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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5 comments:

  1. Thanks Anil - very interesting read. I'm continuing to watch for declines in the base rate and any excess supply of capital vs. borrower demand.

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  2. Thomas,

    Thanks for the comment. I am working on another post continuing this discussion. BTW, any thoughts on measuring excess supply vs demand directly instead of inferential.

    Thanks.

    Anil

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  3. Great explanation Anil. I would say that these days the increasing/lowering of the base rate has more to do with perceived economic conditions than with trying to balance lenders and borrowers. Look at what has happened in the past week or so. We have gone from under 1,000 new loans on the platform to over 1,800 loans in a little over a week with no change in interest rates. Marketing has tremendous control over how many loans appear on the platform.

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  4. Peter,

    It is amazing to see the sudden jump in loan listings in the past week. I don't know what could cause such a jump. I doubt marketing levers can make such a drastic jump in such a short time. It more looks like backlog clearing.

    I also noticed that for past few months LC was taking lot longer to issue loans after being fully funded but within last week the loans are being issued more quickly after being fully funded.

    Trends in both listing and issuance seem to indicate loosening of resource-constraints that LC might had.

    Could this jump be a precursor to interest rate adjustment? We will find out soon. I expect another adjustment to occur within next couple of months, a hunch based on the spread between interest rate on credit card loan and on 6 months CD.

    Thanks for the comment.

    Anil

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  5. Hi,

    I came across this article while researching the drivers behind LC's Adjustment for Risk and Volatility and the estimates for the assumed default rate for sub-grade A1 and G5.

    Have you had any followups to this analysis or any insights as to how the differences in estimated defaults between credit grades translate into interest rates?

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