Fact Check: Was RateSetter Hit By £80m Of Struggling Loans?

Not enough time to read this 4,000 word report? See the simple, plain English summary here.

In this report:

• The Guardian says: RateSetter was hit by £80m of problem loans. Is that true?
• Significant mistakes admitted by RateSetter.
• The risks and rewards at RateSetter have significantly worsened.
• My verdict on whether to sell your RateSetter loans. But I'll save that to the end of this article to build the suspense…

Thanks to Matthew Howard and all the 4thWay research team for your huge contributions to this article.

Fake news!

In these days of fake news (especially fake news created by people complaining about fake news) I'm quite getting into a new type of article that is becoming popular in many newspapers: the Fact Check.

Recently the Guardian said that RateSetter had been hit by £80m in struggling loans and went on again to call them “endangered loans”.

The first half or so of this page is my fact check about that.

What happened? RateSetter took unusual action on three businesses that have been borrowing very large amounts of money from the individual lenders who lend through RateSetter:

Borrower 1: Adpod Limited

Long story.

So, RateSetter lenders were lending to a business borrower called Vehicle Trading Group, which itself was lending the money on to other businesses.

This practice is called “wholesale lending”.

RateSetter is no longer approving new wholesale lending and has given at least two reasons for this:

1. Last year – around November I think, but please don't make me look it up – RateSetter said that it was going to wind down wholesale lending, because the financial regulator had just said that wholesale lending and P2P cannot mix.
2. In a blog in May 2017, RateSetter said it was stopping wholesale lending “as part of our strategy of building closer, direct relationships with borrowers”.

Now, Vehicle Trading Group (let's call it VTG) was lending a huge amount of money to a business called Adpod.

Here's what RateSetter told 4thWay about this.

VTG was already lending to Adpod with no involvement from RateSetter.

Then, a few years ago, RateSetter agreed with VTG that lenders through the RateSetter website would help, which finalised to the tune of a £12m RateSetter loan to VTG, which it lent on to Adpod.

RateSetter set some strong conditions to limit the risks or losses in the event Adpod struggled with repayments on this super-large loan.

The biggest of those conditions was that RateSetter must hold the security over the loans and assets.

(See sidebox, right, to learn about security.)

The big experiment

However, in approving and managing the loan to Adpod, VTG was way out of its depth.

You see, Adpod sells digital video screens on which retailers can advertise. These electronic screens are a bit like modern billboards, although much smaller.

Yet VTG traditionally did car loans. It did loans to motorists so they could buy cars. And it did loans to car dealerships, so that they could buy cars.

Car loans was VTG's purpose in life. Car loans is what VTG understood.

Digital screens, you may have noticed, are not cars.

Then the Adpod loan went bad

RateSetter has explained to 4thWay that it did not realise the trouble that Adpod was in until it was helping Vehicle Trading Group try and sort out its own problems. (More on that shortly.)

It became clear to RateSetter that VTG was not monitoring the scale of the Adpod loan properly. So RateSetter took on the Adpod loan so that it could manage it better for itself. So, rather than lending to VTG and VTG lending to Adpod, RateSetter's individual lenders were lending directly to Adpod on this loan.

Now, RateSetter also owns Adpod due to its difficulties in repaying. If RateSetter owns Adpod, and lenders using RateSetter are lending to Adpod, it means that RateSetter lenders are now actually lending to RateSetter. This is not supposed to happen in P2P lending.

What's the Adpod situation for RateSetter lenders?

Peter Behrens, Ratesetter’s co-founder: “We did something on behalf of our lenders that was quite clearly a mistake. It is not right for them to take that hit.”

From the Guardian

As of now, £8.5m is still outstanding on this huge Adpod loan. I mean, that's a really huge loan to a single business, and way over what you normally lend to individual small businesses.

RateSetter has told its lenders that due to the significant error it made in approving this loan, it is taking the hit on any losses on the loan out of its own pocket, rather than using its separate provision fund to cover them.

To that end, whenever Adpod's monthly repayments are short, RateSetter is using its own cash on a monthly basis to repay the Adpod debt, plus interest, to individual RateSetter lenders.

RateSetter would not confirm how many payments Adpod has missed and what losses RateSetter has had to pay for itself so far, nor what it expects to lose in future. As sensible lenders, we should therefore assume that RateSetter will make a very large loss on this loan and will not earn any interest.

While that has no direct impact on us lenders or RateSetter's provision fund that protects us, higher costs could impact the stability of RateSetter's business.

I have not been given details of this loan, so I have to loosely estimate its monthly costs. I guess the loan payments that Adpod and RateSetter between then need to make to RateSetter's individual lenders might be around £280,000 per month.

RateSetter will not confirm to 4thWay how much money it has, or expects to have, in its own coffers to cover any shortfall in those six-figure monthly payments to the individual lenders of its site.

However, RateSetter has told us that it is absolutely prepared for every eventuality. I take that to mean it can take any realistic level of losses.

I'll come to more details on RateSetter's financial position shortly. But, here, the Guardian isn't wrong to call the outstanding £8.5 million of this £12 million loan a “struggling loan”…

Borrower 2: Vehicle Trading Group Limited

As you now know, Vehicle Trading Group became involved in lending to Adpod, a business that was well outside its core competency of car loans.

It also borrowed more money from other sources than RateSetter. More money than it could handle.

So VTG went bust and RateSetter then stepped in to directly take over its car loans.

What's the VTG situation for RateSetter lenders?

The shell – VTG – was broken. But its portfolio of car loans totalling £36 million is not.

The car owners and dealerships continue to repay these loans to RateSetter lenders, for the most part. And, when any of the loans turn bad, Ratetter can sell their cars and pursue the borrowers for the difference, making the loans far more secure than unsecured personal loans.

The cars are collectively worth £31 million, which nearly covers the debt by itself.

RateSetter had ensured from the beginning that if VTG borrowed from any other lenders then those loans were “junior” to the money VTG owed to individual RateSetter lenders.

This means that, in the event VTG got into trouble – which it did – VTG's spare cash goes first to RateSetter lenders – the “senior” lenders. If there's any money left after that, other lenders to VTG, such as banks, are allowed to take their cut.

RateSetter has told 4thWay that it expects the interest earned on VTG's existing car loans to more than cover losses from any bad loans.

While RateSetter's provision fund might not need to cough up to pay RateSetter lenders their original loans back, it might still need to do so to make up for any lost interest.

But that's normal and not necessarily worrying. When you lend £36 million to lots of car owners, sometimes you will not get every penny you expect in interest. The provision fund covers that. And RateSetter has been paying amounts into the provision fund to cover expected losses on VTG loans from the beginning, as it does for all loans.

RateSetter is still estimating that the provision fund, as well as future payments into it made regularly by existing borrowers including VTG and others, will be far more than sufficient to cover expected losses.

So, when VTG was suffering problems, RateSetter did have around a £36 million “struggling loan” problem. Now that RateSetter has broken this big loan up into the individual underlying loans to car owners, and it expects the initial loans to be recouped, calling them all “struggling loans” is a bit of a stretch.

Borrower 3: George Banco

We can deal with George Banco rather more quickly. The Guardian included this one in its article, because it completely misunderstood what was happening.

The loan payments on this £32 million wholesale loan are going fine, with all repayments paid in full and on time. That's the main point that you need to know.

The reason George Banco came up at all is that RateSetter paid some of its own money to become a part-owner, with a view to changing George Banco's future borrowers into direct P2P borrowers through the RateSetter website. Future borrowers would not be wholesale borrowers through George Banco.

RateSetter later established that this was not the best use of its resources and simply decided not to go ahead with the change.

The existing wholesale loans through George Banco are still being paid down just fine, RateSetter told 4thWay. So there's no real story here for individual lenders and these are not “struggling loans”.

Fact check verdict

The Guardian said RateSetter had an £80 million “struggling loans” problem.

£8.5 million, with Adpod, is definitely struggling.

Perhaps a larger than usual part of the interest payments on some loans to VTG might be struggling. That might be another million or so if we're being very pessimistic.

But there's a big difference between about £10 million and £80 million.

I rate the Guardian's statement as False.

What has RateSetter learned from its errors?

Usually, when you do wholesale lending, you can't keep track of every individual loan that the wholesale lenders are doing.

Yet RateSetter could have kept track of this exceptionally large loan to Adpod, especially as it was clearly outside VTG's expertise.

And RateSetter could have kept better track of huge wholesale borrowers like VTG.

4thWay's Chief Risk Modeller asked RateSetter a variation of one of his favourite questions: “How did RateSetter originally develop good risk models for lending to lending businesses (wholesale lenders) with no or limited data history?”

RateSetter responded that it originally did this by making it RateSetter's business to understand those businesses, how they lend and their processes, and by working very closely with them.

It seems, not closely enough.

RateSetter told us that it has now learned its lessons and made changes to prevent this happening again:

• Specifically, it does not do business loans over £750,000 any more, which is a small fraction of its outstanding loanbook, and therefore eminently more sensible.
• In addition, as I've already said, RateSetter doesn't do any new lending to wholesale lenders.
• It also says it has strengthened its governance to improve checks, balances and oversight of lending.

We as lenders can also learn something important from this. That the experts at RateSetter got it wrong in lending large amounts to two businesses shows that choosing who to trust to lend your money is not as easy as it seems. Certainly, RateSetter didn't monitor these growing loans properly, so we lenders, and 4thWay, do need to keep monitoring the P2P lending sites.

It also bangs home the point we've made many times of spreading your money widely across lots of borrowers.

A bit of overzealous marketing?

RateSetter wrote a very clear email to its lenders in July about the situation, but earlier this year it was not as direct.

So I asked RateSetter a series of questions about how it passed on the information to individual lenders about the above borrowers in prior months.

The theme of all these questions was: was it satisfied that it has always unambiguously conveyed the key points about the above three wholesale loans to RateSetter's lenders?

In other words, how did it rate its transparency on this occasion?

Back in May, RateSetter wrote a blog on its website about VTG called: “Announcing new direct lending partnerships”.

With that title, I think RateSetter lenders could be forgiven for thinking it sounded like good news.

The blog explained that RateSetter bought VTG out of bankruptcy to reduce the risks, but does not explain how that drastic step occurred. Buying companies out of bankruptcy can even be a very positive thing if you can buy them for cut prices, so readers might easily have assumed there were no negatives.

RateSetter decided it would not answer any of 4thWay's questions about its marketing and the tone of that marketing. It focused instead on our more factual questions.

Do I think RateSetter's communication skills and transparency in this matter to be a problem? No, not a big one. I think that both shoppers and investors (including individual lenders) would be hard pressed to find any company in any industry that doesn't try and put a positive marketing spin on things at some point.

Marketing departments that write blogs aren't always paid to put transparency about investment products above positive messages about the company.

Looking at investments elsewhere, the same goes for stock-market listed companies and investment funds too. The best stock-market investors learn quickly to skip over the glossy colour pages in annual reports to read the important numbers and the hidden footnotes. The same sort of thinking applies to investors doing P2P lending.

I still rate RateSetter as far above average on fairness, transparency and communication with its lenders.

Yet individual lenders can learn from this that even transparent P2P lending sites don't necessarily convey the full connotations that you need to know in their marketing materials. You sometimes have to dig deeper and look to independent sources.

Drawing a line under those mistakes

RateSetter admitted its errors and has given individual lenders one month to decide to stop lending if you're worried about the risks. You now have till 18th August, so less than 10 days.

To do that, you email investoroption@ratesetter.com.

If you place your loans for sale in that time, RateSetter will not charge you any fees for leaving your loans. I think you can't say fairer than that.

The biggest error was approving the Adpod loan. RateSetter is now effectively borrowing from its own lenders, since it owns Adpod and Adpod owes RateSetter lenders. With RateSetter not being a profitable business at present, an £8.5 million loan is very substantial indeed.

That said, my view is that these errors are containable and that RateSetter has learned sufficiently from them. Here's why:

• In March 2016, RateSetter had £15 million in cash. This will deplete quickly since RateSetter is deliberately spending more than it earns to grow faster…
• …But it did make a profit for two years in a row before choosing to spend more and it can therefore cut costs to contain this if necessary.
• RateSetter also has so far had no trouble getting money from investors, including Neil Woodford, the UK's most successful fund manager.
• As stated already, the new cap of £750,000 on business loans and the end of RateSetter's wholesale lending will greatly decrease the risk of large loans.
• RateSetter's provision fund is already stocked for expected bad debts on VTG loans.
• If RateSetter was worried that it could not take the hit on Adpod out of its own purse, I think it would probably have agreed to split the difference, having some of the cost coming out of the provision fund. Instead it will swallow everything.
• Finally, if RateSetter has misjudged the size of the provision fund required, it still has a powerful tool in its possession that could aid all lenders to continue to make a profit: it can effectively reduce the interest rate we're earning so that it can pay more into the provision fund. A reduction of just half a percentage point in the interest we lenders earn might see RateSetter top up the pot by £3 million in just 12 months.

The new risk-and-reward situation at RateSetter

Now, those three borrowers are just one part of RateSetter and its £630 million of outstanding loans to consumers, businesses and property developers. So here's a more important question: Are the interest rates currently sufficient for the risks in all those loans?

Measuring risk and reward is something that professional risk modellers do every day and every modeller skins this cat in a different way.

As genuinely independent assessors, it's no surprise I guess that we at 4thWay are much more cautious than the P2P lending sites are themselves.

For example, our 4thWay PLUS Ratings use a very strict version of the international banking “Basel” stress tests. These model what might happen to the P2P sites' loans in an extreme financial crisis that is as bad or worse than the 2008 financial crisis. We also include a house-price crash that sees distressed property sales of 55% below the initial property value.

And RateSetter and the other P2P lending sites would probably call us “tough bordering on mean” in how we measure their risks. E.g. we assume that all late payments will turn into actual bad debts. Among other things.

These tests take into account a P2P lending site's:

• Size and history.
• Type of lending.
• Bad-debt record.
• Security (see sidebox near top of page about security).
• Reserve funds.
• Interest rates.
• And other factors.

We then convert the results of our standard crisis stress tests into our PLUS Ratings, with 5/5 PLUSes being the best.

If a P2P lending site receives any PLUS Rating at all, it means we expect investors, on average, to recover any losses made in a recession. That's even if they lend all their money at the start of a recession, one time only, and nothing more. (If you re-lend repayments and interest, as most people do at RateSetter, your risks are considerably lower.)

Risks and rewards at RateSetter have worsened

RateSetter has held PLUS Ratings ever since we started doing ratings in 2014.

However, recently we have seen three changes that, combined, have quite an impact:

• The proportion of loans at RateSetter that are late or have gone bad has risen, especially with personal loans, reaching 70 in 1,000 loans since 2014, up from 30 in 1,000 loans prior to that. While this is clearly worse, it isn't horrible. Undoubtedly this is partly due to its own success and expansion, but it could also be partly down to a natural rise – bad debts swing somewhat from year to year based on the general economy.
• RateSetter has shrunk its reserve fund. Including future expected payments to the fund that are taken out of existing borrowers' monthly repayments, this fund now stands at 3.4% of the outstanding loan book, down from a peak of 3.9%. Again, this is obviously not as good, but it is still very substantial.
• Interest rates have plummeted, meaning there is less interest to cover any losses if the reserve fund proves insufficient. RateSetter's five-year lending account was paying up to 6.7% two years ago. It's now down to an average of just 4.36% over the past three months. Intense competition in lending to individuals has led to too many loans in the wider personal loans market – a lending bubble. This has pushed interest rates down across the market. The Financial Conduct Authority is concerned – and I think rightly. In addition, RateSetter allows its inexperienced lenders to set the interest rates, with no minimum rates – at least none allowing any large margin of safety that have been apparent to 4thWay so far.

RateSetter's CEO has previously said he is “impressed” by 4thWay's product. I wonder what he'd say now that RateSetter's ratings have slipped.

Based on how we “skin the cat” in modelling these risks, the above three factors are the major reasons why RateSetter's PLUS Ratings have changed on all its lending products.

RateSetter used to have the maximum PLUS Rating of 5/5 on most of its lending accounts.

Now, it has a 4/5 Rating on its five-year lending account.

It has no ratings at all on its other lending accounts.

Hold up, don't panic, this isn't a Wall Street thriller

RateSetter lenders are currently doing just fine and losing ratings does not mean you're going to lose a lot of money. I consider it unlikely, even in a major disaster, that any RateSetter lenders would lose a lot of money.

For well run P2P lending sites like RateSetter, if your money is spread across lots of loans, your losses – if they ever occur – should be limited to low single digits – maybe under 5%. So those aren't stock market-scale losses.

And those losses should be temporary and they will be offset by interest earned. Many lenders will already have earned 3%-6% per year over the past year or two. This gives you an existing, confirmed, huge additional downside protection against making an overall loss with your lending at RateSetter.

Plus, re-lending helps you a lot

Furthermore, you are probably protecting yourselves in other ways without thinking about it. To make comparison across lots of sites easier, 4thWay's PLUS Ratings assume that you just put money in once and you don't re-lend the repayments you receive from your borrowers.

However, if you re-lend your money – as most RateSetter lenders do – your risks are remarkably improved. This is because any losses you suffer lending to borrowers over a difficult year or two are offset by lending to sounder borrowers afterwards (and before).

With RateSetter's strong credentials and historical discipline I would strongly expect that over a period of 5-10 years, everyone re-lending regularly through RateSetter would come out with gains, not losses.

It's down to you to choose to lose money

It's all very well me saying my opinion that it'll be okay in the long run, but, if I'm right, it might still depend on you and what you do when something hits the fan.

You see, crowds panic. Say RateSetter's bad debts are rising fast in a major recession. A lot of other lenders might sell. You see this and in a surge of fear you sell as well.

The trouble is, to sell at this stage you might have to accept less money back than you put in.

In times like this, lenders who want to buy your loans will only do so if they are promised higher rewards. To give them their higher rewards, you would have to sell your loans for, say, 90p in the pound. In other words, your own fear could push up your losses, potentially into double digits.

And you will have turned temporary smaller losses into permanent larger ones.

The way to survive these crises is to follow the golden rule in investing:

Do not invest (lend) unless you personally are highly calm and confident that you personally understand the risks and that you have a large margin of safety.

What's key is that you have to feel this deeply in you. If you're just lending because someone like me says “I think it's okay”, that will not give you enough confidence to see it through when the recession comes and the crowd starts selling wildly. You'll panic, copy them and sell at a loss.

(Read more golden rules in 4thWay's 10 P2P Investing Principles.)

Get to the point: should I sell RateSetter loans?

On balance, I think that RateSetter could still be one of the P2P lending sites you lend through and so I don't see a desperate need for lenders to sell now. Particularly with its five-year lending product, which still has a highly creditable 4/5 4thWay PLUS Rating.

That said, RateSetter's apparent risk-reward balance has worsened and I think there are plenty of choices out there that appear to offer considerably larger margins of safety. A starting point for research on other options are the P2P lending sites that have earned PLUS Ratings.

Whatever you do, spread your money across lots of P2P lending sites, and lots of loans.

Read Wellesley* Is Still A Sell.

The 13 Key Peer-To-Peer Lending Risks Risks.

Read the 4thWay RateSetter Review, written by one of the UK's foremost authorities on peer-to-peer lending.

Update: RateSetter has offered updated figures on loan amounts outstanding, which is now at £632 million. Its reserve fund is also therefore a higher proportion of loans outstanding at 3.4% rather than 2.8%. These new figures will not impact RateSetter's PLUS Ratings.

Most of the figures are based on data correct to end June 2017.