Lending Club's IPO filing puts peer-to-peer lending in the spotlight. If you're thinking about opening your wallet, here's what you need to know.
Your bank makes money off borrowers. Now you have the opportunity to do the same. One of today’s hottest investments, peer-to-peer lending, involves making loans to strangers over the Internet and counting on them to pay you back with interest. The concept may be a bit wacky, but the returns reported by sites specializing in this transaction—from 7% to 14%—are nothing to scoff at.
Investors aren’t laughing either. Lending Club, one of the leading peer-to-peer lending companies, filed to go public on Wednesday. The New York Times reports the company is seeking $500 million as a preliminary fundraising target and may choose to increase that figure.
Such lofty ambitions should be no surprise, considering that the two biggest P2P sites are growing like gangbusters. With Wall Street firms and pension funds pouring in money as well, Lending Club issued more than $2 billion of loans in 2013, and nearly tripled its business over the prior year. In July, Prosper originated $153.8 million in loans, representing a year-over-year increase of over 400%. The company recently passed $1 billion in total lending. “A few years ago I would have laughed at the idea that these sites would revolutionize banking,” says Curtis Arnold, co-author of The Complete Idiot’s Guide to Person to Person Lending. “They haven’t yet, but I’m not laughing anymore.”
Here’s what to know before opening your wallet.
How P2P Works
To start investing, you simply transfer money to an account on one of the sites, then pick loans to fund. When Prosper launched in 2006, borrowers were urged to write in personal stories. Nowadays the process is more formal: Lenders mainly use matching tools to select loans—either one by one or in a bundle—based on criteria like credit rating or desired return. (Most borrowers are looking to refi credit-card debt anyway.) Loans are in three- and five-year terms. And the sites both use a default investment of $25, though you can opt to fund more of any given loan. Pricing is based on risk, so loans to borrowers with the worst credit offer the best interest rates.
Once a loan is fully funded, you’ll get monthly payments in your account—principal plus interest, less a 1% fee. Keep in mind that interest is taxable at your income tax rate, though you can opt to direct the money to an IRA to defer taxes.
A few hurdles: First, not every state permits individuals to lend. Lending Club is open to lenders in 26 states; Prosper is in 30 states plus D.C. Even if you are able to participate, you might have trouble finding loans because of the recent influx of institutional investors. “Depending on how much you’re looking to invest and how specific you are about the characteristics, it can take up to a few weeks to deploy money in my experience,” says Marc Prosser, publisher of LearnBonds.com and a Lending Club investor.
What Risks You Face
For the average-risk loan on Lending Club, returns in late 2013 averaged 8% to 9%, with a default rate of 2% to 4% since 2009. By contrast, junk bonds, which have had similar default rates, are yielding 5.7%. But P2P default rates apply only to the past few years, when the economy has been on an upswing; should it falter, the percentage of defaults could rise dramatically. In 2009, for example, Prosper’s default rate hit almost 30% (though its rate is now similar to Lending Club’s). Moreover, adds Colorado Springs financial planner Allan Roth, “a peer loan is unsecured. If it defaults, your money is gone.”
How to Do It Right
Spread your bets. Lending Club and Prosper both urge investors to diversify as much as possible.
Stick to higher quality. Should the economy turn, the lowest-grade loans will likely see the largest spike in defaults, so it’s better to stay in the middle to upper range—lower A to C on the sites’ rating scales. (The highest A loans often don’t pay much more than safer options.)
Stay small. Until P2P lending is more time-tested, says Roth, it’s best to limit your investment to less than 5% of your total portfolio. “Don’t bank the future of your family on this,” he adds.
The Consumer Financial Protection Bureau issued a report warning of the risks associated with bitcoin and other virtual currencies.+ READ ARTICLE
New regulations may make Bitcoin safer. But some people think they will also ruin what made virtual currencies attractive.
Bitcoin may have just taken a huge step toward entering the financial mainstream.
On Thursday, Benjamin Lawsky, superintendent for New York’s Department of Financial Services, proposed new rules for virtual currency businesses. The “BitLicense” plan, which if approved would apply to all companies that store, control, buy, sell, transfer, or exchange Bitcoins (or other cryptocurrency), makes New York the first state to attempt virtual currency regulation.
“In developing this regulatory framework, we have sought to strike an appropriate balance that helps protect consumers and root out illegal activity—without stifling beneficial innovation,” wrote Lawsky in a post on Reddit.com’s Bitcoin discussion board, a popular gathering places for the currency’s advocates.
“These regulations include provisions to help safeguard customer assets, protect against cyber hacking, and prevent the abuse of virtual currencies for illegal activity, such as money laundering.”
The proposed rules won’t take effect yet. First is a public comment period of 45 days, starting on July 23rd. After that, the department will revise the proposal and release it for another round of review.
Regulation represents a turning point in Bitcoin’s history. The currency is perhaps best known for not being subject to government oversight and has been championed (and vilified) for its freedom from official scrutiny. Bitcoin transactions are anonymous, providing a new level of privacy to online commerce. Unfortunately, this feature has also proven attractive to criminals. Detractors frequently cite the currency’s widely publicized use as a means to sell drugs, launder money, and allegedly fund murder-for-hire.
The failure of Mt. Gox, one of Bitcoin’s largest exchanges, following the theft of more than $450 million in virtual currency, also drew attention to Bitcoin’s lack of consumer protections. In his Reddit post, Lawsky specifically referenced Mt. Gox as a reason why “setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets.”
New York’s proposed regulations require digital currency companies operating within the state to record the identity of their customers, including their name and physical address. All Bitcoin transactions must be recorded, and companies would be required to inform regulators if they observe any activity involving Bitcoins worth $10,000 or more.
The proposal also places a strong emphasis on protecting legitimate users of virtual currency. New York is seeking to require that Bitcoin businesses explain “all material risks” associated with Bitcoin use to their customers, as well as provide strong cybersecurity to shield their virtual vaults from hackers. In order to ensure companies remain solvent, Bitcoin licensees would have to hold as much Bitcoin as they owe in some combination of virtual currency and actual dollars.
Cameron and Tyler Winklevoss, two of Bitcoin’s largest investors, endorsed the new proposal. “We are pleased that Superintendent Lawsky and the Department of Financial Services have embraced bitcoin and digital assets and created a regulatory framework that protects consumers,” Cameron Winklevoss said in an email to the Wall Street Journal. “We look forward to New York State becoming the hub of this exciting new technology.”
Gil Luria, an analyst at Wedbush Securities, also saw the regulations as beneficial for companies built around virtual currency. “Bitcoin businesses in the U.S. have been looking forward to being regulated,” Luria told the New York Times. “This is a very big important first step, but it’s not the ultimate step.”
However, this excitement was not universally shared by the internet Bitcoin community. Soon after posting a statement on Reddit, Lawsky was inundated with comments calling his proposal everything from misguided to fascist. “These rules and regulations are so totalitarian it’s almost hilarious,” wrote one user. Others suggested New York’s proposal would increase the value of Bitcoins not tied to a known identity or push major Bitcoin operations outside the United States.
One particularly controversial aspect of the law appears to ban the creation of any new cryptocurrency by an unlicensed entity. This would not only put a stop to virtual currency innovation (other Bitcoin-like monies include Litecoin, Peercoin, and the mostly satirical Dogecoin) but could theoretically put Bitcoin’s anonymous creator, known by the name Satoshi Nakamoto, in danger of prosecution if he failed to apply for a BitLicense.
One major issue not yet settled is whether other states, or the federal government, will use this proposal as a model for their own regulations. Until some form of regulation is widely adopted, New York’s effort will have a limited effect on Bitcoin business. “I think ultimately, these rules are going to be good for the industry,” Lawsky told the Times. “The question is if this will spread further.”
Mutual funds that mimic hedge funds are Wall Street's hot new thing. Too bad they hedge away your best shot at returns.
So-called liquid alternative funds are the latest product Wall Street is pushing on retail investors. In 2013, about $40 billion of new investments flowed into the funds, up from $13 billion the previous year. The funds employ the kinds of strategies used by hedge funds, the less-regulated portfolios reserved for institutions and high-net worth investors. For example, in addition to owning investments outright, they’ll go “short”—that is, bet on stocks or market indexes to go down.
Hedge funds have benefited from the mystique of exclusivity, and for a while boasted pretty great returns. Lately, though, their returns aren’t all that impressive compared with what you can make just owning an S&P 500 index fund.
And mutual funds that mimic these strategies haven’t exactly shot the lights out either. For instance, the average market neutral fund, which seeks to deliver gains in both good and lousy markets, has returned only around 2% a year over the past five years, according to Morningstar. That’s about a tenth of the gains of the broad market during that time.
Financial sophisticates will call that an unfair comparison. Fine. But there’s a reason besides performance to give clever-sounding hedge-like strategies a pass.
Consider this deal: I’ll sell you this very nice antique vase. And I’ll let you in on a secret, too. A magic fairy lives inside the vase, and will grant the owner a wish.
You do not really believe in magic fairies. But you might still buy the vase at the right price, because, hey, it’s a nice vase. And if there’s a chance about the fairy…
When you buy a regular stock fund, you’re buying the vase. Most of what you get is the market’s return. When the market goes up, most funds make money. And when the market goes down, most funds go down. Managers try to add a bit of performance on top, by making smarter picks than the competition. But for the most part, if you know how the S&P 500 did this year, you can make a pretty good guess about how your fund did. Even if your manager isn’t all that skilled, you can still do okay so long as the market rises.
Buying a hedge fund, on the other hand, is like paying for the magic fairy without getting the vase.
The classic hedge strategy tries to eliminate or reduce the market factor. There are lots of ways to do this, including chasing illiquid assets or hopping among wildly different asset classes. In a long-short or market-neutral strategy, a manager might look at Apple and Microsoft and decide that Apple is a relatively better investment than Microsoft. By buying Apple and “shorting” Microsoft, the manager can in theory make money in both rising and falling markets, as long as Apple falls less than Microsoft in a down market, and rises more than Microsoft in an up market. (Many hedge strategies are head-spinningly more complex than this, but this captures the rough idea.) Investing in a hedge fund might reduce your market risk, but in return it bets more heavily on the manager’s investment-picking skill.
Skilled managers aren’t as elusive as magical fairies, but for practical purposes they may as well be. After fees, the vast majority of regular mutual funds don’t beat their benchmark indexes. The reason is simple: Almost by definition, the average money manager must deliver the market’s average, minus fees. Though some managers do outperform over time, it’s hard to tell which ones were lucky and which ones have a skill that will persist over time.
It might be that managers of real hedge funds, who have some control over when money comes into and out of their funds, can use the extra flexibility they have to find an edge. But it is doubtful that in the world of mutual funds, which must be able to hand investors their cash back on any given day, that there is a special secret pool of skilled managers who only work for funds where shorting and leverage and other exotic tactics are allowed.