Buyback guarantees and provision funds - P2P's get out of jail free cards
Buyback guarantees and provision funds can be thought of as a type of insurance that covers some or all of the losses that investors would normally incur when loans go bad. Many peer to peer loan investors hold loans that benefit from these features, so knowing how they work and what to look out for is important.
Buyback guarantees can be extremely valuable for investors. If a lender has sold a loan with a buyback guarantee, it promises to repurchase the loan if the borrower misses payments. The number of missed payments that trigger a buyback is usually from 1 to 3. Once the borrower misses the required number of payments, the loan is automatically repurchased by the lender. The investor earns the full amount of interest due during the period they held the loan, even if the borrower has made no payments at all. Loans that have buyback guarantees will be clearly marked as such by a loan platform. Some platforms only offer loans that have buyback guarantees.
Another feature that is offered by some platforms are accounts that have access to ‘provision funds’. Provision funds work by offering a form of insurance across an entire portfolio of loans. The size of the fund is disclosed by each platform. Provision funds are typically funded to a size that allows it, in normal economic conditions, to cover the costs of incurred by loans defaulting.
Sounds great - so what's the catch?
Buyback guarantees are often given on loans that are more likely to default, and the lender is getting a significant share of the interest paid by the borrower. Investors have two sources of potential recovery – the borrower, and the lender. The main risk for investors is that the the lender itself becomes insolvent and is unable to honour the buyback guarantee. We recommend that investors verify the track record and financial strength of any lender providing a buyback guarantee before they invest in any loans that receive a guarantee. We think that buyback guarantees can be very attractive features for investors and many investors will allocate some of their portfolio to loans that receive these guarantees.
Provision funds are a weaker form of protection for investors than buyback guarantees. The size of each fund relative to the portfolios they are protecting, can vary considerably. There is no guarantee made by the platform that the fund will be sufficient if losses are higher than expected, either due to poor underwriting or difficult economic conditions. Many of the funds have extremely vague rules and it is unclear how they will work during a period of high defaults. Another thing to consider is that many of the platforms that offer provision funds use them as a way to justify paying investors significantly lower rates of return. As a result, the return profile may be more stable, over the longer term, investors are likely to be better off investing in products that offer much higher returns but do not have the provision fund protection.
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