Recently I read a lot of comments about the current yield offered on Mintos, so I thought it is the right time to give you my 2 cents on why you should expect yields to go down. I used Mintos as an example to introduce the topic but from now on I will talk about p2p in general.
I would like to start with a short digression on how the industry was born.
P2p lending platforms are not doing anything different that standard brick and mortar banks did before them. Banks use the money you deposit to lend to businesses/consumers; consumers get a loan at double digits rates (let’s say 15%) and the remuneration on your deposits is normally in line with the Central Bank rate +/- a little spread (now 0% in EUR). The spread, 15% – 0%, is retained by the bank because they hold the borrower default risk and to cover their cost base (rents for physical branches, salaries, private jets for CEOs, etc).
After 2008, banks were scared by the financial crisis and stopped lending to anyone; at the same time, entrepreneurs were attracted by the above mentioned spread and thought they could slash significantly banks cost base and use only internet as distribution channel: welcome the p2p platforms.
Now here we have to distinguish between platforms that offer a buyback guarantee and platforms that do not, because their business model is different.
Platforms with BB
These platforms have ‘skin in the game’ and they retain (part) of the lending risk. Their ability to make a profit depends on two elements:
- Their risk model, i.e. their capacity to lend to people/biz that will repay loans.
- The volume of loans they are able to generate: they have a fixed cost base (the platform cost) and revenues that grows with originations.
Attracting borrowers is relatively simple since incumbents were offering a poor service: high rates, piles of documents required and a process that could last weeks.
Attracting funding is where the story gets complicated: you feel safe and secure to deposit money in the bank branch down the road, a branch that was there since you were born, that maybe your parents use and is sponsoring your favourite football team. Another thing is to send your hard earned money to a country you did not know existed 5 seconds before (believe me, there was a time when people did not trust using their credit card to buy stuff on internet). This is the reason why p2p platforms give lenders the bigger part of that spread, 13% and not 2% like your deposit account: to fill a lack of trust.
Time passes, platforms validate their models, generate a history (preferably profitable), you are happy about your gains and spread the word: that is another difference from the internet bubble, in 1999 you could brag with your friends at a party how much you gained trading pets.com but pets.com was not giving you rebates to bring people along; referral links are accelerating the trusting and validation process, so in a way your short term gain, the referral fee, is damaging your long term gain, the yield platform offers.
Why? Because the other element of the equation is the balance between supply and demand. Demand continues to grow because who does not want a 10%+ risk free return? At first sounded like an internet scam but now not only people with an IG account and 1M followers are talking about it, also my close friend!
Supply is limited, because there is a limited amount of people crazy enough to take a 20% loan to pay for their wedding AND their back straight enough to repay that debt and not be tempted to run away.
So per econ 101, when a growing demand chases a fixed supply, prices go up…and yields go down.
You lender represent a cost for the platform, the more yield you get the lower it can retain for itself. Once the platform knows its model work, its way to grow its profit is to originate more loans but once it hits the above mentioned ceiling, there are no more trustworthy borrowers, the other way is to lower its cost, finding a cheaper financing source. Like that Mintos issuer who tapped the bond market.
Or the platform can start to invest its own profits in the same loans, eating away the supply for its own users. This is a phenomenon quite common for successful hedge funds: if the set of profitable opportunities is limited and IRR is above 10%, it does not take long before the HF itself returns funds to investors and start to manage only its own and employer funds.
Conclusion: platforms with risk models that do not work will go bankrupt (and your money with them) while platforms with a sound model will offer less and less yield…unless some external event breaks the trust circle, which brings us to the below:
Platforms without BB
These platforms have no skin in the game, all the risk is on the investor and the yield dynamic is a bit different. They have an inherent conflict of interest: they can grow their profit only growing the number of loans but, as said above, the number of positive expected return loans are limited (while capital today is virtually unlimited).
Here the yield dynamic is closer to the stock market: businesses make profits, stock prices go up, more money get invested pushing valuation up, valuations get unsustainable, stock market crashes, investors go out, rinse and repeat.
P2p investors make money, more money chase a limited supply of loans, yields go down, investors lose money because returns do not cover risks anymore, investors leave platforms, repeat.
Reality is more complicated since there is no platform that offer primary-market loans with yield driven only by lenders demand, yields are often capped by the platform rating system. Platform secondary markets, where you can buy loans ‘under par’, where par is the amount the loan is going to repay at maturity, offer a closer picture of the above described dynamic.
Obviously there can be a cycle only if during the downturn the platform is able to cover its fixed cost base, either having enough loyal investors to fund fee-generating loans or using reserves previously accumulated.
Conclusion: yields will go up and down, most likely in big and long waves, and platforms will survive based on their ability to manage their fixed cost base.
A bankrupt of a non-buyback platform can affect the trust to the whole sector, so this is a case where also buyback platform will see their yield rise because investors will abandon the sector en-masse.
To sum, yields are a function of the trust in the sector, until that trust is shaken (for right or wrong reasons), prepare yourself to see your returns go lower and lower.
This a very specific p2p lending sector analysis, obviously living in a financial world where every investor is chasing yields and Central Banks are cutting and going negative, does not help. Nothing exists in a vacuum.
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