Thursday, May 24, 2012

Lending Club Loan Interest Rate and Return - Do Defaults Matter?

Interest Rate

As the chart below shows, since inception the interest rate profile of Lending Club loans has been broadening, from 7.12% to 15.96% in 2007 to 5.42% to 24.59% in 2011. They offer lenders loans with a broad range of interest rates to chose from. The dense colored area within a bar indicates high volume of loans were issued. Whereas the white space within a bar indicates no loans were issued.

For further analysis, I decided to allocate loans in 11 different buckets (called bins) based on interest rate of the loan. One interest rate bin (bucket) has interest rate spread of 1.99% with midpoint listed on the charts below. For example, the interest rate bin labeled 12% includes loans with interest rate from 11% to 12.99%.

From the above chart, two observations stand out right away:

  1. The number of interest rate bins has increased with time. In 2007, there were only five interest rate bins while in 2011, interest rate bins reached to 11 most likely result of increasing volume of loans, diversity of borrowers, return expectations of lenders, and general economic environment.
  2. Though rising, the loan volume at higher interest rate is only a small fraction of total loan volume. This scarce availability of loans with higher interest rate is a challenge for lenders when trying to create a significant size and diverse portfolio of high interest loans in expectation of higher returns.

Default Rate

Peter Renton pointed out in his comment on my previous post Lending Club Loan Issue Date and Default Rate that  loans from 2007 and 2008 may not be representative that of loans issued in 2009 and after due to worst financial crisis in 2007 and 2008 and major changes made by Lending Club in its loan underwriting model.

The significantly small volume of loans issued in 2007 and 2008 also creates larger uncertainty in expected defaults and returns due to small sample size. Though the loan volume is still not sufficiently large in 2009, it is the best we have available to analyze defaults and returns for a 3 year term loan.

The above chart shows the percentage of loans charged off and default as well as fully paid. As the chart indicates, the aging of loans has major impact on both rates - charged off and fully paid. As expected, the default rate rises with rising interest rates (almost linearly with the interest rate bins for years 2009 through 2011). Though default rate at various interest levels in 2009 are significantly better than 2007 and 2008, readers need to keep in mind that only 3 year term loans issued in first four months of 2009 have matured and only about 45% of loans issued in 2009 are fully paid by May 1, 2012.

In my opinion, the default rate for 2009 issued loans are understated and most likely will rise to be somewhere in between the current numbers and ones for 2008 and 2009. It is just a hunch based on the slope of the trend lines for different years and expectation of slope for 2009 trend line to be similar to 2007 and 2008.

Expected Return

At this point, I have information about expected default rates for different ages of loans and  for different interest rate bins. It shouldn't be that difficult to calculate the expected return on three year term loans.

I made the following assumptions to calculate the expected return:

  1. The default rates for past three years 2011, 2010, and 2009 are representative of expected defaults for first, second, and third year respectively of a three year term loan.
  2. The portfolio contains a large number of loans and same amount invested in each loan. I haven't determined an optimum number of loans in portfolio yet. Lending Club claims no negative returns for a portfolio with 800 loans.
  3. All loans that default in a year happen at the same month within that year and subsequent years. For example, default in 1 month indicate that loans defaulted in first month of first year, in first month of second year, and in first month of third year, i.e. 1st month, 13th month, and 25th month in the three year life of the loans.
  4. All payments received until the month of default are full (no partial payments) and after defaults no payments are received.
  5. Late payment fees, collection fees, tax deductions from principal write-off, taxes on interest received are not considered in expected return calculations.
  6. The loan service charge is 1% of monthly payment received.
  7. All loans in portfolio are issued same month and are part of same interest rate bin as defined above.
  8. Inflation and cost of capital are not considered in expected return calculations.
The chart below shows the value of portfolio at the end of 3 year for an initial investment of $2,500 in 100 $25 notes at different interest rate bins and for various default month.

Key Takeaways

  1. The portfolio has positive return for all interest rate bins and various default months. It leads me to ask the question "Do defaults really matter?"
  2. Even though the expected return analysis doesn't consider fluctuations in expected default rate, an hands-off approach with PRIME Account and preset Options with targeted returns offered by Lending Club appear to be attractive feasible options for time-constrained lenders.
  3. Due to low volume of loans with high interest rate, it is difficult to build a diversified portfolio solely from such loans. Also, the expected default rate, and in turn expected return, may have wide variance due to the small sample size for loans with high interest rate.

Brady at Lucrative Lending recently wrote about importance of credit report inquiries in making investing decision in a loan by a lender. I agree with his assertion about filtering available loans based on number of inquiries in past six months. Number of inquiries in past six months is the sixth most important criteria in my loan selection process at Lending Club.

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