Who hasn’t heard of fintech, the industry that will simplify consumers’ banking, borrowing and investing strategies by providing a basket of online services more efficiently and cheaply than traditional institutions?
One of these — borrowing — has developed an investor-borrower model called peer-to-peer (P2P) lending that addresses both investors’ desire for a good return on investment and borrowers’ search for a loan at an affordable rate.
But new research from the Federal Reserve Bank of Cleveland concludes that “P2P loans resemble predatory loans in terms of the segment of the consumer market they serve and their impact on consumers’ finances.”
The Fed’s report notes that defaults on P2P now resemble increases in subprime mortgage defaults before the collapse of 2007. P2P loan delinquency rates are rising faster on newer vintage loans than on older loans. For example, two years after a 2006 loan the delinquency rate on all loans made that year was around 7%. Loans originated in 2012 had a delinquency rate of 14% two years later.
While originally conceived as a way for small investors to lend small amounts to consumers who wanted to refinance credit card loans at lower interest rates or build their credit history, or who had no other banking relationship, the industry now attracts mostly institutional investors seeking better returns than they can get in the bond markets and elsewhere. By using pools of private capital, P2P lenders assume the risk a traditional bank would insure with federal guarantees.
What regulation exists for the industry are designed to ensure that small (unaccredited) retail investors don’t get victimized. For borrowers, no regulatory body oversees P2P lending.
Do P2P loans live up to their promoted claim to lower borrowing costs? That depends. Citing the LendingClub Corp. (NYSE: LC) practice that grades borrowers in a range from A to D, with A and B being higher quality and C and D lower quality, the peer-to-peer interest rate for A and B borrowers is significantly lower than an average credit card rate. For C and D borrowers, however, the P2P average is somewhat higher than the average credit card rate.
The Cleveland Fed report concludes:
[O]n average, the non-P2P debt balances of P2P borrowers grow about 35 percent more than those of non-P2P borrowers within two years of the P2P origination year. … P2P borrowers exhibit a 47 percent increase—rather than a decrease—in their credit card balances after obtaining P2P credit as compared to matched non-P2P borrowers.
How about P2P claims of improving credit scores? From the report:
Our results suggest that the credit scores of P2P borrowers fall substantially and delinquency rates rise after taking on a P2P loan … compared to non-P2P borrowers. We also discovered that numerous measures of derogatory events (number of past due accounts—both revolving and installment—and number of bankruptcies) significantly increased for borrowers who took out P2P loans. These results indicate that P2P loans have the capacity to worsen borrowers’ prospects for future access to financing.
Finally, do P2P lenders provide banking services to a portion of the population that is underserved by traditional institutions? The report’s authors examined the characteristics of P2P markets by ZIP code and then took a detailed look at those markets to evaluate the characteristics of the borrowers. Here’s what they found:
We find that the residents of P2P zip codes indeed have, on average, lower incomes and lower credit scores. P2P zip codes have less-educated and more racially diverse populations. Potentially, these characteristics could indicate that these areas are indeed underserved by traditional banks. However, the results also show that P2P credit is flowing into zip codes in which borrowers tend to have higher, not lower, debt-to-income ratios, and there are more bank branches and fewer individuals without credit cards in these areas. These facts indicate that the residents of P2P zip codes do have access to the traditional banking system and have previously obtained credit; thus, they are not likely to be unbanked.
When we zoom in on the P2P zip codes and compare the P2P and non-P2P borrowers who live within them, we once again observe that P2P borrowers are characterized by lower income levels, lower credit scores, and a higher number of delinquencies. These borrowers are more likely to be African American and not have a college degree. At the same time, P2P borrowers’ levels of debt-to-income ratios tend to be similar to non-P2P borrowers’. This evidence once again indicates that P2P borrowers are unlikely to be underbanked but are likely to be overleveraged even prior to obtaining their P2P loans.
The full report is available from the Cleveland Fed website.