And emotions are heightened in times of uncertainty.
This is quite evident. One study in the Journal of Finance concludes that hospitalisation rates in California correspond with daily fluctuations in stock prices. A significant fall in the stock market has “an almost immediate impact on the physical health of investors, with sharp [stock market] declines increasing hospitalisation rates over the next two days”.
Checking on the performance of your portfolio regularly is important. But don’t overdo it. Take it easy, and draw confidence from the thought that the long-term potential of your investments will ultimately outweigh any short-term turbulence.
Cooler heads prevail.
Having faith in your investments
The 2019 “Quantitative Analysis of Investor Behaviour” report is clear. Trying to predict the market is the number one reason why investors lose money. All other reasons (fees, unexpected need for liquidity, lack of available money to invest) trail behind this lack of better judgement.
Investors don’t have the patience to stick with their investments for more than 4 years. Many panic too quickly and don’t commit for long enough to reap the benefits. Many spread themselves too thin trying to stay on top of time-consuming 24/7 market updates – constantly checking their portfolio and worrying about whether they are investing in the most optimal way possible.
Investing in P2P lending platforms requires commitment. You won’t profit if you panic and sell your loans on the secondary market at the first sign of trouble. Your investments won’t grow as fast as they could if you don’t reinvest your earnings and miss out on exponential growth.
Instead of trying to guess the timing of the next crisis, try to find some time to invest in P2P loans. Financial common sense tells us that “the best time to invest was yesterday, the second-best time is today”.
Strange times we live in
In normal times, investors invest money to make more money. Nowadays, anxiety in the markets leads many to scrounge for the safest assets – government bonds, a quarter of which now trade at negative yields. That’s $13trn worth of bonds, which – if held to maturity – guarantee a loss.
In normal times, we don’t see two of the biggest economies in Europe – Germany and the United Kingdom – both reporting economic contractions in the 2nd quarter of 2019. And we don’t see gold, a safe-haven, trading at a six-year high.
In normal times, governments pay more to borrow for longer. But the 10-year US Treasury bond now has a lower yield than the 3-month one. Such “yield curve inversions” are usually signs of trouble to come – in the US, they have foreshadowed all of the 8 recessions since 1960.
At the backdrop of slowing global economic growth and widespread uncertainty about trade policy, central banks around the world are cutting interest rates and pulling the trigger to other unconventional monetary tools to spur up growth.
So where’s the crisis? Well, to be clear, it’s not doom and gloom yet. Jobs are still plentiful, wages are picking up, and the world economy is still growing. Whether the strange times of today have become the new normal, remains to be seen.
For the doom-mongering sceptics who think otherwise, the Japanese bond market offers some valuable lessons. Big financial players have been shorting the Japanese bond market since 1998 – a year when bond yields reached unprecedented lows. Expecting quick gains from financial turmoil and anticipating a yield spike, many hedge fund managers have destroyed their careers pursuing this loss making gamble now known as “widow-maker” trade. The collapse of the Japanese bond market simply never materialised.
In other words, no level of strangeness in the current economic situation translates directly into “imminent crisis”. To try to predict one with certainty (or bet on it) is a fool’s game.