We've had 2 months of COVID disruption. Here's what is now clear
It has now been around 2 months since most countries started to ‘lockdown’ in response to COVID-19. Since then we’ve seen a huge crash, and significant recovery in stock prices. Interest rates have been cut in many countries. Governments have announced many schemes to help support businesses. There have also been many announcements that directly impact P2P investors and loan originators, relating to payment deferrals, and to price caps. There’s a huge amount of news and information out there and we don’t plan to repeat it. Instead we wanted to try and cut through all this ‘noise’ and try and provide a summary of what has now become clear, and what critical uncertainties remain for P2P investors.
1. 'P2B' is going to really suffer
P2B refers to crowdfunding of loans to small businesses. We have never been big fans of these loans. They are often high risk, and P2B sites rarely provide sufficient information to properly underwrite and assess the loans. Instead many P2B sites tend to be just some stock photos and some vague commentary about what the company does and what it will use the funds for. Frankly, we don’t have faith in the underwriting skills of many P2B sites, and they lack ‘skin in the game’. We expect the losses on P2B loans to be heavy over the next year. Unfortunately, many of the types of companies (which are often retailers and hospitality businesses) that took these types of loans are the ones that are going to suffer most from COVID-19.
2. Loan supply has fallen and will stay lower than normal for the rest of the year
We have been pretty impressed with the ability of the P2P market to balance supply and demand without a huge number of lender insolvencies. Volumes of loans purchased fell significantly during March and April, (down by approximately 85% on Mintos, and 50% on Peerberry). Lenders were however very quick to cut their lending volumes, tighten lending criteria, and increase interest rates. We expect investor demand to start increasing this month, but there is likely to be limited supply of new loans for some time, as lenders wait longer to see how their recently originated loans perform. We expect the loans originated in April and May to perform quite well, because all borrowers will have passed much stricter lending criteria, and is also likely to have successfully repaid loans in the past.
3. Some P2P lenders didn't set high enough interest rates and are now struggling
We have felt for several years that some P2P sites were prioritising growth over investor yield. Some sites were pricing their loans at interest rates that generated only modest net returns during a strong economic period. However they were still able to attract significant funding from investors. The problem with this strategy is that there is not enough of a sufficient yield buffer to deal with recessions (and pandemics). Several British P2P sites could be accused of this. They include Ratesetter, Zopa, Lending Works, and Growth Street. Lending Works and Growth Street have now stopped lending and appear to be in some difficulty. Ratesetter has had to cut the interest rates they pay to investors by 50% to cover a rise in expected losses. Lending Works have stopped all interest payments, and also levied a 2% investor fee. It seems that generating net returns of only 5-6% on unsecured loans during a strong economic period was not high enough to build up a sufficient buffer to deal with the higher losses that come during recession periods. Many pointed this out long before the COVID crisis.
4. The returns earned by P2P investors will vary a lot this year. Smart strategies will pay off
One of the most famous quotes about investing comes from Warren Buffett. He said “You only find out who is swimming naked when the tide goes out”. In other words, all investors can appear to be doing well when the economy is strong; it’s only when there is a downturn that the winners and losers start to emerge. The tide has gone out extremely quickly this time. And now is when some of the most important P2P strategies will likely pay off – holding a large proportion of loans secured with real estate, avoiding risky loan originators, avoiding unsecured loans to small businesses etc.
5. P2P sites and lenders are providing much more information than they ever have (but it's still not good enough)
We are big fans of all the various ‘Ask Me Anything’ forums that have been hosted by the management teams of various P2P sites. We also welcome all the regular and detailed business updates from many loan originators. It’s just a pity that it took a pandemic for this to happen. The quality and timing of information provided by P2P sites and their loan originators still needs to improve. At a minimum, loan originators should be provide updates every 6 months, a proper analysis of their loan default rates, their liquidity position and any key risks (such as currency exposures or regulatory rule changes). If sites like Mintos demanded this, we think they would comply. Instead, it seems that most P2P sites think of their loan originators as their true customers, and let them publish whatever information they like, whenever they like.
What are the biggest uncertainties and risks right now?
1. Will the borrowers who received payment holidays and extensions be able to repay their loans?
In many countries around the world, governments announced forbearance programs. Borrowers were told they could pay less than their contractual loan repayments. In some cases, the interest payable has been capped too. In the UK, around 5-10% of borrowers have taken advantage of this. In other countries such as Poland and Russia the numbers appear to be much higher. Many of these loans have been funded by P2P investors. It is highly uncertain how much lenders will recover on these loans. It is not clear how much financial difficulty the borrowers are really in, whether their finances will recover, and when they can repay their loans. Some borrowers may currently be benefiting from government support schemes that may not be extended. If many borrowers end up defaulting, it could lead to significant numbers of defaults and potential insolvencies of some lenders.
2. How quickly can the global economy bounce back? How deep and long will the recession be?
What will the recovery look like? V shaped? U? W? Equity markets are pricing in a fairly quick recovery in economic activity (a ‘V’ shaped recovery). However no one can have much certainty right now as it depends on so many factors, such as developments of vaccines and antibody tests. Many countries are now making tentative steps to loosen their COVID restrictions on travel and workplaces. This is coming just in time for many businesses and self employed individuals who have suffered significant damage from the restrictions that were introduced. However if this results in a big increase in new infections, the measures may have to be re-introduced, resulting in a longer and deeper recession than most people are currently anticipating.
3. How long will volumes stay low? Can P2P sites stay in business?
P2P sites need a certain volume of transactions and assets to remain viable. That’s why we have said in the past it is important to keep an eye on their volume statistics. We think that the larger sites (such as Mintos), and those connected to lending companies (such as Lendermarket and Viainvest) will be fine. It is the smaller sites that need to be monitored. Companies such as Lending Works in the UK have imposed a fee of 2% to investors to cover their costs while they have stopped lending funds. Others have introduced new fees for using the secondary market and other transactions. Mintos have significantly cut their costs and imposed some fees. We think that many sites are probably charging their loan originators higher fees too. We hope that all these measures should allow most P2P sites to survive, but we expect some of the smaller and weaker ones to stop operating in the coming months.
4. Will real estate prices fall?
It feels likely that real estate prices should fall over the next year. That tends to be what happens during an economic downturn. One potential offset to this though is the interest rate cuts that have taken place in many countries. This makes mortgages very inexpensive and should provide some support to prices. We don’t expect falling house prices to have much impact on P2P investors unless prices fall by by more than 20%.
5. Can property developments be completed without big delays?
Many P2P loans have funded the construction of new property. These loans have some risk towards the value and sale prices of the finished units, and execution of the development plans. The UK is the most important market for these types of P2P loans. The government there has allowed building works to continue, although we expect some delays to take place. There have been minimal disruptions in the Baltic region so far, and construction is resuming this month in Italy. For now this is a risk worth monitoring, but so far the impact has been less than many expected.