The UK’s oldest peer-to-peer service is warning investors that defaults on its recent loans will be running at a higher rate than during the financial crisis.
Peer-to-peer investing offers a trade off to investors: if they lend money directly to riskier borrowers, they can get a high rate of return on their cash.
But Zopa, the dominant peer-to-peer lender in the UK consumer market with £3bn of lending, is anticipating falling investor returns despite increasing its volume of high-risk loans.
When the company was launched in 2005, it matched lenders with low-risk borrowers and offered a safety net in the form of a provision fund which paid out to investors in the event of a loan defaulting.
But in 2016, Zopa began lending to higher-risk borrowers to generate higher levels of return to customers who were willing to take on more risk. It replaced its two lending products, protected by its safeguard fund, with two new products that were outside its protection: Zopa Core and Zopa Plus. Zopa Plus included loans to borrowers with limited credit history, categorised as risk markets “D” and “E” by Zopa.
Since then, investors have witnessed rising defaults on Zopa’s loan book and the company has been revising up the level of defaults as more borrowers than expected fail to pay back their loans.
According to data released last month, Zopa originally expected 4.14 per cent of the loans it originated in 2016 to default over their lifetime, but has since revised its estimate to 4.93 per cent. This compare with a 2.88 per cent default rate on its 2015 loan book.
At the peak of the financial crisis, Zopa expected defaults of 3.58 per cent of loans originated in 2008. Of those loans, 4.2 per cent actually defaulted over their lifetime. Zopa said like-for-like comparisons were difficult as its loan terms were different in each year.
But Zopa expects defaults on its 2017 loan book to be similarly high. Originally it had anticipated defaults of 4.52 per cent on those loans — already far higher than the defaults expected in any other year. The company subsequently revised that estimate higher to 4.86 per cent.
Higher default rates are to be expected with higher-risk lending. According to Zopa it is reasonable to anticipate that 9-12 per cent of the riskiest loans (“D” and “E”) to default over their lifetime. But investors could expect annual returns between 7 and 14 per cent as mitigation for taking on the extra risk, it added.
However, Zopa’s estimated annual returns are falling. Its estimated annual return on loans originated in 2017, which takes account of the rates paid by borrowers, fees and expected defaults, stand at 4.7 per cent, down on the 4.9 per cent estimated return on 2016 loans and far lower than the 5.2 per cent on its 2011 and 2012 loans.
The actual returns on recent loans are higher, according to Zopa, because they are too young yet to have experienced the full level of defaults expected.
Zopa says lower returns are due to the fact that it added lower-risk, lower-return loans to Zopa Plus at the same time as it added “D” and “E” category loans, due to fears over spiralling consumer debt.
Andrew Lawson, Zopa chief product officer, said: “In early 2016 there were increasing signals in the consumer credit market that after years of historic low levels of bad debt, conditions might start to normalise. In 2016, we started acting on those signs by tightening our risk criteria.”
But Zopa is also facing competition from high street banks for its loans. This is constraining the rates it can charge to its highest-risk borrowers and limiting returns to investors.
Peer-to-peer platforms are under pressure to make their rates appealing to investors but also to keep them affordable and appealing for borrowers, who could turn to other sources of finance.
Zopa said it did not always lead on price and that signals in the market, including high debt levels, rising inflation and the level of current defaults, led it to take a more cautious approach to lending throughout 2016 and 2017.
Last month, peer-to-peer lending platform reopened to new customers after being forced to shut its doors to new money amid soaring demand. The company put a waiting list in place in March 2017. This had registered 26,000 customers last month.
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