Where I’m investing my money in 2009 – Part 3

You’ve heard about this ‘Credit Crunch’ right? Well lets be honest, it’s pretty hard not to have when the worlds media have become obsessed about reporting anything that’s been remotely credit crunched. The root cause of everything that is happening right now is a lack of available credit, a symptom of this is the economic downturn which has now transformed into a recession.

Based on the well known economic model of supply and demand, “price will function to equalise the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity”. So with the supply of credit being significantly constrained we either have to reduce demand or increase the price we are willing to pay for credit.

Letting the price of credit increase would not be popular with a lot of voters which is why Gordon Brown, assisted by the Bank of England, is doing everything he can right now to kick start lending again. Their combined efforts have seen some mortgage rates come down, but rates on other forms of borrowings such as loans and credit cards have actually increased. You can hardly blame the banks for being reluctant to lend what precious cash they have, particularly given the number of recent casualties in the sector. 

Demand for borrowing still exists, as taking out a loan in many circumstances can still be a sensible choice. The most frequently cited example of sensible borrowing is mortgages on property, however this is only sensible if the property you are buying is reasonably valued and it is the over-inflated prices in recent years that have got us into this mess.

In addition some consumers are unwilling to give up the lifestyles they have become accustomed to in recent years, funded by ever increasing piles of debt. Existing debt must also be repaid, it can’t simply evaporate over night, so it will take a long time for consumer debt to be reduced in real terms even if we do all decide to kick our debt addiction. 

So if demand is holding strong, and supply is constrained then it stands to reason that whatever scarce credit is still available will be selling at a higher price. And it is for this reason that I have decided to take the plunge and become a lender.

Setting up a bank would be both time consuming and very expensive, but an online money exchange such as UK based Zopa allows people who have money to lend it to those who wish to borrow. In effect Zopa acts as the middle man instead of using savings accounts and loan applications at a traditional bank.

Signing up to Zopa was easy and within a day my first deposit was in my account ready to lend. This being my first steps into peer-to-peer lending I decided to test the water with an initial offering of just £50 to potential borrowers.

Zopa has two different systems for lending called “Markets” and “Listings”. The later enables potential borrowers to state their reasons for wanting to borrow money, with a reverse-auction then taking place amongst lenders with the lowest interest rates winning.

I opted for the market based system where Zopa matches money from lenders to potential borrowers based on the risk and length of loan (hence the name Zopa, Zone of Possible Agreement). Wanting to be conservative with my initial investment I went for the shortest possible loan period of 36 months and restricted this to A* borrowers (the lowest risk borrowers as scored by their Equifax credit records). 

Matching borrowers to lenders is done on a many-to-one basis, so that each lender’s loan is spread across many borrowers, thus reducing the effect of any defaults. This meant my £50 was split equally amongst five different borrowers, each one receiving £10 of my money. There is however still a risk of bad debt and this risk is borne by the lender (hence why riskier groups of borrowers pay higher interest rates). Should a borrower default on their loan then the debt will be sold to a debt collection agency and lenders would be paid a portion of any money recovered.

Borrowers are charged a fixed fee by Zopa for each loan, and lenders pay a fee of 1% per annum on the funds that have been lent. This might seem unfair, but it essentially pays for Zopa to exist and carry out all the credit checks etc.

So far my lending has helped a 43 year old in Gloucester consolidate his debts and four other people across the country buy cars. It’s interesting that so many of the loans were for cars as there has been a significant reduction in the amount of credit available for new cars.

These loans might sound risky but if they work out they’ll net me a return of 5.9% after fees which is better than most bank accounts at the moment.

Arguably this could be classed as an investment, but with bad debt set to rise as a result of the economic downturn I have decided to record this as a speculative activity. The reasoning behind this decision is just like backing the favourite in a football match, however likely the result the outcome is not guaranteed.