Interest rates are going up! Sort of.
Worry over the Fed raising short-term interest rates has caused a sell-off in U.S. Treasury bonds and other fixed income. That drove interest rates on the 10-year Treasury bond higher, from 1.80% to 2.10%, in a matter of days.
While that’s a huge move in the world of bonds, it barely rates a yawn from individual investors who have suffered with almost no yield for half a decade.
Since the financial crisis, it’s been tough for people trying to live on interest and dividends. They’ve had to seek out new sources of income while trying to balance the risk of loss against the opportunity for cash at every step.
In this environment, Lending Club — an online marketplace for loans — gained national prominence as a meeting place for individuals wanting to borrow money and those wanting to make loans
For those not familiar with the organization, it’s a peer-to-peer (P2P) loan agency where individual investors can pick and choose which loans to finance. It comes with cheaper interest rates for borrowers than they could get elsewhere, and often high single-digit returns for lenders. Now that’s a win-win
In effect, the company allows people to be the bank for those who are shut out of the traditional banking world.
Need $521 to fix your car? Write it up and submit it to Lending Club! The company screens borrowers so potential lenders can assess each application before putting any money up, and even assigns them a rating.
Yields on such loans range from roughly 7% for good borrowers to more than 15% for risky debtors. Lenders can even build a portfolio mixing and matching types of loans, quality of buyers, etc. Don’t like the looks of one loan? Pick another.
For anyone seeking more income, this business is very attractive… so attractive that it caught the attention of institutional investors.
I don’t mean the small banks who use Lending Club as their gateway to consumer loans, which I’ve previously covered. We’re talking about hedge funds, big banks, and other large institutions that are now prowling around Lending Club’s website, looking for good deals.
There goes the neighborhood!
The whole idea was to get away from Wall Street, not build another platform for it to gobble up.
Small banks using the program seemed likely to push down yields since they could put more money to work and therefore create greater diversity for their loan portfolios. Bringing on these other guys really messes things up — not because they show up with buckets of virtual cash, but because they bring with them financial engineering.
The new guys aren’t content simply to make thousands of small consumer loans. They’re vacuuming up the higher quality loans and rolling them into securitized offerings, which will be sliced and diced, then sold to other investors. This brings even more money into the picture, which drives interest rates on such loans even lower, crowding out the smaller competition of individuals who had been funding loans… which sort of defeats the whole point.
In addition to securitization, the new investors are also adding on credit default swaps, which is a fancy way of saying “insurance.” Now they can sell fractional shares of pooled securitized consumer loans and offer a third party guarantee.
That sound you hear is the yield on all the higher quality loans at Lending Club falling to the floor.
This is one more example of the mismatched investment world we live in. As populations in developed nations around the world age, there is heightened demand for streams of income. Every pension fund, insurance company, and aging private investor has the same problem, and is therefore chasing the same type of investment.
As institutions squeezed the yield out of traditional vehicles like bonds, individuals sought out unconventional opportunities, like Lending Club. Now that it’s proven itself in scope and size, the institutions are crowding in and taking over.
Individual investors once again will face the unappealing choice of accepting lower yields, or trying to find the next innovation in fixed income. For us, this will continue until the Fed raises rates back to a suitable level… but don’t get your hopes up about that.
For now, when it comes to Lending Club, we’re almost right back where we started.