The Motley Fool

Did Funding Circle learn nothing from the credit crunch?

When Funding Circle (LSE: FCH) listed last year, for many, the future looked bright. We had seen a growth in the peer-to-peer format over more than a decade. Peer-to-peer gambling was well established through exchanges such as Betfair, and the concept of crowdfunding was on everyone’s radar. But this didn’t last long.

Credit crunch all over again

The basic concept of the company is that it matches small businesses that need funding with private individuals who are happy to lend their money. For the borrowers, who were perhaps unable to source cash elsewhere (red flag), they were able to raise money and generally get better loan rates than offered by traditional lenders. For the individuals lending their money, the same was true, their ‘investments’ generally getting better interest rates than regular saving options on offer.

In order to mitigate the risk of these borrowers defaulting – they are, after all, not always able to meet the standards required by established lenders – the company pools lots of loans together in one big pot. Some of these pots (officially portfolios) are deemed riskier than others perhaps, but the premise is that if you collect enough loans together, the one or two that default are not relevant to the portfolio as a whole.

This is exactly how asset-backed securities and mortgage-backed securities work, and is a concept that proved to be flawed when it turned out that subprime loans had been making up a far larger portion of these securities than anyone realised, triggering the credit crunch and subsequent financial crisis.

People who couldn’t afford mortgages were getting them, these were then packaged together to make them ‘safer’, and then these packages were offered to others (in this case as bonds) as entirely different, and supposedly safer, securities. Sound familiar?

Default position

The similarities have perhaps, already started to show. Funding circle has had to revise-up its expected default rates twice this year, and in April announced it would be winding down its sister fund – Funding Circle SME Income – due to a period of “lower than expected returns”. This entity helps provide funding for its loans.

That said, Funding Circle does seem to be making some efforts to get ahead of things. Over the past year it has moved away from the peer-to-peer model and now seeks to fund much of its lending via other financial institutions. It has also said that it is tightening its lending standards, particularly to riskier businesses.

This could be a prudent course of action, but unfortunately for investors it has also led to the company reducing expectations on Tuesday, cutting its 2019 growth forecast from 40% to just 20% due to these tightening standards and “economic uncertainties“, causing the share price to drop almost 27% at the time of writing.

I feel this shift also raises another question though – if the company is no longer going to be a peer-to-peer lender, then what is it? I am not convinced it will work as an institution-to-individual middleman, and if its lending clients are seeing lower returns and higher defaults, how long will they use the platform? I for one want to know where my money goes when I lend it.

Investing For Income?

If you’re looking to supplement your salary or pension with regular dividends, then this special free investing report could be a great place to start! ‘A Top Income Share From The Motley Fool UK’ profiles a company that you’re bound to have heard of … but what you may have overlooked is the current near-6% yield on offer that our Motley Fool analyst believes is “comfortably covered by profits and by the firm’s cash flow”. Click here to claim your free copy now!

Karl has no positions in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.