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 RateThe 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 RateLending 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.
- 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.
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