Not getting the interest on savings you’d like from your bank? Then it’s time to cut out the middleman, says David C Stevenson.
Financial repression sucks for savers. Near-zero interest rates are a conscious effort by central bankers to force savers to become investors (to take more risk) and to effect an inter-generational wealth transfer (most young people can’t really afford to save – but they do need to borrow).
Just consider a comment allegedly made by ex-Federal Reserve chief Ben Bernanke to hedge fund supremo David Einhorn. Bernanke supposedly said: “if you raise interest rates for savers, somebody has to pay that interest. So you don’t create any value in the economy, because for every saver, there has to be a borrower.”
As Société Générale analyst Andrew Lapthorne notes, this suggests “Bernanke is against lenders receiving higher rates of return (ie, higher interest rates) as it is a drain on economic growth”.
I’m not too sure Bernanke’s right – earning more from your money can boost the economy, as long as it’s done sensibly. The good news is that financial innovation might just rescue the humble saver and the even braver investor from financial repression.
We’re talking about the world of ‘alternative finance’ (AltFi) – also known as ‘crowdfunding’ and ‘peer-to-peer (P2P) lending’.
The idea behind the growing number of AltFi platforms isn’t actually new – stock markets were born in crowded coffee houses and money exchanges were once informal, unregulated physical places, where the real interest rate was set on a day-to-day, P2P basis – frequently involving a large slab of stone on which a number would be etched.
What’s transforming the world of saving and investing is the AltFi technology revolution, which we’ll explore in this regular column.
First, some basics. For me, AltFi is compelling for a number of reasons. It’s online and so immediate. It’s immensely social (lenders and investors come together with borrowers and businesses). It involves a form of marketplace where ‘the crowd’ helps set the price of money lent or invested – not central bankers and committees.
Another big plus is that these AltFi platforms are not banks. That means they’re not deposit-taking institutions – a real plus in my book.
Why the cynicism on banks? Don’t they at least offer deposit guarantees such as the Financial Services Compensation Scheme (FSCS)? Banks are indeed ‘safe’ in that they are backstopped by the state for up to £85,000 per person, per institution.
But that comes at a price, in terms of a levy charged on all accounts (which adds to costs and reduces the yield), and a more indirect cost in terms of essentially endless low-cost money from the central bank.
In simple terms, the Bank of England has said it’ll flush money into the deposit system if rates start rising. That means that banks can almost always borrow cash at incredibly low rates from the BoE. This in turn means that they don’t really need to borrow from you or me, and so can offer low rates to savers.
AltFi platforms don’t have that luxury because they are not banks. They have to source their money from you and I, and so the market actually sets the rate. You don’t get FSCS protection – but you do get higher rates.
Many platforms offer some form of protection (though not a guarantee) against risk – the most obvious risk being that a borrower you’ve lent money to defaults. Ratesetter and Zopa (who enable consumers to lend to one another) offer protection funds that have covered existing losses and should cover most if not all future losses. I’d take protection over a state guarantee nearly every time, but it depends on your aversion to risk.
This boils down to a simple question: are you a saver (who wants no risk), or an investor (you’re willing to tolerate some calculated risk in order to have a higher return)? AltFi is best suited to investors willing to take those calculated risks, whereas savers might be worried by some of the risks inherent with the platforms.
What are the risks? We’ll start with the big three, most liquid platforms – Zopa and Ratesetter in consumer loans and Funding Circle in small business loans.
As the table below (from my own website at www.altfi.com/data) shows, these businesses are still, in reality, incredibly tiny when compared to the banks. That means liquidity might be not be perfect if you want to sell in a future market panic, and it’s possible a platform could go bust.
We’d also expect defaults to rise over a business cycle. My guestimate would be for a threefold increase over current default rates for consumer loans (running at under 1% a year currently), and a fivefold increase in defaults for business loans.
Each platform also provides its own estimates on how it thinks defaults will evolve on their own websites. Where the platform offers a protection fund of some sort, I suspect there is enough money – just – to cover any worst case future losses (see the table for provision fund coverage).
In the case of Funding Circle, which offers no protection fund, you really need to make some allowance for any future losses, depending on the risk level you are taking (this rates the borrower in terms of risk, from A to C).
But this extra risk does come with a reward – higher rates of return on loans. I popped along to website Moneyfacts.co.uk and compared a series of loan terms (one month through to five years) against savings rates from banks and other deposit-backed institutions. One benchmark could be to use the Investec High 5 savings account for wealthier savers, which currently offers 1.39% income, according to Moneyfacts.co.uk.
Every AltFi product in the table offers better rates than its Moneyfacts peers, including the low-yielding Ratesetter’s monthly interest option. One-year main market savings bonds offer rates at around 1.5-1.6% a year, whereas Ratesetter will give you 3.5%.
At the three-year level, average savings bonds pay out 2.15-2.25%, against 4% and 4.6% for Zopa and Ratesetter. At the five-year level, it’s 2.5% for the mass market versus between 5% and 5.8% for the P2P platforms.
Pretty much across the board, Funding Circle will pay even higher rates (most of its business loans are for three to five years). Even after allowing for likely defaults, you’ll end up with a higher net yield – although you also need to remember that under current tax rules any defaults cannot (as yet) be offset against income received.
What’s clear is that over durations between a month and three years you’re getting an income uplift of between 1% and 2% a year over savings accounts, and 3% over equivalent (rock-solid in terms of risk) government gilts. By the time we hit five years’ duration, that premium shoots up to well over 3%, a decent uplift – although that might start falling if interest rates rise.
The key for investors at these longer durations is to work out whether any rise in defaults in a future recession might destroy this premium. We’ll return to this subject next month, when we explore three basic strategies for maximising returns and minimising risks.
You can learn more about alternative finance, and find market-leading data at www.altfi.com.
|Consumer debt||SME business debt|
|First loan||2005||September 2010||August 2010|
|Cumulative volume lent (as of 19 May 2014)||£535.6m||£235.6m||£278.2m|
|AltFi market share (last 3 months)||19.9%||17.9%||17.15%|
|Number of investors||50,000+||12,838||29,181|
|Number of loans made since launch||80,000+||37,396||4,952|
|Current rates||3yr||5yr||Monthly Access||1yr Bond||3yr Income||5yr
|Provision fund?||Yes – ‘Safeguard’||Yes||No|
|Provision fund coverage (multiple of estimated bad debt)||1.34x||1.9x||N/A|
|Current bad debt||0.58%||0.48%||0.90%||1.00%||2.20%||1.50%||1.60%|
|Anticipated bad debt||1.89%||1.70%||1.20%||3.00%||4.60%||6.60%||10.60%|
|Secondary market/mechanism to get money back early?||Yes – ‘Rapid Return’||Yes||Yes|
|Secondary market fee||1% plus any difference between loan rate and current market rate||0.25% plus any difference between loan rate and current market rate||0.25%|
|Lending fees||1% pa (included in rates shown above)||Included in lending rate||1% pa|
(Source: www.altfi/data, correct at 19/5/2014)