Thursday, June 28, 2012

Lending Club Loan Length - Credit Grades and Default

Request to my Readers: I am enjoying sharing and discussing with you my findings from analysis of Lending Club historical loan data file. I would like to find out what other topics about Lending Club may interest you. Please take a few seconds to answer the Poll posted in the right sidebar.

You may recall a few weeks ago, Michael at Nickel Steamroller wrote a very interesting blog post Balancing Your Portfolio by Loan Term - 36/60 Month using the spread he painstakingly recorded for currently available loans on Lending Club. Let's compare his findings with analysis of Loan Term in my previous post Lending Club Loan Length: Best 60 month spread with B4 Grade Loan. Let's see if I can answer some of his questions.
"The higher interest rate [for 60 month loan] is to reflect the additional time you have to put your money at risk."
This statement is true but Lending Club goes about it in a round-about fashion. Lending Club reduces the Credit Grade of 60 month loan instead of increasing the interest rate while maintaining the Credit Grade. I assume most investors, as I do, compare the loans of same Credit Grade when selecting loans for investment. So, they don't necessarily pick higher returns with 60 month loans but potentially lower default risk for such loans. If you want higher interest rate/return with 60 month loan, look for such loans with Credit Grade that are within 5 or 6 credit sub-grade from your target Credit Grade criteria for 36 month loan selection.
"If you see the spike for D1 there was actually no spread on the currently listings. There was only one D1 [60 month loan] on the system (Member Loan ID 1333671). Not sure why this was."
As mentioned in my previous post, Lending Club's underwriting process skips D1 credit grade for 60 month loans. The only way of having a D1 grade credit loan is to change the loan amount. This is also the reason why there was no spread listed on D1 loan as Lending Club can't give D1 grade to a loan just by changing the loan length. The chart below shows the loan volume in 2010 and 2011 for all Credit Grades and Loan Lengths. As the chart shows, there is a discontinuity in loan volume at Credit Grade D1 for 60 month loans. Also, there are very few 60 month loans with Credit Grade A.

Credit Grade and Default Rate

Before I review the defaults as a function of credit grade, readers need to keep in mind that the historical loan data file was captured at the end of April 2012. So only loans listed in the first four months of 2010 have aged two years.

The chart below shows the charged-off and default for 36 month and 60 month loans. The 60 month loans listed during the second quarter of 2010 are the oldest loans. As the chart shows for Q2 of 2010, except for Grade D loans, the default rate is higher for 60 month loans. With further aging, I expect that default rate for 60 month Grade E and F loans may be lower considering the high number of 36 month loans with late payments in these grades. The similar patterns are observed for 2010 and 2011.

I made following observations from the chart for loans listed in 2010. Please share any additional insights you may have through comments.
  • For A grade loans, the default rate for 60 month loans is higher than that for 36 month loans. For B and C grade loans, the default rate follows similar pattern. In aggregate, the default rate for A, B, and C grade loans is 6.16% for 60 month term versus 4.34% for 36 month term.
  • The pattern reverses for D, E, F, and G grade loans. The default rate for 60 month loan is lower than that for 36 month loans. In aggregate, the default rate for D, E, F, and G grade loans is 9.064% for 60 month term versus 10.669% for 36 month term.
  • This reversal of pattern is most probably due to a large difference in loan volume with 36 month and 60 month terms. For example, 19.98% of grade A, B and C loans were of 60 month term compared to 49.32% of grade D, E, F, and G loans of 60 month term. The chart below shows number of 36 and 60 month loans for last three quarters of 2010.

It appears that Lending Club's underwriting process does well in matching the default risk between 36 month loans and 60 month loans using the credit grade of the loans. It remains to be seen how much more the default rate for 60 month loans will rise because such loans listed in Q2 of 2010 have completed only 2/5th (40%) of maturity term compared to 2/3rd (66%) of maturity term for 36 month loans.

Key Takeaways

  • Lending Club's underwriting practice to downgrade the Credit Grade of 60 month loan to adjust for extra risk is at best confusing for lenders. A practice of maintaining Credit Grade but increasing the interest rate on 60 month loan would be much more clear as most lenders on its platform understand higher risk deserves higher return.
  • Lending Club may need to provide resources that explain and educate lenders on credit risk evaluation. Otherwise, similar to NSR, lenders may turn away from longer maturity loans.
  • Comparing default rate of 60 month loan with 36 month loan for the same Credit Grade is like comparing oranges to apples. Lenders may need to shift credit grade 5 or 6 steps for 60 month loan to get a fair comparison of default rate with 36 month loan.

Once again, Peter Renton wrote an interesting post Why Aren't Banks Offering P2P Lending and Other Questions in response to an email from his reader. I just wanted to add couple of points.
  • Web Bank is an Utah based industrial bank specializing in private label credit cards and financial services. Their business model differs from traditional banks that offer services to consumers. Instead Web bank offers services to businesses who want to roll out their own financial services products such as from Dell, Circuit City and other retailers. Checkout Web Bank's products and service page for more information.
  • It is very typical of established businesses to ignore the emerging trends in their marketplace until too late. The banks are no exception. A Harvard professor Clayton Christensen did extensive research on this topic and published a very popular book The Innovator's Dilemma: The Revolutionary Book That Will Change the Way You Do Business.

Interested in understanding data analytics field, consider reading How to Measure Anything: Finding the Value of Intangibles in Business and Super Crunchers: Why Thinking-By-Numbers is the New Way To Be Smart.

Monday, June 25, 2012

Lending Club Loan Length: Best 60 month spread with B4 Grade Loan

Loan Length impact on Interest Rate

The chart below shows a Scatter Plot of Interest Rate and Credit Grade from 2010 to 2012. The color of circle represents the loan length and size of circle represents number of loans listed with specified interest rate, credit grade, and loan length. Initially, when I saw this chart I was surprised as I expected interest rate for 60 month loan to be higher than that for 36 month loan in same credit grade. As the chart shows, this is not the case. Interest rates for both 36 month and 60 month loans are same when loans are in the same credit grade.

After reviewing the information on how Lending Club sets the interest rate and prospectus [PDF], it became clear that Lending Club incorporates the difference in loan length by dropping the credit sub-grade five or six steps for 60 month loan.
"Seventh, we modify the sub-grade based on the term of the loan as follows:
Loan Term Sub-Grade Modifier
Three years 0
Five years
A1 - B5 (5)
C1 - G5 (6)

By adding the modifiers to the initial sub-grade, we arrive at the final sub-grade of the requested loan based on the initial credit criteria."
For example, let's assume the credit grade for a 36 month loan is A1 with 6.03% interest rate. If only the loan term is changed to 60 month, the credit grade for this 60 month loan will be B1 with 9.76%. In fact, by changing only the length of the loan, the interest rate on new 60 month loan increased 3.73%. Similarly, a C1 credit grade 36 month loan with 13.99% interest rate will change to D2 credit grade 60 month loan with 17.99% interest rate, an increase in interest rate of 4.00%.

Loan Length impact on Credit Grade

The chart below shows the new Credit Grade and new Interest Rate if length of a loan was changed from 36 months (Blue dots) to 60 months (Orange dots), without changing any other parameters of the loan. The sub-grade of 36 month loans is listed at the bottom of the chart. The sub-grade of equivalent 60 month loans is listed at the top of the chart. The gray bars show the extra interest rate (spread) for 60 month loan term. The scale for extra interest rate (gray bars) for 60 month loan is on the right side of the chart. The scale for interest rate on 36 month loan and 60 month loan is on the left side of the chart.

You may notice that there is no sub-grade D1 for 60 month loan. The reason for this anomaly is that if loan sub-grade is in A1 - B5 range, Lending Club drops the sub-grade 5 steps, i.e. the new loan sub grade is in B1 - C5 range. But if loan sub-grade is in C1 - G5 range, Lending Club drops the sub-grade 6 steps, i.e. the new loan sub grade is in D2 - G5 range. In fact, skipping sub-grade D1 in the underwriting process.

As you are more attentive now, you may notice and ask why are the loan sub-grade F5 - G5 range for 36 month loans and loan sub-grade A1 - A5 range for 60 month loans missing in the chart? If the only parameter changed for loan is the loan length, Lending Club can't have 60 month loans in the missing A1 - A5 ranges because the credit sub-grade of equivalent 36 month loans will need to be left of A1. Lending Club only defines credit sub-grades from A1 to G5. Similarly, no sub-grade above G5 is defined by Lending Club so you can't have equivalent 36 month loan with sub-grade right of F5 to be able to drop the sub-grade 6 steps for equivalent 60 month loan.

Now, you are paying much more attention, you may notice in the first chart at the top that there are a few 60 month loans in the credit sub-grade A1 - A5 and ask how is this possible? Well, let me tell you a story of a guy going to a car dealership to buy car through financing.

A guy goes to a car dealership to buy a car that cost $20,000. He wants to keep the monthly loan payment as low as possible. The nice car salesman says no problem, I will extend you our longest financing term of 60 month and your monthly payment will be $350. But, the guy want to keep monthly payment at $300. The car salesman really wants his commission from this car sale but he also can't increase the term of the loan any further. So, he convinces the guy to borrow little lower amount to keep the monthly payment at $300. Same sort of thing is most likely happening at Lending Club.

Lending Club only has two levers, Loan Length and Loan Amount, that it can pull to change the Credit Grade, resulting in change in Interest Rate, and resulting in change in Monthly Payment. All other parameters used for calculating Credit Grade of a loan are influenced by borrower's credit report. When borrower balks at monthly payment or interest rate, Lending Club most likely suggests to lower the requested loan amount to reduce the sub-grade resulting in lower interest rate and monthly payment.

Best Bang for the Buck

According to above chart, you will receive additional 5.21% interest rate by investing in B4 60 month loan over an equivalent A4 36 month loan. It is the largest spread (gray bar) among all 60 month loan credit grades. The abnormally high spread (greater than average + one standard deviation) is received for 60 month loans with sub-grades B3, B4, B5, and C1. The abnormally low spread (less than average - one standard deviation) is received for 60 month loans with sub-grades F5, G2, G3, G4, and G5.

Key Takeaways

  • The interest rates for 36 month and 60 month loans of same Credit Grade are same. Lending Club compensates for higher default risk with the longer length of 60 month loans by changing the Credit Grade of 60 month loan.
  • A lot fewer 60 month loans will be issued with Credit Sub-Grade D1, A1, A2, A3, A4 and A5 due to this quirk in Lending Club underwriting process for 60 month loans.
  • Lending Club only has two levers - Loan Length and Loan Amount to influence the Credit Grade, the Interest Rate and Monthly Payment for a loan.
  • The best bang for the buck, a spread of 5.21%,  is offered by Credit Grade B4 60 month loans over equivalent A4 36 month loan.
Recently, Nickel wrote an interesting comparison of "real-life" returns of a low risk portfolio and high risk portfolio in article Lending Club High vs. Low Risk Loan Experiment Complete. Check it out.

Interested in starting a business, consider reading Nail It then Scale It: The Entrepreneur's Guide to Creating and Managing Breakthrough Innovation and The Startup Owner's Manual: The Step-By-Step Guide for Building a Great Company.

Thursday, June 21, 2012

Lending Club Loan Length and Default Rate

If you are new to peer to peer lending, check out the introductory article An Introduction to Peer-to-Peer Lending by Peter Renton.

Loan Length

Lending Club issues loans with two different maturity lengths - 36 months (3 years) and 60 months (5 years). The loans with 60 month term were first introduced to Lending Club platform in May 2010, a little over two years ago. In 2011, the loans with 60 months term became very popular as more than 50% of the loans listed on Lending Club had 60 month loan repayment term. The chart below shows the number of loans listed every quarter with 36 and 60 month terms. It appears fewer loans with 60 month term are being listed in 2012.

Default Rate

The chart below shows the percentages of loan with 36 and 60 month terms in either charged-off and default status or in grace period, late and performing payment plan status. As the chart shows, the charged-off and default rate for 60 month term loan is almost twice the default rate for 36 month term loan for the same quarter of loan listing date.

Originally, I assumed that fewer borrowers may default with longer maturity of loan as borrowers will have smaller monthly payment. The chart shows this not to be the case. In fact, the borrowers are twice as likely to default with loans of longer maturity.

This observation is inline with Michael's real-life experience of much higher default rate with 60 month notes as described in his blog post Balancing Your Portfolio by Loan Term - 36/60 Month. A quick back-of-the envelope calculation for his portfolio default and late payment rate is shown below. It will also help some readers who requested examples of using default rates.

Assuming Michael has portfolio of 100 notes with 76% of portfolio in 60 month notes and all notes were listed in second quarter of 2010.
Number of 60 month notes in portfolio = 76% * 100 = 76
Number of 36 month notes in portfolio = 100 - 76 = 24
From the above chart, the default rates for 36 month and 60 month notes are 6.24% and 11.45% respectively. Similarly, the late payment rates are 3.36% and 3.61% respectively.
Default and late payment rate for 36 mo. notes = 6.24% + 3.36% = 9.60%
Default and late payment rate for 60 mo. notes = 11.45% + 3.61% = 15.06%
Number of 36 mo. notes in default or late = 9.60% * 24 = 2.304
Number of 60 mo. notes in default or late = 15.06% * 76 = 11.4456
Percentage of notes in default or late that are 60 mo. notes = 11.4456 / (2.304 + 11.4456) =  83.2%
Michael reported 95% of his notes in default or late are 60 month notes. Considering our assumptions of all notes issued in same quarter, we came up pretty close with 83.2% of notes in default or late should be 60 month notes.

Days between Loan Listing and Issued Date

The chart below shows the number of loans issued as function of days between loan listing and issued date between 2010 and 2012 for both 36 month term and 60 month term. The dotted line represents decile and each decile is 10% of loans. For example, one decile line indicates 10% of 36 month term loans were issued within three days of listing while 10% of 60 month term loans were issued within four days of listing. Similarly, two decile line indicates 20% of 36 month term loans were issued within six day of listing while 20% of 60 month term loans were issued within seven days. The chart shows that loan length has negligible influence on days required to fund and issue the loans. Update July 6, 2012: Please ignore the decile lines on the chart and related findings. There is a mistake in my interpretation of how Tableau calculated the deciles.

The chart below shows the percentage of loans with status charged-off and default or in grace period, late, and performing payment plan for both 36 month term loans and 60 month term loans for 2010 and 2011. The default rate for 36 month term loan is much higher when such loans were issued about 3 weeks after being listed. The default rate for 36 month term loans rises when it takes longer to issue loans after being listed. The default rate for 60 month term loan shows very different pattern. The 60 month term loans issued within four days of listing have much higher default rate.

Key Takeaways

  • Reducing the monthly repayment amount by lengthening the loan maturity doesn't reduce the risk of borrower default. In fact, the borrowers are more likely to default with longer maturity debt.
  • The coat-tailing strategy, described in my previous post Days Between Listing and Issuance of Lending Club Loans - Rush at Listing Expiration, may be a good strategy to invest in 36 month notes.
  • Personally, I have stopped investing in 60 month notes until I further understand the mechanics of setting interest rates for such loans and able to observe the default rate of 60 month loans to maturity.

Interested in Data Visualization, check out The Visual Display of Quantitative Information and New Perspectives on Microsoft Excel 2010: Comprehensive.

Monday, June 18, 2012

Guest Post: Let's do Lending Club night!

Today, I have a special guest writing about her experiences with Lending Club. Her post about setting up Lending Club date night is so compelling that I postponed my previously planned post to later this week.

Let's do Lending Club night!

by Mrs. Random Thoughts
"I enjoy the process and feel empowered."
For those who are looking for data and graphs with another interesting analysis by Mr. Random Thoughts (RT), sorry to disappoint you. No data nor analysis in today’s post. This is my perspective and experience with Lending Club investment.

Next scheme?

When Mr. RT mentioned about Lending Club investment a few months ago, I was like, “hmmm, sounds like new scam” and did not believe him. Then, he pointed me to the post 10 Things You Need To Know About Peer to Peer Lending on The White Coat Investor blog. I thought “well, if smart guy like this doctor is doing this, it must be worth a try.” See, how much confidence I have in Mr. RT! I consider myself better-than-average-financial-savvy, experienced with stocks and options investing and a Quicken addict. After I understood the concept of P2P lending, I jumped into Lending Club investment with Mr. RT.

Lending Club night

As a married couple, we are pretty transparent about how we spend money. We know how much we have, set the financial goals together, and discuss how we invest. Hence, selecting P2P loans and purchasing notes  have naturally become "our" activity. This is how we started “Lending Club night." What a geeky couple!

We usually pick one night a week and call it “Lending Club night”. On that date, after dinner, Mr. RT downloads the available loans spreadsheet, reviews the data and filters out loans for possible investment. The number of candidate loans is no more than 10, usually 5 to 8. Then, I sit next to him, review and give my opinion on each loan.

Listen to me or ...

Mr. RT has already selected pretty reasonable notes at this point by filtering quantitative data. Then, we look into qualitative data; i.e., where the borrower works and lives, purpose of the loan, etc. I also learned some tips from other blog posts such as P2P Lending For Extra Retirement Income and 7 Ways to Increase Your Return at Lending Club to back up my own views. So, our discussion on selecting notes sometimes lead to new findings.

For example, Mr. RT thinks that loan for building a pool as home improvement is bad. He considers having a pool at home a luxury and unreasonable. Yes, it is most probably true for people living in Seattle. But for people who can enjoy summer weather for a long time, like people living in North Carolina, for example, having a pool may be a part of upkeep of backyard as home owner. It is very reasonable upgrade cost and will increase home value. So, I convince Mr. RT to invest in this type of loans.

Be consistent even if ...

Where people work and how much money they  make provide good decision points. We tend to agree on quickly loaning out to people working for name value companies or for city, state, and government organizations. Too much advertisement from applicants, meaning flowery comment, does not work for me. It often seems to me fishy and suspicious.

I carefully read those comments and answers to the questions. Sometime these expose inconsistent information or lack of common sense. Hmm, how can this seemingly rich borrower wants to borrow the amount of money that he or she should be able to save in a few months with his or her income. If it's true, does he or she lack discipline? Or, how can this borrower with low income living in NYC pay back loan? These type of questions always come to my mind while reviewing loans. I enjoy such discussions with Mr. RT.

Finally, on to something

Time to time our selected loans are not approved or expire in the end. So, I feel rather assured that Lending Club does background check of borrowers diligently and does not approve some loans even after being fully funded.

Our investment at Lending Club is getting bigger, even though slowly as each note is only $25. Also, Mr. RT is excited about seeing 10%+ interest. Unlike him, I don’t count much on this investment, rather I enjoy the process and feel empowered.

Only concern I have is that filling out tax form. As I do taxes for us, I’m afraid of ending up entering all gain and loss for small investments. Then, I’d be happy to give that privilege to Mr. RT.

Interested in Personal Finance and Investment topics, consider reading:

Thursday, June 14, 2012

Lending Club Credit Grade - A & B offer better risk-adjusted returns

Loan Credit Grade and Interest Rate

The chart below shows the Interest Rates as a function of Credit Grade for all years of loan issued since 2007. The size of the circle indicates the number of loans issued at the specified interest rate and credit grade. The color of the circle indicates the year in which loan was issued.
  • The chart indicates a few loans under all credit grades issued at 6% interest rates. These appear to be data entry errors.
  • From year 2007 through 2010, the Interest Rates for loans rose somewhat linearly with Credit Grades. Since 2011, the relationship between interest rates and credit grades have become curved, an indication of evolving default risk modeling with experience at Lending Club.
  • The interest rates for A grade loans have declined while interest rates for other credit grade loans have risen over the years. I suspect Lending Club is trying to attract high credit quality borrowers by reducing the interest rates on grade A loans.
  • For each credit grade, interest rates seems to change during the year. As my previous post Lending Club Base Interest Rate - Excess Lending Capital Supply mentions, Lending Club adjusts the interest rates multiple times during the year.

The chart below shows the Interest Rates as a function of Credit Grade for the month of February 2012. Unlike the previous chart which shows loan issued year, this chart shows the loan listing month. As the chart shows, there were two sets of interest rates for most loan credit grades. This indicates that February was the month when Lending Club adjusted the interest rates on loans.
  • The lenders would have received additional 1+% interest on their notes of same credit grades if they waited until February when loan interest rates were adjusted upward.
  • By waiting for interest rate revision, the lenders would have reduced the default risk (as measured by the credit grade) by buying the loans at similar interest rates but of higher quality credit grade.

Similar chart for the months when Interest Rate changed in 2011 is shown below. In 2011, interest rates were revised in the months of January, April, June, and September (four times). In 2010, the interest rates were revised in January, May, and October (three times). In 2009, the interest rates were revised in July (one time). These observations indicate that there is no pre-determined schedule and interval for reviewing and revising the interest rates.

The interest rate revision, however, appears to be triggered by an external event. Even though, there is not enough data points to support and I am not very confident, the external event appears to be the spread between Commercial bank interest rate on credit card plans and Average rate on 6-month CD, as discussed in previous post. It appears a change of 2+% in the spread triggers a review of current interest rates on Lending Club.

The chart below shows the Average Interest Rates as a function of Credit Grades plotted for each year.
  • The average interest rate for Grade A loans are at least 1% lower for the loans issued since 2010 than that issued prior to 2010. The average interest rate for all grades, except A, is consistently rising year over year.
  • Since 2010, the average interest rate curve for grade A and B loans have steeper slope than that for other grades. Assuming the credit grade represents default risk, lenders can receive better risk-adjusted return (more bang for the buck) by focusing on credit grades where the slope of the curve is highest, i.e. the interest rate rise faster than the credit grade. From the chart below, loans with credit grade A and B may offer highest risk-adjusted returns.

Key Takeaways

  • It may be beneficial to hold on or speed up purchasing notes when interest rate may be adjusted.
  • In order to know when Lending Club might review and revise interest rate, the spread between interest rate on credit card and interest rate on 6-month CD may provide a clue. 
  • The better risk-adjusted return may be obtained with loans of credit grade A and B if default risk is evenly distributed from A1 to G5.

Recently, Richard published an interesting post Using the Social in Social Lending about how he selects loans using the descriptions and answers provided by the borrowers. He is definitely on to something that can be used as qualifying criteria. Check it out.

The language and persuasion in online peer-to-peer lending market has been of great interest to academic researchers also. I came across a particularly interesting research paper Peer to Peer Lending: The Relationship Between Language Features, Trustworthiness, and Persuasion Success published in Journal of Applied Communication Research. Unfortunately, the full text is behind a paywall but you may be able to request a copy from author Laura Larrimore. The abstract mentions:
"The use of extended narratives, concrete descriptions and quantitative words that are likely related to one's financial situation had positive associations with funding success which was considered to be an indicator of trust. Humanizing personal details or justifications for one's current financial situation were negatively associated with funding success."

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Monday, June 11, 2012

Lending Club Base Interest Rate - Excess Lending Capital Supply

Lending Club provides information online on how credit grade is assigned to a loan application. The detailed procedure for setting credit grade, loan interest rate, base interest rate, and adjustment for risk and volatility is described in the latest prospectus [PDF] dated April 10, 2012. Let me review the base interest rate today as I expect it may be an important component of analyzing Loan Credit Grade and Interest Rates.

Base Interest Rate

The starting point for base interest rate is the middle of the spread between the interest rate for unsecured consumer credit as published in Federal Reserve Board Consumer Credit G.19 Release and the average interest rate for 6-month certificates of deposit as published in Federal Reserve Board Selected Interest Rate H.15 Release.

Last time when Lending Club set the base interest rate on January 24, 2012, the interest rate for unsecured consumer credit was 12.78% (November 2011) and the interest rate on 6-months CD was 0.52% (February 2012). The average of these two interest rate was (12.78 + 0.52) / 2 = 6.65%.

The latest interest rate for unsecured consumer credit, as reported in February 2012, is 13.04%. The latest interest rate on 6-months CD, as reported in May 2012, is 0.46%. The average of these two interest rate is (13.04 + 0.46) / 2 = 6.75%. Thus, most likely the new initial base rate will be higher than previous.

Lending Club modifies this initial base rate for economic slowdowns or expansions, whether borrowing requests exceed investor commitments or vice-versa, and rates set by other lending platforms and financial institutions.

Last time, Lending Club determined an adjustment of -1.60%. Considering Lending Club is a leader among lending platforms and economic condition was stabilizing or getting better in January 2012, I suspect that the decrease in the final base interest rate was due to investor commitments exceeding borrowing request. In other words, Lending Club presumed that there would be more lending supply than the borrowing demand.

A few Lending Club blog posts from 2007 and  2008 also mention the base interest rate adjusted based on demand (loan applications) and tend to rise when demand increases faster than supply (lenders' lending capital). This trend is also confirmed by Peter's observation in recent blog post Every P2P loan is Getting Funded at Lending Club that since September 2011, all loans listed on Lending Club platform have been funded.

Assumed Default Rate & Interest Rate

Lending Club determines the assumed default rate by dividing the difference between assumed default rate of sub-grade A1 and that of sub-grade G5 into 35 equal intervals, i.e. a linear relationship between sub-grade and assumed default rate. It is not clear how Lending Club determines the assumed default rate for sub-grades A1 and G5.

The reason for using same assumed default rate for both Three Year and Five Year term loans is also not clarified in the prospectus. Michael in his recent blog post Balancing Your Portfolio by Loan Term - 30/60 Month points out that 95% of his late or defaulted notes have five year term. This observation suggests that assumed default rates also depend on length of the loan term.

Finally, the base interest rate is adjusted for assumed default rate, volatility factors, investor value and other factors, referred collectively as Adjustment for Risk and Volatility. I need to further research how Lending Club estimates the assumed default rate for sub-grade A1 and G5 and what factors influence the Adjustment for Risk and Volatility.

Key Takeaways

  • The lowering of base interest rate by Lending Club indicates that there is more supply (lenders' lending capital) than demand (loan applications). Lending Club may need to focus on  increasing the demand by attracting borrowers that are not accepted by conventional lending channels.
  • Lenders need to distribute their capital across multiple peer-to-peer lending platforms to reduce excessive capital flow to one platform and maintain higher returns on all p2p lending platforms.
ClickZ recently published an interesting article Peer Learning: Gaining Insights From Social Lending Platforms by McNeal Maddox on the topic of Social Lending in the context of small business and entrepreneurs. On Lending Club platform, I would really like to support entrepreneurs. I just wish entrepreneurs provide more information about their businesses in loan details to make lenders comfortable lending to them.

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Thursday, June 07, 2012

Lending Club Loan Credit Grade - Is There Demand for High Interest Loans?

Loan Credit Grade

The way Lending Club calculates loan credit grade and interest rate has been constantly evolving for past five years. Lending Club provides detailed information on method for setting the Interest Rate and Loan Grade for each loan. It appears from my analysis, Lending Club continues to tweak interest rates and underlying dependencies especially for lower quality loans. Before I review the relationship of Loan Grade with Interest Rate, let's look at Loan Grade with Loan Issued Date and Loan Listing Date.

Loan Volume

As the chart below shows, more than 50% of loans issued every year are categorized as top two best grades; Credit Grade A and B. The volume of loans of all credit grades has been growing at spectacular rate, year over year. However, only 1,301 and 377 loans were issued with Credit Grade F and G respectively in past five years. It is difficult to build a diversified portfolio (800+ loans) solely from grade F and G grade loans that carry high interest rates due to low volume of such loans.

Default Rate

As the chart below shows, the number of loans with charged-off and default status increases with the credit grade, from A to G, for loans issued each year. The trend is similar to the ones shown in my previous post Lending Club Loan Interest Rate and Return - Do Defaults Matter?.  While the default rate and interest rate bin relationship was much more consistent, that is not the case with loan credit grade. The relationship with loan credit grade is only consistent for better quality loans, those with credit grade A to D.

Days between Loan Listing and Issued Date

A reader 'Learner' commented on Peter's blog post Every P2P Loan is Getting Funded at Lending Club:
"The more creditworthy the loan, the longer it will take to fund."
As I was preparing to analyze the data for Loan Credit Grade with respect to the Number of Days between Loan Listing and Issued Date, I became curious to find out if the above quote holds true for loans with different Credit Grade. Do higher quality Grade A and B loans take longer to be issued after listing? I don't have the date when funding for a loan completed so I can't directly analyze the days it takes a loan to be fully funded. However, days between loan listing and issued date for a loan offers a close proxy.

The chart below shows the number of loans of a specific grade issued as a function of number of days between listing and issued date for the loans. The Lower quartile line represents the number of days from listing to issue (timeline) for 25% of loans, the Median line represents timeline for 50% of loans, and Upper quartile line represents timeline for 75% of the loans.

Days to Issue Loans Credit Grade
Percentage of Loans Issued A Grade B Grade C Grade D Grade E Grade F Grade G Grade
Lower Quartile (25 percentile)
Median (50 percentile)
Upper Quartile (75 percentile)

As the chart below shows, I couldn't find a trend that indicates loans with Grade A and B take longer to be issued than loans with other grades. In fact, 25% (Lower Quartile) of Grade A loans were issued within four days of listing, the shortest timeline among all loan credit grades. It is more surprising that the lower quality loans, supposedly Grade E, F, and G, in spite of very low volume are not issued any faster than higher quality loans. It leads me to suspect that either demand for low quality loans is not high enough or Lending Club takes too long after being funded to issue low quality loans. Update July 6, 2012: The quartiles in the chart and associated findings are incorrect. I made error in interpreting how Tableau calculated the quartiles.

The chart below shows the percentage of loans of each grade that have Charged Off and Default status as a function of number of days between listing and issued date of loans. In general, the default rate is higher for loans as the days from listing to issue loans increases. The exceptions are the loans issued within two days of listing and lower quality loan grades. I suspect these exceptions have more to do with fewer number of loans and data points for loans issued within two days of listings and in lower quality loan grades.

Key Takeaways

  • To build a high return diversified portfolio, investment need to be made in all or most lower quality loans listed on Lending Club platform at much higher risk.
  • There is no evidence from above analysis that better quality loans take longer to be issued.
  • The lower quality loans, in spite of higher interest rates and small volume, are either not in much demand or take too long to be issued by Lending Club after being fully funded. Update July 6, 2012: This takeaway may not be correct due to error in interpreting how Tableau calculates quartiles.

Leigh Drogen at Surfview Capital recently published an interesting article Complete Lending Disruption. He writes "Lending is about to be taken out of the hands of the banks, and put into the hands of the average person." I couldn't agree more. Worth a quick read.

Recommended Book: Your Money or Your Life: 9 Steps to Transforming Your Relationship with Money and Achieving Financial Independence is a classic book that should be read first by everyone interested in personal finance.

Monday, June 04, 2012

Days Between Listing and Issuance of Lending Club Loans - Rush at Listing Expiration

Coat-tailing Strategy

Some P2P lending investment strategies may rely on the percentage of loan amount already funded or number of lenders already committed or average funding per lender in a loan. I agree with the basic premise of coat-tailing on commitment of someone else or institutional money as a qualifying criteria. However, I suspect that such strategies predominantly will select loans that are late in their funding cycle and listings near expiration. This will be especially true for investors who review and select loans infrequently. Such investors, including myself, may miss out attractive loans that get funded very quickly.

Is there a right time to review loans in their funding cycle on Lending Club? I started out today's analysis with this question. As I mentioned in my previous post Lending Club Loan Application Date - When to Invest?, I switched my note selection day from Tuesday to Wednesday night as majority of new loans seem to be listed early in the week. But this schedule change means catching loan listings near expiration. Are the loans funded and issued quickly more desirable from defaults perspective?

Days between Loan Application and Issued Dates

Though Lending Club provides information on amount and number of lenders already committed to a loan during notes selection for new loans, it doesn't provide such details in historical loans data file. Thus a direct analysis using such parameters is not feasible. The days between the loan listing date and loan issued date may serve as a close proxy for lender interest in loans.

Loan Volume

The chart below shows the loan volume with number of days between when loan was listed and when loan was issued. Originally, I was surprised to see a few loans issued up to five days before they were listed on the platform. After reading comment "I invested a significant amount of my own money to fund the first loans on the platform" by Lending Club CEO in Finovate interview, such loans no longer seem surprising as most start-ups in their early days need to be creative to generate demand and show traction. Still, this is an interesting observation that needed to be highlighted as such loans were issued in early 2009.

The issuance of loans can take as long as 36 days after being listed on the platform though most get issued within 21 days. The period between listing and issuance has been lengthening year over year, from 21 days in 2007 to 36 days in 2012. I'm guessing its because of Lending Club staff is not able to keep up with the tremendous growth in loan volume.

Some loans are issued within couple of days after being listed. These loans might be funded by or reserved for institutional investors, LC Advisors, and PRIME account holders. Someone needs to have inside access at Lending Club for such a quick turnaround. Such borrowers might also be fully-vetted before loans being listed on the platform.

Two separate peaks are visible in the chart, one at 7 days and another one at 14 days. Most loans took either 3 to 11 days or 13 to 15 days between listing and issue. The former group most likely contains desirable loans. The later group appears to be right about the time when loan listing expires. The later group may be result of everybody rushing into fund at the last moment. Also, by the time loan listing expires, most borrowers are fully-vetted so turnaround time for issuing loan may be shorter. I suspect the former group of loans to have lower defaults than the later group.

Default Rate

The chart below shows the percentage of loans with Charged Off and Default status with the number of days between loan listing and loan issued date. One observation right away stands out - the loans issued within a day of listing have higher than average default - so much for "insider" advantage!

As the number of days increase between loan listing and loan issue, the default rate increases, peaking just after expiration of loan listing. It appears a lot fewer loans issued within 10 days of listing have charged off and default status compared to the ones issued at near or after listing expiration.

The chart below showing default rates for interest rate bins separately confirms the above observation. The percentage of loans with charged-off and default status is higher near and after loan listings expiration for most interest rate bins. See my previous post Lending Club Loan Interest Rate and Return - Do Defaults Matter? for explanation of interest rate bin.

Key Takeaways

  1. A coat-tailing strategy to select loans for investment may be a viable strategy as long as the selected loans are not near listing expiration.
  2. Default rate can potentially be reduced by selecting loans that are being funded very fast and soon after being listed on Lending Club platform. From default perspective, loans issued earlier in their funding cycle are more desirable. But it is better to stay away from loans that are issued within a day of listing.
  3. This analysis still doesn't help with choosing the right time to select loans as lenders don't have influence on when loans are issued.

Recently Caron Beesley wrote a very good article P2P Lending and Crowdfunding - Explore the New Frontier for Small Business Lending with good suggestions for borrowers planning to start a small business. I frequently notice on Lending Club that business borrowers don't provide sufficient information about business. Borrowers will have much better chance of getting funded if you tell lenders your story and share your achievements and progress to date.

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