Niall’s virtual diary archives – Thursday 16 May 2019

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Thursday 16 May 2019: 21:28. These next few posts I’ll be talking quite a bit about retail investing in subprime lending, as I’ve been watching the whole area intently for two years now, and I finally felt confident enough to drop in some of my own money. I should stress that you shouldn’t risk any more of your money on this than you can afford to completely lose: the chances of losing all your money are higher than investing in a stock market index tracker fund (e.g. tracks the FTSE 100), which is by far the best place to put money that you know that you probably won’t need for a few years. However, the risk of losing no money at all, even if you need all your money back quickly, is far lower investing in subprime lending than investing in the stockmarket.

That makes this type of investment a good fit for some of the cash that you might normally keep in a quick access bank account, because you can configure it so you never lose money, and you can get it back into cash within a week. That lets you proof all your cash savings against inflation, so you aren’t constantly losing value every year. For example, €100,000 in a ‘high yield’ instant access Euro savings account right now is paying 0.2% which is 0.1% after DIRT. But inflation is ticking away at about 1%, so you’re watching €900 of value evaporate every year. If you can get €10k of that €100k out earning 10%, you’re now preserving the long term worth of your savings. And you still retain nearly instant cash access, which is the whole point of holding cash in the first place. This particularly suits someone like me, who wants to buy a site on which to build a house, and may need all my cash at once within days.

But first, a refresher on how modern lending to individuals works.

A brief history of subprime lending 2002-2008

You no doubt remember that the 2008-2009 economic crash had something to do with ‘subprime lending’ in the United States. What the banks did back then was to take lots of mortgages issued to lots of people barely able to afford them (i.e. sub, or below, ‘prime’ borrowers), repackage them by splitting them into small pieces, and resell bundles of small pieces of lots of mortgages to other investors in a primary market of new debt. The theory was that by diversification one reduced the risk of losing your money, because each individual mortgage default could only affect a tiny slice of your investment. This meant that such bundles of small slices of many mortgages could be rated as less risky than just a bundle of ordinary mortgages, and thus the amount of cash that you needed to collateralise the debt could be lowered, and thus more cash put out to earn more profit by lending. This was great, lots of rich folk made lots of money, until enough subprime mortgages soured at once that the entire system collapsed.

Most educated people know the part above, more or less. What they aren’t usually aware of is how the rebundling of debt can suddenly go from fine and healthy to very, very bad so quickly. The reason is because many individual borrowers are hassle to deal with, so a loan originator specialises in dealing with the individual borrowers e.g. with call centers of staff who say no and are mean to people etc. They finance the money that they lend to individuals from wholesale money markets where investors buy collateralised debt which pays interest.

As the investor wants to make sure that the loan originator does not go soft on the borrowers with their money, most investors require the loan originator to fund a certain percentage of the loan out of their own money to ensure they’ll try harder to recoup on defaults, and any losses come out of the loan originator’s money first before any of the investor’s money gets touched. So, if subprime mortgages had a 10% loan originator funding requirement (‘skin in the game’), all is fine right up until 8-9% of mortgages by value default, as the loan originators all start making losses and burning cash reserves. If they run out of cash flow, they cannot pay their ‘skin in the game’ any more on future defaults. This causes the investors to rush to the door to sell, at a discount, their loans to somebody else on the secondary market, which is where people who bought debt can resell it onto other investors for a premium or discount. This rapidly cascades, causing losses to bounce around the entire debt market, until the whole thing collapses under the weight of everybody trying to dispose of souring debt all at once.

As one can see, this entire system is quite brittle. Traditional debt is bonds issued by governments and companies which pay a rate of interest. There is a direct relationship between the borrower and investor, so there is no need for ‘skin in the game’ to keep the middleman acting in the interests of the investor. However, such is the enormous political importance of individual mortgages, personal loans, car loans, credit cards and the like, that when that system collapsed, governments rushed to swap lots of new government bonds (i.e. mutualised i.e. national debt to be paid off by all taxpayers) for all that bad debt incurred by individual firms. That’s what the banking bailout was, the swapping of lots of soured individual debt for national debt, brittle structured debt for simple debt.

Fintech (‘Financial technology’)

Europe is surprisingly the world superpower for Fintech. The US, and then China follow by some distance. My best guess is that there is far more competition here between banks due to all the national champions, but also because there is a much higher hatred of banks, a much stronger credit union movement, and a stronger perception of getting ripped off by banks all the time. This has led to a prevalance of globally dominant fintech startups based in Europe such as Transferwise, who operate something which is awfully close to a fee-free multi-currency bank account, with debit card, and individual account routing numbers per Transferwise account in twenty countries or so, and with extremely low currency conversion and transaction fees. They move about US$60 billion a year, and it’s roughly doubling annually. In fact, all my pay goes through Transferwise, my US employer pays me just like a US employee via ACH. That money drops into my Transferwise account in US dollars, from where I can convert/send/buy stuff1.

If you think it through, Transferwise simply expose the innards of currency trading and bank routing directly to the retail consumer. Your bank always had access to multi-currency accounts, it always could route payments anywhere in the world, and it usually cost it virtually nothing to do any of those things. If you are wealthy enough, rich individuals always had access to those systems, along with a personal bank representative to do your bidding. Now ordinary retail consumers are getting access to those systems, and it is driving down costs, increasing service, and represents major disruption to traditional banks for what was once a very lucrative market niche.

The equivalent ‘big daddy’ to Transferwise in the EU for loan investing by retail investors is Mintos. They are a ‘loan marketplace’ of currently sixty or so commercial loan originating companies from around the world, like an Amazon Marketplace for debt (note that they are NOT like Lending Club in the US, the only loans you see on Mintos come from professional, commercial, lending companies looking to reduce the cost of their own financing. You do NOT lend to individuals directly on Mintos). You can invest in any kind of debt, everything from mortgages to payday loans to invoice financing (bridging loans until an invoice is paid by a supplier), in any of a dozen currencies, in any of two dozen countries around the world, everything from low risk stable rich Western economies, through to risky basket case countries. You can choose each loan to invest in manually, and such active investors can do very well. Or you can automate the investing using bots given investment rules by you to slice up loans into as small or as big chunks as you like, and cut the cognitive effort and maintenance overhead to near zero as the bots run along in the background without your involvement, sending you a daily status update of what they’ve done.

Mintos are far bigger than any of their competitors in their specific niche of exposing commercial debt to retail investors, they already place US$2.4 billion of loans annualy, and annual growth is an eye watering > 300% per annum. Due to their sheer size, you will disperse any amount of investment you place with them very quickly, so there are no problems with uninvested capital sitting around earning nothing because there are insufficient borrowers, like on the smaller platforms. If you need your money back before the loans come to term, there is a large secondary market into which you can sell your loans quickly, instead of having to wait around for weeks or months for all of it to sell like with smaller fintechs. All this makes Mintos a great place to start for the European retail investor, which is why I chose it.

Peer to peer lending?

Some reading may recognise the name Mintos, and wonder ‘isn’t that peer to peer lending?’. Yes, they call themselves that, and yes, all the loans on Mintos are attached to some individual somewhere. But what I would call ‘true peer to peer lending’ is when the investor directly invests in the borrower personally, arranged by the fintech startup as a facilitator, but without a legal middleman in between. That’s the kind of lending which retail banks used to do once upon a time – the bank manager looked at the whites of your eyes, and made a call on whether to take a chance on you. There are lots of fintech startups which do true peer to peer lending in that same mould e.g. the UK’s Funding Circle, but those are not the subject of this series of articles.

The kind of lending which Mintos does is the same kind of lending which big multinational banks do: it’s all a numbers game i.e. you spread many small bets far and wide, and aim for statistically rather than individually successful outcomes. The novelty introduced here is that ordinary retail investors can get in on the act, rather than just the very wealthy and the banks. And said retail investors will get to lose their shirts when the system tips over again as it always does, instead of getting bailed out by the taxpayers.

The relationship with subprime lending in all this is that while you can choose extremely safe debt on Mintos paying maybe 5.5% (currently Spanish mortgage Euro debt is the safest on Mintos, it pays 5.5%), you can also choose ultra-risky debt, such as payday loans to Russians in Rubles, which currently pays 20%, and in which you will either make a lot more if the Ruble strengthens and Russia’s economy improves, or maybe a lot less if the Ruble sags and the Russian economy runs into more trouble. One can of course also create auto investment bots which implement a diversified mix, and then your biggest immediate risk is whether Mintos itself goes under (it is profitable), or more likely, gets hacked and someone runs away with enough money to bankrupt the firm, or fraud or embezzlement by a founding partner occurs etc. But let’s be clear here, the loan originators go to Mintos to get cheaper financing than they can get from the money markets, because the money markets think this debt is subprime, and so charge a higher rate of interest than what they have to pay on Mintos. There is no charity happening anywhere here, this is all about financing subprime debt more cheaply by getting lots of Joe Soaps to hand over their cash bank balances.

In my next post in this series, I’ll have a look at the risks involved in investing in Mintos specifically. In a third post I may then get into potential investment strategies on Mintos, as there are a ton of approaches, all with advantages and disadvantages.

You can find the next post in this series here

  1. Transferwise are not a bank and therefore do not provide a deposit guarantee. In other words, don’t keep too much money with them, they are not obligated to return any that they accidentally misplace, for example, whereas a government guaranteed bank is so obligated. [return]

#mintos #p2p-lending

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