Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 35 of Risk Parity Radio. Today on Risk Parity Radio, I thought I would share with you my experiences with peer-to-peer lending. It is an alternative asset class that has really only existed for about 12 years, and there are a plethora of outlets now that do this, some attached to real estate and some not. But I thought I would go over my experiences with it because I do have a lot of experience with a couple of these platforms that some of you may find informative. But to do this, we are going to use the 10 Questions to Ask to Master Successful Investing from David Stein, and I'll link to these questions in the show notes. These just help me make sure that I cover all of the relevant topics in an orderly manner. Before I get to the meat of this show, I have an interesting anecdote to relate. I entered a contest on Chuck Jaffe's Money Life Show, his podcast, for picking the price of gold a week in advance, and I came within $1.20 of it, and so won a book that he's gonna send me, which I thought was highly amusing. I will link to that in the show notes if you want to just hear that little, little clip. But it's funny how things that go around come around in podcast land. So what is it? What is peer-to-peer lending? Well, I'm going to focus on the peer-to-peer lending that I am most familiar with. because there are many platforms out there now and I have not vetted all of the platforms, but I do have extensive experience with Lending Club and a little experience with Prosper. And what these platforms are is they allow private people to loan money either to other people or to some kind of a project, and then you get paid interest on the money. It's usually legally turned into the form of some kind of promissory note. But the idea is that you are lending money and somebody else is paying you interest on the money. And it's all done through the interwebs. You often have a choice at the beginning as to which investments you are going to make. So in the case of Lending Club, the applicants would fill out information which would then be presented to the potential lenders with lots of different statistics as to income, inquiries on prior credit, and whether there were any bankruptcies, the credit scores, and you could evaluate all these different things deciding whether you wanted to loan this person any money and usually you would take a portion of what they were asking for. So say they were asking for $5,000 but you wanted to loan them $25 or $200. You could do either one. And once the loan was filled up by lenders, then it would become a real loan. And then it would, the money would be dispersed to the borrower who would then pay you back over time on Lending Club. These were three-year loans and five-year loans that we were talking about. All right, question two, is an investment a speculation or a gamble? Well, while it has speculative and gambling qualities to it, it really does come down to being an investment because you are talking about a debt instrument at the bottom line of it. These debt instruments do have a considerably higher default rate than you would find in standard bonds. They are more like junk bonds, if you will, but it does fall into the investment category of these three things. All right, what is the upside? Question three. Well, the upside is you get paid the interest. That's basically it for the upside on making a loan. So as we say, it's all downhill from there. Now the interest rates on these loans, depending on the quality of the borrower, ranged from about just under 6% all the way up to in excess of 20% for the lowest credit quality borrowers. So you could potentially make a lot of money if you did not have a lot of defaults there. It's interesting that if you go back in time to the beginnings of Prosper and Lending Club, but mostly Prosper back in around 2006 or 2007 when I first started looking at these things, it really was almost more of a social platform at the time that it was really focused mostly on the borrowers and people talking about what they needed the money for. And they had a board there that people would talk about various loans and recommendations and what they were borrowing the money for. and that was all fine and good, but it really led to a fraud, basically, in a lot of circumstances. And the Prosper got sued at one point, and they kind of shut that side of things down and really began focusing more on the lenders and what the lenders wanted, which was more hard numbers and not social chit-chat. So it was interesting how this all began at the same time that Facebook was becoming a thing. All right, so going on to question four, what is the downside? Well, the downside is there are fees associated with this and the default risk associated with this. A certain percentage of each class alone was going to default. And so the default rate could exceed the amount of interest rate is particularly for those really high risk loans that were being offered the default rates on the A and B quality loans. The highest rated loans were typically only a few percent, but those large interest rate loans could have default rates in excess of the interest that was being provided, which at some point they stopped even issuing those because they ended up being too risky for what the rewards were. What happens when a loan goes into default there? It goes to a collections essentially, and you will get a tail, you will get some money back after the collections agency goes after the deadbeat borrower, and I'm still getting money back on those things to this day. Even though I haven't made any loans in years there, but there was this, this tail that comes out of it. Now, in addition to that, there are fees that are attached to the loan. It's usually 1% for the borrower. So really the lender, you knew what you were getting as far as the interest rate that was listed for you. There were also collection fees for the ones that went into default. All right, question five. Who is on the other side of the trade? Well, you have the company there that's running the operation, in that case, Lending Club or Prosper, and so you had to have some confidence that they were going to be able to service the loans and that they were up and up. And both of these companies did have some legal issues as they went forward, particularly for Prosper. There was a class action lawsuit that I actually got some money out of because it did intend it did tend to encourage fraud on some of those platforms when there wasn't really much monitoring of those applications at the beginning. And you saw people using the same applications over and over again. So you could tell that there was something nefarious going on there. there. There are other platforms that have gone into bankruptcy. I'm aware of one in the United Kingdom called Lindy that I once looked at and it is in a form of insolvency there. I believe it invested in real estate property. So it's possible for these platforms themselves to have problems. But the other side of these these trades are obviously these borrowers which you have some information about, but you were really relying on the platform to collect the correct information and to vet it in some way or review it in some way before they present it to you. All right, question six. What is the investment vehicle? As far as the lender is concerned, you basically put the money in there and it goes into a note. and then it gets paid back out. There's more to it than that in terms of the SEC rules for these things which were clarified and amended around 2009 to change the way they were presented. But as far as an investment vehicle for you, it is a debt instrument for the lender. Question seven. What does it take to be successful? Now, this is an interesting question because there were a lot of failures from people on these platforms and there were a lot of complaints, which is why a number of them have gone out of favor over time. And Lending Club itself is essentially shutting down. It's being absorbed into Radius Bank becoming more of a banking platform. I'm not sure what future is going to be, but there were problems and successes here. I found that in order to be successful you had to come up with some little algorithms that you would apply because the way these loans were, they would put out maybe a thousand different potential loans with these characteristics and you could filter them then using various characteristics. to get to ones that would hopefully have a lower default rate and therefore ultimately a higher return. What I found was that there were two characteristics that tended to make the default rate lower, which one was whether the borrower had had any inquiries in the last six months. I wasn't sure why that was so important, but I'm guessing that it appeared that borrowers that had other inquiries had previously gone out and tried to borrow money elsewhere and been turned down. And so they were going to Lending Club more as a last resort. But the ones with zero inquiries always seem to have a lower default rate. The other main characteristic I found that was useful was simply the the monthly income of the borrower and that the higher it was, the more likely it was that the borrower was going to repay the loan. The best kinds of borrowers I found to find were people who had high interest credit cards that they were just refinancing. So they were accustomed to being profligate with credit cards and paying them off on a monthly basis. And it was no skin off their back simply to change that payment stream from the credit card company to the lending club. The kinds of loans that tended also to go into default more often were loans for small businesses and loans for automobiles and vacations. There was a whole panoply of statistics that you could run and they're actually Databases that were created on many websites when this was all in vogue. And so you could go back and analyze lots and lots of this data. And you really needed to do that in order to be successful at this kind of lending because you could not rely on your own just reading the file, the application file. That was actually a bad way to go about investing in these things. So I created a number of little algorithms to find loans that were less likely to default and that was the basis for the way I invested. You also needed to be sufficiently diversified to be successful here. Over time, and I was investing in Lending Club for about a decade, I had over 10,000 loans over that time, if you can believe that. 10,087 I think was the final number there. And almost all of those loans were found using these little algorithms I came up with. Now they also had an automated investing thing that would automatically invest for you. I did not find that to be as useful. I thought you could do better by making up your own criteria and going for that. I think the people that had the worst results are people that went after high interest loans who read the storyline of whoever made the application and were doing it based on their own sort of personal thoughts about whether that person would repay the loan or not, or whether they liked them or not. And then if they were insufficiently diversified, But I am aware of a number of people that lost money in these platforms, and there were a number of complaints because they had gone out and said that it was going to be easy to make 10 or 15% on these platforms, and it really didn't turn out to be that way in the end. All right, who is getting a cut? That's question eight. Well, the platform itself is getting a cut, a percentage for managing the thing. Other than that, it's really you're getting most of the interest. The other parties that would be getting a cut are the collection agencies that have to go after the defaulting parties and there are fees that were charged with respect to those. Now how does it impact your portfolio? This is question nine. In terms of putting this as part of a risk parity style portfolio, it actually was part of the attraction for me originally that it would be a diversified stream of revenue because it is not that correlated with any other financial asset that you're likely to hold in a portfolio. There was some additional risk that I saw during 2008, during that financial crisis, particularly for those high risk borrowers. There was a higher default rate at that point in time. but there was not really a higher default rate for the lower risk borrowers, the ones with better credit scores and higher incomes, didn't seem to change all that much through that period of time. So it did end up being a decent stream of income over that time period. It did not live up to the lofty expectations that one might have had of 10 or 15% returns. My returns ended up more overall in the 6.5% to 7% range for this investment, which is not terrible, but it's not great. There were some other downsides to this or issues with it, one being the effort that you needed to do this, to do it right, that you had to go and review or have algorithms review the various loans. You had to take some time to really get yourself familiar with the way the whole thing worked because if you just sort of went in and picked things willy-nilly or picked things just because they had a high interest rate, your results were not going to be very good. the other issue that came up with respect to this investment was the tax treatment of it. And it's a complicated thing. You would get in your 1099s and then other forms a printout with all of your loans and at one point I had 10,000 loans overall. So some of these forms got really, really long. and what you would end up with was a mismatch between the kinds of income and the kinds of losses you were sustaining. And what I mean by that is the interest rate that you got paid would come in and would be counted as ordinary income. And so it would be like your ordinary wages or any other income that would be tacked onto your adjusted gross income. But then when you were experiencing losses, because we were talking about these loans, they would actually be capital losses. So they'd be go after your go against your capital gains. So you could have short term and long term losses through this mechanism. So you couldn't write off easily one against the other. What this meant was in order for this to make sense in a portfolio, you probably had to have other investments that were giving you capital gains because then you could match them off. And I did a lot of that over the past 10 years that you had this automatic stream of capital losses coming through a lending club that could then be tax loss harvested against gains coming from other investments. But again, that was more work as this developed over time. So I found that while it was a decent investment, it wasn't a great investment, which led me to eventually to just decide to be done with it and let it run out. The impact it eventually had on the portfolio is I was making that extra income, which was useful. A lot of that money actually ended up going to pay for college educations because that was a savings mechanism for this. I wanted to have something that I thought would give me an intermediate return without having stock market risk in it. And it did play that role fairly well for what it was. Another interesting about it is this kind of long-term run-off I've experienced with it that I still have about $27,000 invested at Lending Club from loans from 3 to 5. years ago, most of these were five-year loans that were established back in 2016 and 2017. It's still running off, but what also is interesting is there's this long pile of defaulted loans that are now getting sent to the debt collectors and money is coming back out of that. So there's this small stream of money that's also coming back out of that. there's going to be this long tail I can see that may go out for years where I'll be getting somewhere between a hundred and a thousand dollars every month as these things get processed over time through the bankruptcy courts and otherwise. All right, question 10 is should you invest or should have I invested in this? I would say it wasn't a terrible idea. It wasn't the greatest idea. I don't think I'm likely to get involved in another one of these platforms, mostly because of the work involved, not because of the investment itself. I've found that it is much easier to buy something on exchanges like a preferred stock fund PFF that, you know, pays five to six percent interest and doesn't require any machinations or choosing loans or borrowers or going through any of that sort of thing. And it was a good learning experience for that. I would say that if you're going to get involved in any of these kinds of platforms, there are a couple of sort of guidelines. First, you really need to be familiar with how the platform works and what its history has been. Some of these platforms now have only been around a couple of years or a few years, and so the jury's kind of still out. as to whether they will be viable. I think that some of them probably will be viable, particularly ones involved with real estate. But I'm not certain that I want to do all the research anymore to try and figure that out. It seems like it's easier to invest in financial markets or real estate itself for the most part than to choose this kind of investment. the other thing I think that you need to be mindful of is not to put too many eggs in any of these baskets because you are beholden to the platform and the people running it. I would want to have a platform that is being monitored by securities agencies, so make sure you know what country it's in and what regulatory standards it could come up under because you want to, you want to know in the back of your mind that if these people who are running these platforms do something improper, that they can be sued and get in trouble for it and not just take all of your money to Bermuda or something like that. So I'm still involved with one of these platforms. I have, well, I have my runoff from, from Lending Club. still going to go on for several years. But the other one that I have recently become involved in is Worthy Bonds, which pays a flat 5% interest. And what it does is it takes the money that is used from its investors and then loans that money against goods that are held by retail sellers or dealers in those goods. I have not put too much money into that simply because it's difficult to know whether you can trust such a platform or not. But it has proven over the past year to be a decent place to source some money, at least for a short term. That's one of the advantages it had over lending club or prosper that those loans, your money was essentially going to be locked up and you were just going to get the stream of payments from it with these worthy bonds. You can actually use it almost like a savings account and put the money in and then take it out and go back and forth into your checking account within a couple of days. But again, I would not put too much into that. I would only keep maybe a few months worth of expenses in such an account. because of the danger that something could happen to it. Lawsuits are not. You don't want to be having to wait around for your money. So that is another barrier, I think, to using these kinds of investments is that you would want diversification by platform and not to have too much money tied up in any one just in case there is some sort of a legal problem with them. So I guess where I come out on this is that these are really not necessary for anybody to invest in, but they are an interesting possibility. You have to be a little bit curious and sort of want to deal with these sorts of things and learn the process for each one of them. But if you are interested, you should do your research and maybe you'll find something that will help you out in the long run. I think I will probably myself stick with very small amounts in these things and only when my curiosity is peaked in one or more of them. But I think I will continue to monitor them over time because Over time, there is likely that there will be more established platforms that once have operated for a decade or more will enjoy more confidence and have a better process for this that you could more reliably use them. But now I see our signal is beginning to fade. I hope you found this little presentation to be informative. If you have any questions about it or about anything else involving risk parity or risk parity radio, you can send them to me at frank@riskparityradio.com that's an email frank@riskparityradio.com www.riskparadioradio.com or you can fill out the form on the website which is at www.riskparadioradio.com. We will pick up this weekend with our weekly portfolio review. But until then, this is Frank Vasquez with Risk Parity Radio signing off. The Risk Parity Radio Show is hosted by Frank Vasquez.

Mostly Mary [28:39]

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