A Tale of Four Loan Markets (1)

 Peer to Peer Lending: Zopa and RateSetter

Early banknote @AD 940, China, courtesy Wikipedia

 

Prolonged low savings rates coupled with a reduction in bank lending has led to fringe banking that excludes the traditional banking sector.

According to the consumer organization Which?, the best savings rates currently available from the banking sector are:

Bank	Term	Minimum deposit in pounds*	APR interest %
Post Office	30-day call	500	1.6%
Shawbrook Bank	1 year	5,000	1.95%
FirstSave	2 years	1,000	2.35%
Shawbrook Bank	3 years	5,000	2.65%
Vanquis Bank	4 years	1,000	2.91%
FirstSave	5 years	1,000	3.15%

*All deposits are guaranteed up to 85,000 pounds by the Financial Service Compensation Scheme

This and subsequent articles on this blog will focus on the new loan markets, where the risks are much higher than for bank savings accounts.  While the Financial Conduct Authority (FCA) or the Office of Fair Trading oversees all these markets, their characteristics - risk, liquidity, transparency, return and loan size - vary greatly. There are four main classes of loans.

1. Peer to Peer lending (P2) - Where individuals lend to individuals. An intermediary screens and assesses the risk of the borrower. He matches lenders and borrowers so that the lender's funds are spread over as many borrowers as possible, thereby reducing the risk of a single large default. The intermediary, which operates online, takes a fee from the transaction. Sometimes the intermediary sets up a fund to protect lenders from borrower defaults. There is no secondary market for the loans, they are not guaranteed and they are not eligible for independent savings accounts (ISAs).

2. Peer to Business lending (P2B) - Where individuals lend to small businesses. An intermediary assesses the risks of the borrower and informs the potential lender of the borrower's rating. The lender bids an interest rate that he or she believes compensates for the risk profile of that specific borrower.  The lender may bid in small sums, called 'parts', for many different business borrowers. The intermediary matches borrowers and lenders and takes a fee for this service. There is a secondary market for these loans, but they are not guaranteed nor are they eligible for ISAs.

3. Order Book for Retail Bonds (ORB) - Where individuals buy bonds from established companies listed on the London Stock Exchange. Individuals must assess the risk of each investment and purchase the bonds via a trading platform. ORB bonds have a secondary market, they are not guaranteed and, if bought with more than 5 years to maturity, they are eligible for ISAs.

4. Mini-bonds- Where individuals buy bonds from individual companies directly. The bonds, which are often unsecured, are marketed directly by the company to the public. The companies are usually privately held and they are much smaller than ORB bond issuing companies, but larger than P2B loan issuers. They are not required to provide a detailed prospectus and it is often difficult to assess their credit worthiness. Mini-bonds do not have a secondary market, they are not guaranteed nor are they eligible for ISAs.

------------------------------------------------------

Peer to Peer (P2P) loans

Five candidates for P2P loans, courtesy Wikipedia

 

P2P got going in 2005 with the idea of using the internet to match people who wanted to borrow money for relatively small purchases (20,000 pounds is now the upper limit at Zopa) with savers who wanted a better rate of return than they were offered by the banks.

 Typical borrowers are people who use the loan to buy consumer durables (cars, computers etc.), make home improvements or pay off credit card debt. They are credit screened and assigned a risk rating by the intermediaries. Consequently, the rate of interest they pay is below that they would have to pay to a formal lending institution.

The average saver lends about 3,500 pounds, though Zopa claims it has two lenders who are owed over a million pounds and several hundred who are owed over 100,000 pounds (interview with the Guardian, 12 August 2013).

P2P debt management companies currently fall under the responsibility of the Office of Fair Trading, where they are required to obtain consumer credit licenses. However, the oversight for P2P will pass to the FCA from April 2014. This is likely to result in more controls, higher costs and, consequently, lower lending rates for savers.

 

Zopa (acronym for Zone of Possible Agreement) Ltd.

Zopa was founded by former employees of the internet bank Egg in 2004 and it began trading in 2005. Zopa soon became the biggest intermediary for P2P, and it has changed its operating model many times since 2005. It eliminated high risk and youth borrowers. It has changed the programming used to match lenders and borrowers thereby preventing savers gaming the system to control lender queues. And it now includes a fund, called Safeguard, to compensate lenders for losses. The consequence is that Zopa pays lenders less interest than previously.

The Safeguard (SG) fund of 1.8 million pounds, while small, would seemingly cover 700 million in loans if Zopa's current default rate of 0.25% is maintained. Zopa has lent 165 million this last year and 427 million since its founding in 2005. Zopa is not covered by the Financial Service Compensation Scheme.

Any UK resident over the age of 18 can sign up on Zopa's website and offer as little as 10 pounds for a bit of a loan. Advertised interest rates, net of fees, are 5% for savers, although this is above the rates currently recommended as 'trackers' at its website:

For loans of 2 and 3 years, 4.0% APR

For loans of 4 and 5 years, 4.4% APR

The procedure:

·         The lender deposits funds with Zopa and the company spreads the investment in small bits between many lenders. The minimum loan period is 2-3 years and the maximum from 4 to 5 years.

·         The lender sets an interest rate that 'bids' for the loan, and his position in the queue for loans depends on a) the demand from borrowers and b) the rate other lenders are willing to lend at. Interest payments are made without any deduction for income tax. Alternately, the lender may offer loans at the 'tracker rate' suggested by Zopa. Either way, the rates lenders are willing to loan at are matched to borrowers who are willing to pay (including an uplift for Zopa's margin).

·         The borrower pays a fee to Zopa, and Zopa takes 1% of the annual interest rate to cover its costs.

·         The lender receives payments monthly and can elect to reinvest this amount in new loans. If the lender wants to recover his money before term, he may do so. The cost to the borrower is a 1% fee to Zopa plus any additional credit that another Zopa lender might require to take on the business. If the borrower is in arrears, the lender is not eligible for RR.

·         The lender receives a spreadsheet detailing the terms of the loans and the profile of the borrowers.

At December 2012 Zopa, which is a private company, had a net worth of 3.5 million pounds.

 

RateSetter Ltd

RateSetter was launched in October 2010 "to make peer-to-peer lending simple and safe for everyone."

 

Two of the founders have worked in banking and the third in a start-up. To date RateSetter has loaned 141 million pounds, and the company is Zopa's main competitor

 

The lending procedure is very similar to Zopa except that the sums loaned are not parceled out in such small tranches. But while Zopa has a very active chat room, this is missing from RateSetter.

 

Latest matched interest rates are somewhat higher than Zopa's, and they cover a longer span of time:

1 month - 1.7%

1 year - 2.9%

3 years - 4.3%

4-5 years - 5.7%

 

Like Zopa, RateSetter permits lenders to recoup their funds early, provided another lender is willing to take on the loan.

 

And, also like Zopa, RateSetter has a 'Provision Fund' that reimburses lenders for defaults. The Provision Fund is currently worth 2.4 million pounds and it is financed by borrowers.

 

RateSetter does not explain how it earns a commission. However, as the typical offer rates for borrowing for 5 years are 2.7% above the 5-year rates received by lenders and the difference for one month is 4.7% (annualised), RateSetter evidently make a turn on the interest differential. 

 

At March 2013, RateSetter parent company Retail Money Market Ltd. had a net worth of 1.5 million pounds.

 

Conclusion

 

P2P lending rates received by savers have been falling.  RateSetter interest rates for 1 year have declined from 5% in January 2012 to 2.9% now, while 5-year rates are down from 7.6% to 5.7%. In part this reflects the fall in savings rates that followed the Funding for Lending scheme launched by the Treasury.

 

Lenders can still get better interest rates from P2P than the banks:

 

Interest rates for lenders/savers	Best bank	Zopa	RateSetter
1 month	1.6%	N/A	1.7%
1 year	1.95%	N/A	2.9%
3 years	2.65%	4.0%	4.3%
5 years	3.15%	4.4%	5.7%

 

However, lenders would be wise to consider the risks associated with P2P before lending their money:

 

1.       Savings deposited at banks are guaranteed up to 85,000 pounds by the Financial Service Compensation Scheme (FSCS). The FSCS does not guarantee any sum lent via P2P.

2.       Although both Zopa and RateSetter have sinking funds to compensate lenders for the default of borrowers, they have no statutory requirement to do so. At any time they may reduce payments into these funds. And, if there is a sudden increase in defaults, the sinking funds might prove to be inadequate. In that event, the lender will suffer a capital loss.

3.       The FSCS guarantees savings deposits at banks. If the bank becomes insolvent, the FSCS will pay the saver any sum up to 85,000 pounds. In practice, the government has guaranteed all bank deposits, regardless of their amount (at Northern Rock, Bradford and Bingley and RBS). However, if the P2P intermediary fails, the lender is not backed up by the FSCS or the state.

4.       In the event that the P2P intermediary fails, the only recourse the lender has to recover his money is to contact the borrower and, if necessary, take him to court. Given the small individual amounts involved and the large number of lenders for every borrower, any such failure would almost certainly result in a total loss except for the small amounts currently available in the sinking funds (3% of loans for RateSetter, less for Zopa).

5.       The two largest intermediaries are very small companies. Zopa has a net worth of 3.5 million pounds, RateSetter 1.5 million pounds. Both are privately owned. While Zopa appears to be profitable, recent funding from RateSetter shareholders suggest it is not. And Zopa closed its US operation in 2008.