Recession's likely impact on p2p lending

"In the financial news you can find a story almost every day about the weakness in real estate markets, rising foreclosure rates, and increases in the number of bankruptcy filings. Some economists worry about the effects spreading across the broader economy and triggering a recession. The bearish outlook suggests that lenders will tighten up their borrowing criteria, consumer spending will decrease, and unemployment will start to increase." - Matt here on Prosper Lending Review, June 28, 2007

The stock market just had its worst week ever based largely on fears we are entering a recession. Last year Matt wrote an article about the likely impact of a recession on P2P lending. His points are all still valid. It's worth another look now.

What effect would a recession have on the Prosper marketplace?

Prosper warns lenders of high risk credit grades

Prosperousland points out an interesting change in the bidding page for the riskiest credit grades. When you click to bid on E and HR credit grade loans you are now greeted with a large banner - Warning: Very low credit grade.

The disclaimer shows that E borrowers with 2 or fewer delinquent accounts have a default rate of 9.2% and E borrowers with 3 or more delinquent accounts have a default rate of 35.3%. High risk borrowers with 2 or fewer delinquent accounts have a default rate of 17.5% and high risk borrowers with 3 or more delinquent accounts have a default rate of 52.1%. This data is for loans with origination dates of Jun-Nov 2006 and as of Jan 2007.

There have been complaints in the forums that many lenders, especially new lenders, do not fully understand just how risky HR and E credit grades are. A lender who goes by the username thisguy has been the most vocal proponent of warning new lenders about the risk associated with E and HR borrowers. He has posted several messages such as this one, "If nothing else I still think there should be a 30 day ban from day 1 thru 30 of your lending life here where you are banned from bidding on HRs - then at least you will have had some time to build up your knowledge base, and see the 'reality' of the site." Other veteran leaders agree. In an open letter to Prosper in April Fred93, one of Prosper's largest lenders, accused Prosper of misleading lenders about potential returns and default rates.

This move by Prosper appears to be an attempt to respond to the criticism. It helps increase visibility of the likelihood of default on E and HR loans and will help new lenders fully understand the risk associated with lower credit grades.

While I think this is a great move for Prosper, it is also likely to make it harder for E and HR borrowers to get loans. As I mentioned in an earlier article, nearly 7 of 10 listings are from E and HR borrowers but very few of them get funded. Six months ago lenders aggressively funded low credit grade loans, but they have backed off due to the high default rate.

Analyzing the data using Prosper's Marketplace Performance, it appears that Prosper presented the most brutally honest, worse possible data. It also appears they included the rate adjustments in the default amount to come up with their percentages. If you move the range of dates forward or back the default rate gets slightly better or stays about the same.

What effect would a recession have on the Prosper marketplace?

In the financial news you can find a story almost every day about the weakness in real estate markets, rising foreclosure rates, and increases in the number of bankruptcy filings. Some economists worry about the effects spreading across the broader economy and triggering a recession. The bearish outlook suggests that lenders will tighten up their borrowing criteria, consumer spending will decrease, and unemployment will start to increase. FX Street lists 6 historical indicators that suggest we may be heading for a recession (all of which have now occurred):

1. When GDP growth was below 3% annualized for 5 consecutive quarters.
2. When the Fed tightened monetary policy (8 of the last 10 times).
3. When the yield curve was inverted (6 of the last 7 times).
4. When the Conference Board Leading Indicators were 0.5% or more below a year earlier (9 of the last 10 times).
5. When new building permits were 25% or more below a year earlier (7 of the last 9 times).
6. When payroll employment growth dropped to 1.4% over a year earlier.

Other economists are more optimistic and suggest that the sub-prime fallout won't spread, and we will continue to see the economy improve and move ahead.

The truth is that economists have never been good at predicting short term moves in the economy, but history does show cycles of booms and busts (or expansions and recessions). During a recession you will see a significant increase in the number of defaults among the lower credit grades. The following is a graph of historical default rates for speculative and investment grade loans.



From the above graph you can see that during the 1990-1991 recession there was a significant spike in default rates. In addition, most other asset classes don't do very well in a recession. In 1990 the S&P returned -3.11%, the Russell 2000 was at -19.48%, the US housing market showed a decline, and the junk bond market took a hit as default rates rose. In fact it is because of the 1990-91 recession that rates on junk bonds are so much higher than rates on better classes of bonds. When a recession hits it is likely that it will be accompanied by higher default rates on all types of debt including Prosper loans. If past recessions are a guide, the increase in default rates will be much more profound among sub-prime and lower credit grades.

So, what is the best way to protect against this potential risk?

First, make sure that you have the appropriate time frame outlook for your investments. At Prosper, your minimum time horizon is 3 years since all loans originate based on a three year term. I would suggest that your time horizon should be longer than that. If you have 20+ year time horizon then your returns are going to approach the market average. The long term average for the stock market is about 10%. For the bond market it is about 5%. We don't have good numbers for Prosper's long term average over cycles that include bull and bear markets, but I would guess that the long term performance for a portfolio of above prime loans would fall somewhere between the 5% bond market return and the 10% stock market return.

If you have a shorter time horizon, for example, if you absolutely needed the money in 3 years then you could end up taking a loss or smaller return on your investment. Think what would happen if you invested in the stock market before 9/11 and then took your money out 3 years later. Given enough time, however, the markets recover from downward cycles and investments return to their long-term historical rates of return (in economic terms this is called regression to the mean). The same is true for Prosper; with a short time horizon you could end up with less than the long-term expected rate of return if your investment horizon overlaps with an economic recession. With a longer time horizon, the recessions will have a small overall effect on the portfolio as they are balanced out by better years.

To further protect your portfolio from economic downturns, you can consolidate your loans into better credit grades and spread your risk out across a variety of loans as I discussed in my risk management article. If, for example, you loan primarily to homeowners or real estate investors than your portfolio will be more exposed to a real estate downturn than if you have a wider variety of loans. Focusing on the higher credit grades help, since historically it is the sub-prime loans that are least able to weather an economic downturn.

Lastly, don't put all of your investment money into any one asset class. You should start with an emergency fund in something like a money market or savings account that can be easily accessed if needed for an emergency. Then any remaining money can be diversified among several different asset classes - stocks, bonds, real estate, foreign markets, and Prosper. The allocation percentages should be based on your risk tolerance and investment timeframe. The longer term (10+ year) money can have a higher percentage in stocks, the mid-term (5-10 year) money can have a higher percentage in Prosper, and the shorter term (<5 year) money should be mostly in cash accounts or bond funds.