Season Investments

facebook-logo.pngtwitter.pnglinkedin-logo.png

The Hunt For Yield

Posted on September 10, 2013

“What we’ve done is radically transform the way consumer lending operates.” - Renaud Laplanche, CEO of Lending Club

2013-09-10_target.jpgOne of the ramifications of the Federal Reserve’s super loose monetary policy over the past six years has been a lack of good investment options for low risk, yield hungry investors. Money has poured into high yield debt and “debt like” equities with good dividend yields. The influx of capital into these instruments has pushed prices up and yields down making it harder to earn an acceptable return on any capital that has to be reinvested. This reach for yield where investors are forced to move down the capital structure and take on more risk in order to find acceptable levels of return is one of the expressed goals of the Federal Reserve’s uber-dovish monetary policy. The inflation of asset prices (whether artificial or real)  creates a wealth affect which leads to more spending from a now richer consumer base which in turn leads to economic growth. This is known as the virtuous circle in economics.

The problem with the current virtuous circle is that it “forces Grandma to subsidize Goldman” by taking away the income-oriented investment options for risk-averse investors in order to help the banks recapitalize their balance sheets from the carnage that was the financial crisis of 2008. Given that this is the world we live in, our job as portfolio managers is to find the best option for our investors to help them meet their investment objectives. The lack of available income in almost every corner of the publicly traded investment universe has forced us to broaden our horizon in the hunt for yield. One area that we think offers excellent risk adjusted returns is in the relatively new peer to peer lending space.

The concept of peer-to-peer (P2P) lending in and of itself is not new. I’m sure almost everyone reading this Insight has either had someone ask or asked someone else for a loan at some point in their life. In 2007, two startup companies (Prosper and Lending Club) decided they would take P2P lending mainstream by creating a platform through which individuals could cut out banks by asking for and lending money directly to each other. The best part about the new P2P platform was that it allowed investors to invest small chunks of money into a wide variety of different loans. In doing so, lenders were able to diversify the risk of default from any one single borrower by spreading it out over hundreds if not thousands of different loans. Like any budding industry, peer-to-peer lending has gone through some growing pains, but the industry is better off today because of it. As an example, all of the loans offered through either platform are now registered with the SEC, which wasn’t the case in the early years of operations. This year, the two platforms are expected to surpass $2 billion in new loan volume combined.

2013-09-10_P2P_Loan_Volume.png 

Here are the basic steps of how internet based P2P lending works.

  1. The borrower submits an online application for a loan detailing how much they would like to borrow, the purpose of the loan (consolidate debt, pay off car loan, launch a new business, etc.) and background information on their financial situation.
  2. Computer algorithms screen applications and pull credit reports on applicants to weed out unqualified borrowers (Lending Club states that they reject 90% of applicants) and assign a risk score to qualified applicants. The risk score determines the rate the borrower will be charged ranging from 6% - 35%.
  3. Approved applications then go live on the platform website where lenders/investors can scan a large variety of loans with different risk and return profiles. Investors than fund loans they like making investments as small as $25 in some cases. A typical loan is funded by several hundred different investors all biting off small chunks of the total amount borrowed.
  4. After the loan is fully funded, the borrower must verify the answers on their application with an actual person working for the peer to peer lending platform. If a borrower is unable to provide proof in order to verify their application, the loan is cancelled and no money is exchanged. If the borrower is able to produce verification, the loan is issued and funds are electronically transferred.
  5. The borrower makes monthly payments to the peer-to-peer lending platform which then distributes the interest to the hundreds of different investors backing the loan.

The reason Lending Club and Prosper have been so successful is that they have delivered attractive returns for the level of risk their lenders/investors are accepting. If they weren’t able to meet this objective, institutional money wouldn’t be pouring into this space as it is right now. Both Lending Club and Prosper publish average return statistics for investors on their platforms of a little over 9% after factoring in defaults and fees going back to 2007 for Lending Club and 2009 for Prosper. Internet based P2P lending has survived the financial crisis, gone through growing pains leading to positive change, and is now thriving. For these reasons, we think it warrants consideration for investors looking for an income solution who are willing to spread their investment risk across hundreds or thousands of individual loans as an answer to the low interest rate environment we face today.


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


Subscribe to our Weekly Insight via email!

 


Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.