What is Buyback Guarantee in P2P Lending and Investing? Explained.

What is Buyback Guarantee in P2P Lending and Investing. Explained Ultimate Guide.
What is Buyback Guarantee in P2P Lending and Investing. Explained Ultimate Guide.

In P2P lending, a buyback guarantee is a contract between the lender and the loan originator, with the purpose of protecting lenders against borrower defaults. The buyback guarantee is provided by the loan originator and the loans for which applies will often be marked with a shield.

The way the buyback guarantee works is if a borrower misses payments for a certain number of days, usually between 30 to 90 days, the loan originator is obligated to buy back the loan either fully or partly. Depending on how the buyback guarantee is structured, this will compensate lenders for the remaining principal and some or all of the interest and penalty fees.

Do a Buyback Guarantee Eliminate Risk Completely?

A buyback guarantee does not eliminate risk, it simply moves it to a more centralized place – the loan originator. If the loan originator goes bankrupt, it will not be able to honour its “guarantee” and the loans will have to be handled by someone else or be lost.

An example of a loan originator bankruptcy is Eurocent, who went bankrupt on May 9, 2018. Eurocent was listed on Mintos, one of Europe’s biggest P2P lending platforms. The loans listed on Mintos went bad, causing investors to lose both the principal and the interest. Mintos is trying their best it can for the investors to recover some of the money. The latest financial report of Eurocent can be found here.

In many ways, the buyback guarantee in P2P lending resembles a small system like the risk-free scenario seen in the 2007 financial crisis with the giant AIG insurance company going bankrupt on excessive gearing and the defaults of many sub-prime borrowers. It is, therefore, necessary to show some caution even when investing in loans with a buyback guarantee.

What are the Benefits of such Guaranteed investments?

The main benefit of a buyback guarantee is a higher certainty of obtaining the cash flow generated from investing in loans issued by the loan originator. If a loan defaults, you as an investor do not have to wait maybe years for the loan to be paid back or the default claim to settle. Because of this, this type of contract gives better predictability of the cash flow on a short-term basis. On the other hand, there is a higher risk of an instant drop in cashflow if the loan originator guaranteeing the buyback goes bankrupt.

The buyback guarantee basically connects the default of loans to the company who issues them. A benefit of this might be that it removes some of the incentive structure for the loan originator to accept bad borrowers to earn a quick commission.

On the other hand, the buyback guarantee can also create an illusion of operating in a risk-free environment. The consequence of this might be that the moral hazard is moved from the borrower to the risk of a loan originator indirectly gearing deferred revenues resulting in a scenario similar to what arose with Credit-Default-Swaps (CDS).

In conclusion, the benefits of investing in a peer-to-peer loan with a buyback guarantee is that you can better predict the cash flow and interest earned from the portfolio of loans. Also, there is most likely a better incentive for the loan originator to provide quality loans because as long as the loan originator is operating it will have to buy back issued loans with missed payments.

Should I Prefer Loans with a Buyback Guarantee?

When investing in P2P lending you should not necessarily only go for loans with a buyback guarantees as this means you will only be operating on p2p platforms based on the four-party business model consisting of a borrower, an investor, the p2p platform and a loan originator. Compared to the three-party business model that does not involve an independent loan originator, the structure in the four-party business model is more complex and harder to understand – and it will normally be risky for you as an investor to operate on this type of p2p platform. Also, the four-party business model involves considerations such as direct and indirect investment structure and the level of Skin in the Game can be very different from platform to platform.

Buyback guarantee only exists on peer-to-peer platforms based on the four-party business model. Lending to businesses, real estate or persons directly with only one serious part involved, where assets are secured transparent legal documents established is probably less risky and more like traditional investing in promissory notes.

Diversification is important in the P2P lending market and although buyback guarantee is often involved with high risk, it can be a good solution with certain loan originators to insure the cashflow. If you want to bypass the costs with loan originators and its security of the buyback guarantee, it is possible with these high-interest non-bank loans on platforms like Estateguru or other three party platforms without loan originators.