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Peer to peer loans burst on the scene several years ago, promising to revolutionize banking for both investors and borrowers. By removing the bank as a middleman, investors could supposedly get higher returns investing in a new asset class and borrowers could get better rates. Investors purchase tiny chunks of many loans, which provides diversification and reduces the damage of any one loan that goes bad.

In a world of 1 to 2% CDs, many investors (including myself) garnered no effort/easy as pie returns in the 9-12% range. So back in the day I was one of its biggest cheerleaders and most eager investors. Life was good!
 

The Honeymoon Ends

But over the years this has changed. My juicy returns at Lending Club from previous year loans (called "vintages"), have dropped year after year and are now a measly 4.9% with the current vintages. The rates charged to consumers have not gone down so much, so the problem is obviously increased defaults by people who are not paying back their loans.

Lending Club says they've made changes to their underwriting to address the unwanted uptick in dud loans. I'm not seeing that this has made enough of a difference for me in the final results.

I'm also highly concerned about an over-reliance on untested techniques like machine learning to do underwriting, and the apparent abandonment of time-tested means. For example, Lending Club recently revealed in the security offering that it did not verify basic loan information like borrower income and employment on up to two thirds of its loans. In my opinion, this appears to be borderline reckless.

 

The Circle of Disappointment
 

I've had similar woes on Funding Circle. In 2015-2016 I purchased almost every loan on the marketplace (to ensure proper diversification) expecting a decent projected 7-9%. Instead, I'm currently stuck in the dumps in the high 4% to low 5% in returns. (And to add insult to injury, I had to calculate my return manually because they don't publish the total return in your dashboard... something I was told was being worked on for over two years).
 

And although I'm not invested in Prosper, a recent article in American Banker talked about how they overstated their returns (as high as 50% for some unlucky investors who probably thought things were going great). Total returns have dropped from a weak 6.93% in 2015 to a miserly 3.95% in 2016. Depressing.
 

"Inefficient" or a nail gun to the scalp?
 

To add insult to injury, the tax treatment of your losses on peer to peer loans is disastrous for anyone investing a significant amount (outside of a tax-sheltered investment).

The 1st problem is that while gains are considered taxable income and taxed at that higher rate, the losses are bizarrely put into another tax category of capital losses which gives you a credit at a much lower rate.

Normally, if you make $1000 on one note and lose $1000 on another, you've made $0 in real life and don't pay taxes since you made no money. However, due to the tax structure, you end up paying taxes even though you made nothing. 

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And it gets worse. You're generally limited to only deducting the 1st $3000 of capital losses (unless you're "lucky" enough to have other capital losses that year to offset them). If you're not in the habit of losing lots of money every year on other investments, then you are going to be stuck at the $3000 limit and have to carry forward to future years. And if you invest a significant amount like I did, you can accumulate more and more carryover faster than you can ever get credited for it. If I kept investing in Lending Club, I theoretically could go decades or longer without getting the credit back.

In a huge understatement, some of the perpetual peer to peer cheer-leading sites call this "tax inefficiency". At tax time, it feels more like hitting myself with a small rock over and over. (Because, it can take hours to enter never-to-be-credited losses on thousands of notes on every tax return). No matter what you call it, it ends up killing the already bad return even more.

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Dark Clouds Gathering

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All this sounds bad enough, but none of this covers the biggest problem. In 2017, the economy is humming steadily, jobs are being created and peer to peer is doing worse than expected.  What's going to happen when there's some real stress to deal with in the next downturn?

 

Once people start losing jobs, defaults will get worse, not better. I believe that the peer-to-peer underwriting models will continue to do what they're doing now, and perform worse than expected. If we have a prolonged recession, there is a great chance of catastrophic defaults and significant losses of principal. 

 

No shirt, no collateral...no loan.

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Compare that to alternatives with better protection, like making a loan on real estate through a hard money fund.

When a borrower defaults on Lending Club, you take a 100% loss because you own no collateral.

 

When a borrower defaults on a real estate loan, you own the collateral (the property) and can sell it to recoup some or all of the loss. If you've underwritten the loan conservatively (65% LTV maximum, conservative underwriting) you're unlikely to lose your principal. 

 

So it's difficult for me to justify putting more money into unsecured loans on peer to peer, when there are safer options for this stage of the cycle (that also yield higher).
 

Dump first. Ask questions later.
 

I believe that the next downturn is a lot closer to us than the one we put behind. So I've been winding down all my peer to peer investments for the last year, and moving all funds from finished loans into other places.

Two thirds of it is liquidated and the rest will take some time, because it's stuck in loans with 3 to 5 year terms.

This is the other limitation of peer to peer, versus a hard money fund like BroadMark Capital. Hard money funds generally let you liquidate in any quarter (assuming they don't gate withdrawals, of course). With peer to peer, you can guarantee that you'll always be stuck for the long, full ride.

Yet another reason I'll be very happy once I'm finally and completely off the bus. 

2017-07-30: I'm currently experimenting with liquidating/selling my long-term notes on the secondary market on Lending Club. This is not part of Lending Club itself, but provided by a third-party company. You can sell the note  at a price you specify,  for a 1% charge. So if you're able to sell them at current value, it costs you only 1%.  That may be a big if, because not all notes may sell at that price.  But at least it is an option to liquidate at hopefully not too huge of a discount. Currently, there is no secondary market for Funding Circle or Prosper.