Almost every review of a peer-to-peer site or offering focus on the existance of buyback and the detailed terms. More seldom is the question asked:
Is buyback really worth the associated cost?
The obvious risk when buying a P2P loan is that the borrower can’t pay his interest. Eventually the loan will default, usually after 60 days. Then, normally, the buyback guarantee kicks in and pays the investor the principal value or part of the principal value, sometimes even interest.
How much does this guarantee cost? It depends of course, but generally the P2P loan investments with buyback yield around 12% currently (Mintos, Twino, Fast Invest). The corresponding figure without buyback is maybe around 19% after credit losses (Finbee, Neo Finance). The comparison is complicated by the fact that there are other differences between these offerings. But it is astonishing that buyback has become so popular when it is so expensive in terms of lost yield. So what is it that investors try to insure themselves against that makes it worth the cost? Here are the reasons I could think of, there may be more:
- Defaults could rise if the economy deteriorates, especially if the unemployment rises. There is a very strong correlation between unemployment and personal loan default rate.
My view on this is that buyback is a good insurance in this case up to a point where the loan providers get in financial trouble from absorbing all the defaults or alternatively the buy-back-fund is empty. Then the buyback guarantee becomes useless.
- It is as far as I know impossible to make a tax deduction for non-performing loans until collection is complete, so there may be a tax penalty for having a large stock on defaulted loans. In my model it makes a quite small difference if the collection is completed within a year compared to selling the loan (for the collection percentage). I will not go into the details in this post.
- There are sometimes no or limited possibilities to sell defaulted loans so there may be a long lock-up time for funds for the investor.
- The investment becomes more predictable, thus planning investments ahead becomes easier.
My personal take from this is that it makes sense to diversify. A portion of the portfolio can be more locked up, without buyback, giving higher yield. Another portion can be protected by buyback, being more accessible.
In case of a severe economic downturn, the question is what level of defaults the loan originators can manage and still maintain the buyback guarantee. It can be attractive to reduce exposure to buyback in such a case, especially loan originators with mainly low grade loans (C, D). As an alternative high grade (A+, A, B) loans without buyback could be considered.