Rent Your Capital

What to do with the cash you’re hoarding? Rent it out!

You can earn 10%+ returns, you will be doing trustworthy borrowers a service, and the risks are less than you suspect.

Making Loans

Renting your cash means what? Yes – you’re making loans.

If you will not be needing some of your cash for 1-3 years, then watching it melt away at inflation’s 3% average annual rate is not going to get you any closer to retiring.

Prudently developing a diversified portfolio of loans is the ideal alternative to a portfolio consisting exclusively of stocks and bonds, but how to do it?

The Original Underwriters

In the old days, determining which borrowers had the ability and willingness to repay loans was hard work.

Underwriting consisted of local bankers knowing which farmers could be trusted with seed money, and which were drunks.

The End of Privacy

Fast forward to the end of privacy. Would-be lenders now swim in an ocean of personal data.

Multiple credit agencies gather this data and use it to assess creditworthiness.

Two companies, LendingClub and Prosper, have built peer-to-peer lending businesses on top of this mountain of data. Neither company lends it’s own money – instead they function as half a bank.

Underwriters For Hire

LendingClub and Prosper do the hard work of identifying creditworthy borrowers, but they do not fund the loans themselves, as a bank or credit card company would.

Instead the loans are funded by you and me.

A Typical Loan

Dave wants to pay off $10,000 in credit card debt over the next three years. He has excellent personal credit and a good job.

Congrats Dave – you are one of the 10% of applicants accepted by LendingClub to qualify for a loan.

While those odds are ivy league tough, Dave will not get this loan for free. Any interest rate under the 19% he’s paying on his credit cards will save him money.

Dave Pays 15%…and Likes It

Dave will likely pay an interest rate of 15%, of which LendingClub will take a 1% servicing fee.

To earn this fee, LendingClub will chop Dave’s $10,000 note into 400 smaller notes of $25 each.

Individual investors will buy bundles of these $25 notes, and Dave will get his $10,000 from hundreds of different investors.

Dave will pay this loan off over the next 3 years via monthly automatic transfers directly from his bank account.

Building a Porfolio of Loans

Ok – so we now have a mechanism for finding trustworthy borrowers, but sifting through thousands of loans sounds like a lot of work.

What you really want is someone to build you a nicely diversified portfolio of loans. Not surprisingly, both LendingClub and Prosper have solved these problems as well.

On the LendingClub side, investors with at least $10,000 can open a Prime account. Prosper is similar. LendingClub will automatically fill this account with an appropriate selection of $25 notes.

Investors watch the loans mature, paying interest and principal. When too much cash is generated, new loans are purchased by LendingClub traders.

Net Returns of 10%

Set up correctly, returns on both LendingClub and Prosper can average around 14% gross. Subtract 4% for defaults, and you should net around 10% in profits each year.

Given the massive diversification across 800+ notes, the monthly returns are extremely consistent. If you want to watch your money grow at just under 1% per month, then you will like these investments.

Understanding Defaults

Defaults are a baked-in part of loaning money to consumers.

A good underwriting engine will generate defaults at a predictable rate within each loan grade, so that consumers that are 4% likely to default will pay 14%, and consumers that are 10% likely to default will pay 22%.

In this way you can blend credit ratings to get a portfolio with an average expected net return appropriate to you.

Unemployment Risk

The biggest future risk to consumer loan repayment is unemployment.

Nationwide, unemployment is running 8.2%, down from a high of 10% in November 2009.

We would like to know what will happen in the event that unemployment increases substantially.

P2P Loans During The Great Recession

LendingClub has been in business since 2007, so anyone can look at their 2007 vintage loans on their Statistics > Download page, where you can download a 32 megabyte file containing the performance of every loan they have every funded.

Both the LendingClub and Prosper underwriting models have been running since 2007, both had hiccups during the recession, and both are now in excellent shape.

LendingClub’s 2007 vintage loans had two marks against them:

1. Their underwriting model was brand new then, versus five years old today
2. Unemployment went from 5% in March 2008 to 10% in May 2009

The 2007 Vintage vs the S&P 500

So how did LendingClub’s 2007 vintage loans do during this earthquake of unemployment?

They returned 2.2%. In 2008 that went up to 3.9%, and in 2009 through 2012 the company has been delivering just north of 10% on appropriately constructed portfolios.

While 2.2% in 2007 is not good in absolute terms, it is a lot better than the S&P500, which dropped over 37% from January to December of 2008.

While it is true that the S&P500 has recovered most of those losses in the 4+ years since October 2007, a portfolio of consumer loans has increased in value by 45% in that time.

The Big Picture – A New Asset Class

What we are seeing with P2P consumer loans is nothing less than the birth of a new asset class.

Never before have consumer investors been able to conveniently loan money to consumer borrowers with transparent underwriting, simple diversification, and low costs.

A $798 Billion Market

LendingClub and Prosper together have loaned about $950 million since inception, of which about $420 million was loaned in the last 12 months.

Together they are growing at around 10% a month.

The Federal Reserve G.19 report lists revolving balances as $798 billion, so credit card companies have plenty of customers for LendingClub and Prosper to cherry pick.

Overcoming Your Skepticism – A How To Guide

Most people’s reaction to 10%+ returns can be summed up in five words: Too good to be true.

I’m here to tell you that these returns are very real.  I have retired clients who depend on them, and who spend the money every month when earned interest is wired directly into their bank account.

To convince yourself, start with the following:

• Read this WSJ article about former the Morgan Stanley CEO: John Mack Joins Board of Alternative Lending Company
• Read the LendingClub.com Investors tab and take a look at their Board of Advisors. It’s an impressive group.
• The more quantitatively inclined will want to explore LendingClub’s Statistics tab as well
• Prosper is about 1/3 the size of LendingClub by loan originations.  Prosper’s website is very similar to LendingClub’s.  Their returns are identical though they have fewer alternatives for larger investors.

How to Invest

First, a caveat: I am in no way affiliated with LendingClub or Prosper.  I’m not a member of their affiliate program, and I don’t benefit financially from you clicking on any link in this article!

I do work directly with clients to structure optimal portfolios across the spectrum of credit grades, but I get paid by clients for that, not by LendingClub or Prosper.

Peer-2-peer loans do extremely well in three situations:

1. IRA Accounts – Paying no taxes on interest earned means a 10% return translates into a 7 years doubling schedule.
2. Retirees – P2P loans are great generators of current income. You can spend the interest earned while preserving principal.
3. SWAN – If you are younger but want a “Sleep Well At Night” portfolio, then these are a great investment even in taxable accounts. I fit in this category myself.

As with most asset classes, different levels of wealth require different commitments to professional help to get the best returns.

1. Under $20K – Keep saving. Above $20K you can get diversification across 800 loans of $25 in value each.  That is the minimum diversification to make this work.
2. Under $100K – If you have either an IRA or a taxable account that is under $100K, or if you want to just “try this out” then open a Prime Account at LendingClub. If you are filling out the paperwork and want a little help, reach out to me, though I can’t take you as a client.
3. Over $100K – At this point you can participate on the LendingClub institutional side where there are a few additional features, and more control.  I have favorable treatment there, and you’ll probably benefit from working with me. But if you’d like to go your own way, just follow the Prime path and let them know that you want to be on the Institutional side.
4. Over $250K – Your choices open up a bit.  If you are a Qualified Purchaser (net worth over $5 million) you can participate in a number of attractive hedge fund that actively manage portfolios of loans, earning an extra 1.5-2.0% by picking notes based on their own algorithms.
5. Over $500K – You will want to do LendingClub in your IRA and other Funds in your taxable account. This is how I invest family money in P2P loans.

Final Thoughts

The P2P loan industry is five years old. Continuing coverage by the Wall Street Journal will fuel their 10% per month growth for the next few years.

I believe outsize returns will persist in this space as long as credit card companies continue to charge 14%+ to creditworthy borrowers.  Certainly the next decade will see returns here compete favorably against a relentlessly moribund stock market.

LendingClub and Prosper have cracked the code on consumer lending. Another place where P2P is poisted for takeoff is with small business loans. More to report on this exciting area in the future.

Get started!

When you click through, choose the Interactive Graphics tab. It’s really a very impressive effort – the best to date.

Hopefully this email-able link from my paid subscription will be readable to all for a week or so.

Investors signing up for a free account on the Roubini Global Economics site can receive dozens of emails with his well-though-out opinions on an astonishing variety of subjects.

To avoid burning out, you might try restricting your subscription to The RGE 360 (weekly) plus all three of his Quarterly Macroeconomic Outlook emails.

His most widely read pieces are probably those published under the category “What’s on Nouriel’s Mind.”

“So we are trying to grow this economy with one hand tied behind our back. [Brendan: meaning traditional banks aren't loaning money]. But that doesn’t mean the entire economy will stagnate. It just means that credit will have to be allocated from non-bank sources. High yield corporate bond markets will flourish. Foreignholders of US risk free assets will switch to hard US asset investments. Money managers, private equity firms and hedge funds that do not have financially repressive guidelines will also take risk and prosper. There are headwinds from banks, but there are tailwinds from alternative credit allocation sources. We will still see investment in real risky endeavors – and the positive real returns will generate positive real growth.”

I agree. A new crop of companies is sprouting up that can successfully evaluate credit risk and line up borrowers, but that needs outside capital to make loans. This is the part of the economy that deleveraging has impacted most severely, and it is where consistent 9%+ returns will be found for the next half-decade.

I need to write a longer post on this important topic. More to come…

If you read between the lines, Germany’s proposal that a European Commissioner be appointed over Greek taxation and expenditures amounts to receivership for a sovereign nation.

Question: What is “Greece” if it doesn’t have control over monetary policy (because of the Euro) or fiscal policy (i.e. taxes and spending controlled by a European Commissioner)?  It will not be an independent country in any modern sense of the word.

I read Stratfor weekly – they have a unique, global perspective, clearly know their history, and pull no punches. This one in particular is worth reading.

Germany’s Role in Europe and the European Debt Crisis

There are two Americas. One is based on fierce competition, and one is based on father knowing best. Both Americas are large employers, but in only one America do bad decisions punish the decision-makers and their employees.

Both Capitalist America and Communist America deliver essential services to Americans, but with two differences:

1. Capitalist Firms that fail will disappear. Bureaucracies that fail will keep growing.
2. Communist America is entirely paid for by taxes on Capitalist America.

The Government Keeps Growing

In America, the proportion of our economy that is controlled by Bureaucracies that have no feedback mechanism for economic failure has been steadily growing for 100 years:

The Need For and The Cost of Central Control

Modern industrial nations need central control of certain essential functions: roads, courts, defense. But central control comes at a huge, inevitable cost: inefficiency.

Industrial nations whose pendulum swings too far over to Communism all crumble for one simple reason: humans are only efficient when they are competing.

The Tipping Point

There is a tipping point, when too great a proportion of a nation’s goods and services are provided by Communism based on taxes on Capitalism. Over that tipping point, the Golden Goose dies by 1,000 cuts, and nations stop growing. If you are in debt and you stop growing, you will default.

No one quite knows where that tipping points lies for the developed world, but Europe’s stagnation is an uncomfortable exploration of the danger zone.

Saving the Goose vs Dividing the Pie

As whole nations approach the zone of insolvency, the classic liberal/conservative argument about dividing the pie becomes a less useful metaphor. Instead we need to focus on Saving the Goose.

The US Census Bureau reported that 49% of households have one member receiving at least one type of government benefit.

The White House budget office estimates that 63% of federal spending next year will consist of checks written to individuals who performed no services in exchange (2012 budget – large file). That number has climbed from 18% in 1940 to 46% in 1975, and it will continue to rise in the absence of entitlement reform.

We need to resist the urge to characterize cutbacks as liberal or conservative because we’re spending money we don’t have. Stopping isn’t conservative, it’s merely sane.

Bureaucracies Never Go Away

Both Capitalist and Communist America are full of ambitious, power-hungry entrepreneurs. The Capitalist entrepreneurs fight each other for market share. If one firm expands in a static market, another shrinks or fails, leaving room for growth.

In Communist America, institutions also fail, but they rarely go away. Instead, failure is often rewarded by budgetary growth.  Under this Logic of Bureaucracy, the drug war isn’t successful, so we must not be spending enough to win, so the budget goes up every year.

The Power To Tax

Failed institutions grow by taxing the successful parts of the economy, transferring economic decisions about asset allocation from humans who have created economic success to those who administer economic failures.

Not Demagoguery

All of this talk of Communism may sound like demagoguery. You may be tempted to think that huge areas of nuance are missing. I would argue that they aren’t so critical to understand the big picture: Yes, we need some government, but nations that cannot control the growth of their government institutions will self-destruct as these institutions grow stagnant, growth disappears, and debt grows out of control.

Turning it Around

Unfortunately, turning this situation around will not be without extraordinary pain. We need to find the courage to dismantle failed institutions, and to rebuild only those that contribute to economic growth.

Let’s hope we choose to take our medicine soon, when unemployment is at 9%, rather than being forced to by the bond markets, when unemployment is at 21% (Spain), 17% (Greece), or 14% (Ireland).

Sounds like the 2012 US Federal Budget…

Chinese New Year 2012: Meaning and Predictions for the Year of the Dragon

The US has over $60 trillion in unfunded liabilities, mostly for social security, medicare, and veterans. That’s over $500,000 per household.

Retiree Imbalance Underlies Filing

Their “Economic Overview“ page contains links to all of their quarterly perspectives. Worth reading the last two of them.

“I support capitalism, but if somebody does anything that’s kind of questionable, then we have the right to ask all the questions,” said Jean Hampton, vice chairman of Carolina Patriots, a tea-party group based in Myrtle Beach.

Good to know that Jean “supports capitalism.”

GOP Split Over Attacks on Private Equity