When The First Bad-Debt Provision Fund Will Fail

What happens when, not if, a provision fund is overwhelmed by bad debts?

What makes these reserve funds so solid?

Before we look at how some of the bad-debt provision funds will eventually be breached, let's look at why they're such tough nuts to crack. Because that just makes a breach all the more astounding.

Really, the size of the fund is of secondary importance. Top of the list when rating the safety of a P2P lending opportunity is the quality of the borrower or the security.

The safest P2P lending companies focus on either quality borrowers or they lend against property – and lend far less than the property is valued at.

What this means is that, during really tough times, when loans are going bad everywhere else, loans to quality borrowers tend not to get a great deal worse. At least, the bad debts don't rise as dramatically as for riskier loans.

Loans against property also do better, particularly if the loans are considerably less than the original property value.

The size of the bad-debt provision funds is the next item to consider. The safest P2P lending companies have large pots of money that are well placed to withstand a seriously bad period of time.

They're typically between 2% and nearly 4% of outstanding loans. If you don't know what that means in real terms, it means they have between “great” and “huge” defences. (Those are the technical terms.) It'll be difficult or very difficult for bad debts to get passed them.

As things stand.

What causes heavy investing losses?

I still have to keep you in the dark for a few more minutes about how some bad-debt provision funds will eventually be breached.

Because I'd like to take a step back and look at what usually causes lots of investors to lose a lot of money in a short period of time. Regardless of the investment.

The cause is invariably the same. Here's what happens:

1. Investors (or lenders) see that things have gone well, everyone's making money and there have been few cases of losses anywhere.

This continues for some years.

2. People begin to believe that nothing can go wrong, so they put more money in.

3. Investing prices become less attractive as investors/lenders put more money in.

In the stock market, this means stock prices are higher (more expensive). People are prepared to pay more because they currently think it's safer.

In P2P lending terms, if the “price” is higher, it means interest rates have been pushed lower.

4. So this happens, but still nothing goes wrong. So even more lenders think it's even safer, and they pile more money in. Yes, this extra competition to lend pushes rates even lower, but now lenders are convinced the risks are lower and they don't need a premium to compensate for the risks.

5. Again, nothing goes wrong, so lenders accept even lower interest rates.

6. Slowly but surely, one by one like dominoes in slow motion, the sceptics are converted. Even those selling themselves as experts, one at a time, start softening their cautioning tone.

This is when the stock market is pricing lots of companies as high as 50 times their profits. And it's when interest rates in peer-to-peer have, say, halved.

7. Just as the last expert has said, “You know what, this is all completely safe. It's a new paradigm. I've always thought that really! I'm putting all my money in too!” That's exactly when the whole thing collapses.

It's usually a recession, high unemployment, a property market crash, or some other unexpected, special event that knocks down this house of cards.

Suddenly, everyone realises that this time it's not different. Prices cannot rise forever. No investment is risk free.

If you want to lose money, you might need some help

But, when peer-to-peer lending through the safest P2P lending companies with bad-debt provision funds, it doesn't just take lenders to turn this horrendous mistake into serious lending losses. It'll probably take the P2P lending companies screwing up too.

Because, right now, as I've said, I think they have seriously impressive defences.

We'd do well to draw parallels with another industry I've worked in: the insurance industry. Just like investing, it, too, has a cycle of boom and bust. It's called the “insurance cycle”:

1. In insurance, you get this period where there isn't much competition. Insurance companies can charge almost what they like.

2. Other people and businesses like the sound of that, so they set up new insurance companies to get a piece of the action.

3. Slowly but surely, the insurance market becomes competitive.

4. Then it gets intense. Growth grinds to a halt. In order merely for an insurance company to keep its existing customers, it has to cut prices. And then again. Their profits fall.

5. And now the insurance market has got so hot that insurers have a difficult choice:

a) They can accept a quieter period where they'll probably shrink, but at least they maintain their discipline and only sell to customers willing to pay a high enough price for the risks involved.

b) They can gamble everything. They will continue to chase greater market share and greater immediate profits by cutting prices dangerously low.

It's astounding how many of them feel the pressure – perhaps from their shareholders – to keep pushing for growth even in these times when they should batten down the hatches.

6. Suddenly, insurance companies everywhere are reporting losses.

a) Those who were disciplined have it relatively easy. They can cut a few costs and use their reserves to keep them ticking over, albeit with fewer customers.

b) Those who weren't disciplined are finding that not only have profits fallen due to competition, but they're making dreadful losses because they haven't charged enough for their most recent insurance policies.

7. That's why a large part of the industry collapses. Those that were disciplined and still have cash in reserve buy up the remnants of the broken ones at knockdown prices – along with their customers. Other insurance companies are obliterated entirely.

8. The insurance market shrinks and the survivors get to mop up customers and charge what they like. The cycle begins again…

Lollapalooza effects

I want to show you the parallels in insurance to lending, because they are very similar.

Both insurance companies and P2P lending websites have to use their skill and data to assess which customers they should accept and how much they should charge them to cover the risk.

They even call the task of assessing and accepting customers by the same name: “underwriting”.

Their job is to keep their heads, but history shows that quite a few lenders do not.

We saw one class of lenders go through a similar cycle a few years ago. These lenders are called high-street banks. They had a very long period where nothing went wrong so they took more and more risks to keep market share and grow.

Despite the fact these banks should have all flailed to death in agony from the losses, they were saved from their dreadful behaviour by you and me: the taxpayers.

Many bank shareholders were not nearly so lucky. Especially if they were UK taxpayers bailing them out, as well.

So, back to P2P. This combination of individual lenders crazily lending more at lower rates and their P2P lending company of choice scarily chasing growth in a highly competitive market creates what some investors call a “lollapalooza effect”. That means several strong forces combining to create a powerful investing result.

Unfortunately, that result is going to be a powerful loss.

They're all going down together

If quite a few insurers and banks get this wrong at the hottest part of their respective cycles, we would be wise to assume that some P2P lending companies will go wrong too.

They will feel pressure to retain their customers and to keep growing. Not all of them will maintain high standards in selecting borrowers. The weaker minded and greedier ones will find ways to justify to themselves a gradual slackening of standards.

They might even let their bad-debt provision funds shrink in order to keep funding worse behaviour.

Some time after this, a lot lenders are going to lose money.

But it won't be you!

We at 4thWay will be sure to keep our heads. We draw lines in the sand that are not allowed to be crossed.

No matter how excited everyone else gets about how safe P2P “always” is, if you sign up to our newsletter, we'll be there to let you know at the first sign of trouble from any of the P2P lending websites.

We keep track of every warning sign we can. How many loan applications are being accepted? Have late payments risen significantly recently? Has the size of the bad-debt provision fund fallen? And more.

Then you'll know what you have to do: don't lend any more money in those services until they recover their senses.

And we'll send you our best tips to help you draw up sensible minimum interest rates and other simple rules to ensure that you stay on the safer side of P2P.

We might not always get it right for everyone. (Although I hope we do and we aim for that. It'll be a sad day when we fail any one of you.) Because we're reliant on the data we receive and the P2P lending industry is fairly new, as are the 4thWay^® Risk Ratings.

However, if we make mistakes, it won't be because we lost our heads.

Read more:

How the P2P Lending Provision Funds Compare

Secured Lending vs Provision Fund. Which is Better?