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Daniel Foggo on why P2P lending is not what you think

Daniel Foggo is the Chief Executive Officer of RateSetter, Australia’s largest peer-to-peer (P2P) platform, now commonly called marketplace lending.


GH: You're approaching your fifth anniversary. How has the peer-to-peer or marketplace lending business in Australia, and RateSetter, progressed versus your initial plan?

DF: Very much in line with our expectations. When we started, we believed we were building a structural alternative to the bank model. We were moving consumer loans from funding by bank deposits into a new investment class for investors and opening it up. From day one, we wanted a comprehensive reporting environment and to move away from a negative reporting environment to make sure that our credit performed.

GH: What’s a negative reporting environment?

DF: It’s when a consumer applies for a loan, the lender looks up the applicant’s credit file to learn if they have previously defaulted. When we launched, the Australian credit bureaus didn’t offer the granularity of information we wanted but that has now changed, and we have a much better ability to assess credit. The building blocks of the business have been around credit standards and we’ve funded almost $600 million of loans. The loss rate to date is under 1.8% of what we've funded.

GH: Is that of the number of loans or of the amount you have lent?

DF: Of the total amount. We offer granular risk-adjusted pricing to our borrowers and pleasingly our credit models have proven accurate in the rank order of losses. And the independent Provision Fund held in trust has covered every one of those losses and still represents about 6% of our loans outstanding on our retail book. Borrowers pay different amounts into the Provision Fund, depending on their credit characteristics.

We’ve had to build profile with both investors and borrowers. We obviously advertise and feature on comparison sites to attract customers, and we work with corporate partners. For example, we integrate with installers of renewable energy products and different battery, energy and solar panel companies for loans on our renewable energy lending markets. It's important to reach scale, especially finding ways to attract good borrowers.

GH: A lot of readers might think that a ‘marketplace’ is like eBay where anyone can put up an item for sale. What borrower checks do you perform?

DF: Well, we call ourselves a marketplace lender and we do operate several markets through which investors can access loans. However, the term maybe disguises the fact that in many respects we are a fund manager, only we are specifically focused on consumer credit. We think of ourselves as fund managers focused on consumer credit, and we need to ensure returns are reliable. Less than 10% of the people who want a loan from us will have it funded because we decline most people.

GH: I’m surprised it’s so low.

DF: We decline loan applicants at different stages where they don’t meet our credit criteria. About 40% of applicants don't even get through to our application form because they don't meet our initial criteria. Once people go through an application, they might be declined immediately based on some of the information they provide. Or they might get through to our underwriting team and get declined there.

GH: Why might someone get declined?

DF: Our loan underwriting process is not dissimilar to that performed by a bank or other traditional lenders. We collect information from the applicant and use third party information sources for form a view on their credit strength and the suitability of the loan they’ve applied for. We use the Government’s document verification service to assist in our credit checks. We also check the applicant’s credit file with a credit bureau. We typically require bank statements from the applicant to confirm identity, income, expenses and other debts. We go through all the usual processes that are required under the National Consumer Credit Protection Act 2009. Amongst other responsible lending obligations, we must ensure the loan will not place the borrower in financial hardship and that the loan is for a suitable purpose. For example, paying off a holiday over five years does not make sense.

The second component of making sure it's a sound investment option is how we price risk. We not only want to fund the right people, but we put aside enough money to cover expected future losses.

GH: How is the interest rate on a loan determined?

DF: The base funding rate is the same whether the client is an ‘A’ borrower or a ‘B’ borrower. What is different is how much the borrower pays into the Provision Fund. That may be a fee up front or part of their interest rate. So, Joe might borrow at 7% but Jim might pay 10%. Joe owns his own home and has a stable job, while Jim is a tenant who might change jobs more regularly. Joe might be paying 2% into the Provision Fund while Jim is paying 5% of the outstanding loan balance. It’s representative of the risk.

However, the investor is receiving say 6% whether they are funding Joe or Jim, and both are protected from default by the Provision Fund.

GH: Let’s focus on the Provision Fund, because not all marketplace businesses use them. If I’m an investor and my borrower places say 2% into the Provision Fund, if the loan defaults, I have access to the full 100% of my loan, not only the 2%, right?

DF: Yes, it’s not just the amount your borrower puts in. Rather, you as an investor have the benefit of all the money paid into the Fund over the last five years. It delivers a diversification of credit risk and the Fund currently has $14 million in it. Our expected losses on loans outstanding are about $9 million, giving a 1.6 times coverage ratio.

GH: And that $9 million is based on your experience with the types of borrowers in your loan portfolio?

DF: Exactly. We analyse our loan book daily, not dissimilar to the way a bank forecasts expected losses. We have enough loss curve data to have a good understanding and we can quite accurately assess the loss rate. Clearly, if the economic environment changes, we need to take those things into consideration as well.

GH: Given your detailed lending process, what are some of the main reasons for defaults? What happens to people?

DF: It’s generally a change in personal financial circumstances. In line with industry averages, about a quarter of losses are associated with some sort of bankruptcy. The remainder might be losing a job or health issues, but there’s a diverse range of reasons.

GH: What’s your process for chasing a default?

DF: We seek to cure loans in arrears for the first 45 days and we have a successful track record doing that. If a loan remains in arrears beyond this period, then we work with three different collections agencies to support our collections efforts. These agencies are regulated businesses and they operate on a contingency basis, and given our scale, we ensure there's competitive tension around their services.

GH: Which bank products are you replacing?

DF: The key trend is the decline in credit card usage. Card spending has remained stable but the balances where customers are paying interest have declined. People are looking for alternative ways to hold that sort of debt and personal loans are a good solution. Also, personal loan market share of the Big Four banks has fallen over recent years. Businesses like RateSetter have gained meaningful market share.

GH: How does it work for an investor if I want a strong borrower, a homeowner with good income, buying a solar system for their house. What do I find out about the borrower? Can I know how much of their home they own or their income?

DF: We believe we're in a better position to understand the credit characteristics of the borrower than our investors. We’ve got more information available to us to price their credit risk. It includes information from a credit bureau that we can't pass on to an investor. That's why we think the model works better with us as a manager of consumer credit, where the investor relies on us to manage the risk, rather than the investor choosing the specific borrowers they want to back.

To gain the investor’s trust, we do various things. We make sure we maintain a good track record, we are transparent by providing information to our investors and we have the Provision Fund. If we relied on the marketplace model by saying, “You go away and assess that credit and make a judgment”, we don't think that model would work very well. Most investors are not experts in credit, nor do they know how to minimise risks appropriate to them.

Investors don't see a lot of information about the borrowers they have funded.  However, every quarter, we upload our whole loan book onto our website so investors can see every loan we've funded. We include information on the age of customers, the credit bands and whether they are homeowners. 

GH: Tell us about the characteristics of your investors, including SMSFs?

DF: Sure, there’s a great diversity. SMSFs represent about 20% of our retail lending by funded amount and it continues to grow. The average amount invested by an SMSF is about $90,000.

GH: That’s significantly more than I expected.

DF: Yes, whereas the typical non-super retail investor averages about $20,000 and that’s where most funding comes from. Our investors are typically aged 45 and over and investing in our five-year, higher-rate markets, looking for yield outside of super. But that masks a lot of relatively young investors who are investing smaller amounts. About 75% of our investors are male.

GH: And what about institutions?

DF: We were delighted to introduce Future Super, the leading fossil-free superannuation fund, to our investor base last month. We also have the support of some fixed income funds, some financial advisers who have put their clients in. The Government's Clean Energy Finance Corporation invests alongside other investors in the renewable energy lending markets. We went through 12 months of due diligence to get them comfortable with our business model and underwriting process. Plus, we have a small number of ADIs (Authorised Deposit-taking Institutions).

Our investors are looking for strong fixed income returns, and our investor surveys show over 80% have shifted money from term deposits or savings accounts into their RateSetter account. We often describe RateSetter as offering an attractive middle ground between the safety of deposits with a government guarantee and equities which can be more volatile.

GH: How to you respond to arguments that marketplace lending has not been through a recession in Australia?

DF: We are funding the same borrowers who in the past would have borrowed from a bank. We have not found a new class of borrowers so there’s no reason our borrower loans will perform in a materially-different manner in a recession. In fact, our losses are less than large banks typically experience on ‘new-to-bank’ customers, which are typically around 6%. This is because our checks are more vigorous and our loss rates are around half that level.

Also, the asset class we're investing in is highly resilient. Australia has not had a recession in the last 20 years but if you look at credit performance in the UK and the US during the financial crisis, consumer credit outperformed small business credit, large business credit, property lending and even in the US, mortgage lending.

The other component of our asset resilience is our short duration loans, averaging a little over three years. Plus, we have the Provision Fund.

GH: Do you think there is a general preconception in the market that your borrowers are people who can't borrow elsewhere?

DF: It depends how much time people have spent looking at us and our history. Investors just need to go to the statistics page on our website to understand the type of borrowers we fund. There are two types of people who come to us: those who can't get finance elsewhere and those who come to us for a better deal. It’s the latter type we’re good at tapping into.

Over 2,000 borrowers have reviewed our offering on Product Preview and it gives a sense of the type of people we lend to and what they care about. These are not people who couldn't get financing elsewhere. They’re refinancing their credit card or improving their kitchen.

GH: Can you explain what people do with the money, especially the green and automotive loans and what some new areas might be.

DF: We're looking after good credit customers through their life cycle. When they are relatively young, they might need a small loan for a holiday or wedding, for example. When further along in life and applying for a mortgage, they might want to improve their financial situation by consolidating their credit cards into lower monthly cash flows. After they buy their home, they might refurbish the kitchen. About 60% of people who buy a new home then buy a new car in the next 12 months. Then they might send their kids to private school.

About 40% of our customers are looking for a better value alternative to existing finance and that's most commonly credit card debt. The next most common is automotive finance and the third is home improvement. Then there’s a long tail of reasons such as weddings, holidays, medical. We want a diversity of terms, purposes, geography.

A growth area is that more people care about the environment and they want solar panels and maybe a battery. When we think about the future, we want to have an impact on electric vehicle finance, because with it brings together our experience in renewables and automotive finance.

GH: Finally, what do you think of this confusion of names, such as peer-to-peer lending and marketplace lending?

DF: It's a misnomer in many ways. We're more akin to fund managers. It's taken us time to realise that in many ways. We live and die by credit performance.

We are giving people access to an asset class, and a key competitive advantage of ours is not being reliant on wholesale funding lines that can come and go. We've had record numbers of investors sign up each of the last three months, and undoubtably low interest rates are one of the reasons behind that. They are placing investments with a fund manager.


Graham Hand is Managing Editor of Cuffelinks. Daniel Foggo is CEO of RateSetter, Australia’s largest peer-to-peer lender, and a sponsor of Cuffelinks. This article is for general information purposes only and does not consider the circumstances of any investor. Investors should make their own independent enquiries and consult with a financial adviser.

For more articles and papers from RateSetter, please click here.



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