Around a month ago Lending Club instituted a new policy which does not allow lenders to write specific questions to borrowers any more. Now lenders must select from a short list of predetermined questions which do not include the questions that many lenders are the most interested in such as what type of job the borrower has. Although I am not a lender with Prosper.com I have read that they recently made similar changes to their lending platform as well. The stated reason for all of these changes has been that the websites are attempting to better protect the borrowers' privacy. However, this policy really hinders the investor's ability to distinguish between good and bad loans. Many lenders have left the website all together as a result of this new policy.
I have continued to invest with the website despite my disapproval of this new policy. However, there is one significant change that I have made to my investing strategy. Previously I invested exclusively in borrowers with verified incomes. Now income verification is not a requirement in my investment criteria. My reasoning for this change in philosophy is below.
I am certain that nearly every borrower used to be asked by at least one lender to have their incomes verified. I know this because in many cases I was one of the lenders making this request. The response that I liked to see most was something along the lines of "Lending Club has not contacted me about this but I will call them and get it done." Many of the borrowers had no idea that getting their income verified was even an option until it was suggested by a lender. Lending Club selectively picks certain borrowers to verify their income based on some sort of algorithm which finds borrowers that are higher risk or more likely to be lying. Therefore, it has actually been shown that loans with unverified incomes have actually been performed slightly better than loans with verified incomes in a Reuters blog. However, I have always been comforted by loans with verified incomes because the income plays such a huge role in my decision to invest. Now that borrowers will only have their income verified if they are "red flagged" by Lending Club it is likely that the unverified loans will perform significantly better in the future than verified loans. I certainly don't ignore loans with verified incomes because I think it is still valuable with my investment process however I no longer ignore loans with unverified incomes either.
Hopefully in the future lenders will once again have the ability to ask personalized questions. However, for the time being I will try to adapt to the new changes. I am keeping track of the loans with unverified incomes by putting them in a separate portfolio and I will keep you updated as to which loans perform better in the future.
Tuesday, June 14, 2011
Monday, June 13, 2011
Personal Performance
I have received several questions from readers regarding my own performance on Lending Club. After doing a quick search for "Lending Club Reviews" on Google it is easy to understand why people would want to see some credentials before blindly accepting my opinions. There are literally thousands of blog posts out there by people who are promoting Lending Club so shamelessly that they must be working for the site. My posts are completely independent, however, I have had much more success investing with Lending Club than any other investment I have managed myself so at times I may sound like those other paid promoters.
I have been investing with Lending Club since February 2010. Initially I invested $1,000. Subsequently I have made 3 separate $3,000 investments to bring my total investment to $10,000. I will post more detailed descriptions of my strategy in the future but I will provide a quick overview of what I look for in this post.
I have a rather unique investment strategy that focuses exclusively on the highest yielding notes. My weighted average yield fluctuates, but I try to keep it above 19%. Currently I do not hold any notes in the A-D grading categories. I also have a tendency to focus on borrowers with high incomes (at least 10x their monthly payment). I also look for borrowers who provide answers to a lot of questions and go into detail in their responses. I assume that all borrowers are asked at least 6 or 7 questions over the period that their loans are listed and if they don't have a lot of responses I assume they are lazy or hiding something. Finally, I prefer loans that are used to consolidate debt. The logic behind this is that the borrower is already used to making that payment each month so it should not be a problem for them. On the other hand, loans for new purchases will likely be a new burden on the borrower.
Another aspect of my strategy is to sell notes as soon as they become delinquent. On the first day that they are late I typically mark them down 5%. Many of them will sell within hours of posting them on the trading platform. If they do not sell I continue to mark them down further at a relatively subjective rate until I can unload them.
Using this strategy I have been earning returns of about 1.2% per month. This translates to an annualized return of about 15.4%. Due to the slow ramp up of my investment my $10,000 has only grown to around $11,200 so far. However, I am consistently earning well over $100 a month now so hopefully that will grow more quickly in the future. I will continue to keep you posted on my performance.
I have been investing with Lending Club since February 2010. Initially I invested $1,000. Subsequently I have made 3 separate $3,000 investments to bring my total investment to $10,000. I will post more detailed descriptions of my strategy in the future but I will provide a quick overview of what I look for in this post.
I have a rather unique investment strategy that focuses exclusively on the highest yielding notes. My weighted average yield fluctuates, but I try to keep it above 19%. Currently I do not hold any notes in the A-D grading categories. I also have a tendency to focus on borrowers with high incomes (at least 10x their monthly payment). I also look for borrowers who provide answers to a lot of questions and go into detail in their responses. I assume that all borrowers are asked at least 6 or 7 questions over the period that their loans are listed and if they don't have a lot of responses I assume they are lazy or hiding something. Finally, I prefer loans that are used to consolidate debt. The logic behind this is that the borrower is already used to making that payment each month so it should not be a problem for them. On the other hand, loans for new purchases will likely be a new burden on the borrower.
Another aspect of my strategy is to sell notes as soon as they become delinquent. On the first day that they are late I typically mark them down 5%. Many of them will sell within hours of posting them on the trading platform. If they do not sell I continue to mark them down further at a relatively subjective rate until I can unload them.
Using this strategy I have been earning returns of about 1.2% per month. This translates to an annualized return of about 15.4%. Due to the slow ramp up of my investment my $10,000 has only grown to around $11,200 so far. However, I am consistently earning well over $100 a month now so hopefully that will grow more quickly in the future. I will continue to keep you posted on my performance.
36-Month versus 60-Month Loans
Initially all notes issued through lending club were repaid over a period of 3 years. On May 7, 2010 LendingClub began issuing notes with 5 year terms. All of these notes have standard, mortgage style amortization with level monthly debt service payments. The new 5 year notes pay interest rates of 2.23% - 4.60% higher than 3 year notes. Additionally, the impact of the 1.00% service fee is significantly reduced on notes with a 5 year term. For 3 year notes the service fee reduces net annualized returns by 0.71%, however, for the 5 year notes the service fee only reduces net annualized returns by 0.45%. There are, however, increased risks associated with the longer term that I will explain below.
Some of the risks are quite obvious. For example, having your capital tied up for a greater term means that it is more likely that you will need that money for some other purpose while it is tied up with the LendingClub note. This other purpose could be making a purchase, or it could also be another, higher yielding investment opportunity. This risk is substantially mitigated by the added liquidity of the trading platform. If an investor needs to liquidate their notes they can sell them rather quickly for a 1.00% service fee plus whatever discount they must offer in order to make the sale price attractive. However, there is still some degree of risk if an attractive opportunity becomes available to all investors at the same time (for example a better peer-to-peer lending platform or a raise in interest rates for new loans on LendingClub) then sellers will forced to reduce the prices of their notes in order to find buyers.
Another seemingly obvious risk is interest rate/ inflation risk. As with any fixed rate security, real returns are subject to fluctuations in the interest rate environment. If inflation increases or if the prevailing interest rates rise over the term of the loan, the underlying security will become less valuable. Conversely, if inflation rates fall the underlying security will appreciate. However, this still poses a risk to investors because it will make it more difficult for borrowers to repay their loans and it will increase the likelihood of default. The possibility of interest rate fluctuations and inflation add risk to the longer term notes and therefore the interest rates paid by borrowers must be higher in order to compensate the investor.
One risk that is less commonly known by LendingClub investors has to do with tax law. For a 3 year note, if the note is delinquent at the end of the term LendingClub will still make payments to the investors on any payments they collect from the borrowers until 5 years from the initial issuance date. However, if a 5 year note is delinquent at the end of its term then LendingClub will not make any future payments to investors even if they are able to collect from the borrowers. The prospectus explains this policy as a tax issue. Apparently, if LendingClub makes distributions to investors more than 5 years after the initial issuance date then they cannot write off the interest payments and must pay taxes on them even though they are distributing the payments to the investors. They do not go into any detail about the reason for this interpretation of the tax code. Presently, none of the 5 year notes have reached their final maturity yet so we don't know what percentage of them are likely to be delinquent on their final payment. However, this certainly adds a degree of risk to the notes that the investor must be compensated for through higher interest rates.
Finally, borrowers who select the 5 year term are likely less able to repay the loan than borrowers who select the 3 year term. Borrowers are informed during the application process that they will pay a higher interest rate for a 5 year loan than a 3 year loan. Therefore, by selecting the 5 year loan it is probably that they are unable to make the higher payments on a 3 year loan. We can assume that the loan payments for 5 year borrowers, on average, have a bigger impact on the borrowers day-to-day finances and pose a greater risk to their solvency. We can also assume that by electing to take the higher interest rate of a 5 year loan, the borrowers have a longer term debt problem rather than a short term cash flow problem.
Ultimately, it is up to the individual investor to decide whether the increased interest payment adequately compensates for the increased risk of a 5 year loan. Personally, I believe that it does and the majority of my portfolio is comprised of 5 year loans. Please let me know your thoughts below though.
Some of the risks are quite obvious. For example, having your capital tied up for a greater term means that it is more likely that you will need that money for some other purpose while it is tied up with the LendingClub note. This other purpose could be making a purchase, or it could also be another, higher yielding investment opportunity. This risk is substantially mitigated by the added liquidity of the trading platform. If an investor needs to liquidate their notes they can sell them rather quickly for a 1.00% service fee plus whatever discount they must offer in order to make the sale price attractive. However, there is still some degree of risk if an attractive opportunity becomes available to all investors at the same time (for example a better peer-to-peer lending platform or a raise in interest rates for new loans on LendingClub) then sellers will forced to reduce the prices of their notes in order to find buyers.
Another seemingly obvious risk is interest rate/ inflation risk. As with any fixed rate security, real returns are subject to fluctuations in the interest rate environment. If inflation increases or if the prevailing interest rates rise over the term of the loan, the underlying security will become less valuable. Conversely, if inflation rates fall the underlying security will appreciate. However, this still poses a risk to investors because it will make it more difficult for borrowers to repay their loans and it will increase the likelihood of default. The possibility of interest rate fluctuations and inflation add risk to the longer term notes and therefore the interest rates paid by borrowers must be higher in order to compensate the investor.
One risk that is less commonly known by LendingClub investors has to do with tax law. For a 3 year note, if the note is delinquent at the end of the term LendingClub will still make payments to the investors on any payments they collect from the borrowers until 5 years from the initial issuance date. However, if a 5 year note is delinquent at the end of its term then LendingClub will not make any future payments to investors even if they are able to collect from the borrowers. The prospectus explains this policy as a tax issue. Apparently, if LendingClub makes distributions to investors more than 5 years after the initial issuance date then they cannot write off the interest payments and must pay taxes on them even though they are distributing the payments to the investors. They do not go into any detail about the reason for this interpretation of the tax code. Presently, none of the 5 year notes have reached their final maturity yet so we don't know what percentage of them are likely to be delinquent on their final payment. However, this certainly adds a degree of risk to the notes that the investor must be compensated for through higher interest rates.
Finally, borrowers who select the 5 year term are likely less able to repay the loan than borrowers who select the 3 year term. Borrowers are informed during the application process that they will pay a higher interest rate for a 5 year loan than a 3 year loan. Therefore, by selecting the 5 year loan it is probably that they are unable to make the higher payments on a 3 year loan. We can assume that the loan payments for 5 year borrowers, on average, have a bigger impact on the borrowers day-to-day finances and pose a greater risk to their solvency. We can also assume that by electing to take the higher interest rate of a 5 year loan, the borrowers have a longer term debt problem rather than a short term cash flow problem.
Ultimately, it is up to the individual investor to decide whether the increased interest payment adequately compensates for the increased risk of a 5 year loan. Personally, I believe that it does and the majority of my portfolio is comprised of 5 year loans. Please let me know your thoughts below though.
Sunday, June 12, 2011
What If LendingClub Goes Bankrupt
One of the main concerns investors raise with LendingClub is not the risk of borrowers defaulting, but rather the risk of LendingClub going out of business. The prospect of LendingClub going out of business is not only possible, many would say it is likely. The fact of the matter is, LendingClub continues to lose money each quarter. Despite the fact that they have been steadily increasing the volume of loans issued nearly every month since inception, for some reason LendingClub has not found a way to be profitable. Their most recent annual report shows that LendingClub lost $10.25 million during the year ended March 31, 2010. This trend had not been corrected as of their most recent quarterly filing for the quarter ended December 31, 2010. This filing showed a net loss of $2.89 million for the quarter. They have already received tens of millions of dollars in venture capital funding, however, one has to assume that if they cannot become profitable soon it will become increasingly difficult to obtain follow on financing. Additionally, they have millions of dollars worth of secured outstanding debt that is senior to our investments in borrowers' notes.
Due to the significant risk of bankruptcy, it is very important for lenders to know what will happen to their investments should LendingClub go out of business. Unfortunately, there is no clear cut answer. In order to attempt to understand what would happen in the event of a bankruptcy, it is important to understand exactly how the lending process works and understand the flow of funds. When a borrower receives a loan a company named WebBank sends issues the loan to the borrower. Then, WebBank sells the loan to LendingClub at approximately face value. LendingClub uses the the money that lenders have invested in the specific loan to buy the note from WebBank. However, LendingClub has legal claim to all of the actual principal and interest payments received from the borrower for the loan because they hold the note. Investors are essentially making a loan to LendingClub, not the borrower, that is "secured" by the revenues from the note that LendingClub purchased from WebBank. I put "secured" in quotes because there is actually no legal or moral obligation of LendingClub to repay the lenders loan. It is simply their policy to do so. Therefore, since the lender has no legal claim to the revenue stream provided by the borrower's loan payments it is unclear that the lender has any claim to any assets or revenues in the event of a bankruptcy.
Initially, LendingClub made it seem as though a bankruptcy would have little impact on lenders. They advertised the fact that they had a 3rd party ready to step in to service loans should they become unable to do so. They also said that they only used member loan payments as security for a very small amount of debt and that most creditors had no claim on member loan payments at all. This language implied that lenders did have claim to these revenues, or at least seniority to other creditors with regards to these revenues. This language has been removed from the most recent prospectus so it is likely that LendingClub attorneys no longer believe this to be the case. The new prospectus essentially says that LendingClub does not know who would have claim to any of their assets or revenues in the event of a bankruptcy.
According to the new prospectus there are a few things we can infer. In the event of a bankruptcy LendingClub would likely stop making all payments to both creditors and investors until they had clear direction from a judge. This will include loan payments as well as distributions of available cash which is held in an account "in trust for" the lenders. Then, there would very likely be an extended court battle between all parties who had an interest in LendingClub. This could take years and be very costly for everyone involved. LendingClub has refused to give any guidance in their new prospectus as to who would likely ultimately have claim to any of their assets, including member loan payments.
It is very likely that in the event of a bankruptcy all lenders would lose a portion of their investment. Even if it is determined that investors do have a legal claim to loan payments, it would be a very costly legal battle to reach that decision. However, one comforting factor is that it does not appear that LendingClub's outstanding debt is significant in relation to the amount of outstanding member loans. As of their most recent quartely report there were $122.5 million of outstanding member loans. However, they do not have nearly that much in debt. Therefore, even if lenders were the last in line to collect from LendingClub, they would still stand a good chance of receiving a significant portion of their investment.
At this point it seems as though LendingClub is not certain what events would transpire during a bankruptcy. We really don't have many options other than to wait for additional guidance. Also, we can continue to monitor their financial statements to make sure they have enough cash to continue operations which would decrease the likelihood of a bankruptcy in the near term. Stay tuned for future updates.
Due to the significant risk of bankruptcy, it is very important for lenders to know what will happen to their investments should LendingClub go out of business. Unfortunately, there is no clear cut answer. In order to attempt to understand what would happen in the event of a bankruptcy, it is important to understand exactly how the lending process works and understand the flow of funds. When a borrower receives a loan a company named WebBank sends issues the loan to the borrower. Then, WebBank sells the loan to LendingClub at approximately face value. LendingClub uses the the money that lenders have invested in the specific loan to buy the note from WebBank. However, LendingClub has legal claim to all of the actual principal and interest payments received from the borrower for the loan because they hold the note. Investors are essentially making a loan to LendingClub, not the borrower, that is "secured" by the revenues from the note that LendingClub purchased from WebBank. I put "secured" in quotes because there is actually no legal or moral obligation of LendingClub to repay the lenders loan. It is simply their policy to do so. Therefore, since the lender has no legal claim to the revenue stream provided by the borrower's loan payments it is unclear that the lender has any claim to any assets or revenues in the event of a bankruptcy.
Initially, LendingClub made it seem as though a bankruptcy would have little impact on lenders. They advertised the fact that they had a 3rd party ready to step in to service loans should they become unable to do so. They also said that they only used member loan payments as security for a very small amount of debt and that most creditors had no claim on member loan payments at all. This language implied that lenders did have claim to these revenues, or at least seniority to other creditors with regards to these revenues. This language has been removed from the most recent prospectus so it is likely that LendingClub attorneys no longer believe this to be the case. The new prospectus essentially says that LendingClub does not know who would have claim to any of their assets or revenues in the event of a bankruptcy.
According to the new prospectus there are a few things we can infer. In the event of a bankruptcy LendingClub would likely stop making all payments to both creditors and investors until they had clear direction from a judge. This will include loan payments as well as distributions of available cash which is held in an account "in trust for" the lenders. Then, there would very likely be an extended court battle between all parties who had an interest in LendingClub. This could take years and be very costly for everyone involved. LendingClub has refused to give any guidance in their new prospectus as to who would likely ultimately have claim to any of their assets, including member loan payments.
It is very likely that in the event of a bankruptcy all lenders would lose a portion of their investment. Even if it is determined that investors do have a legal claim to loan payments, it would be a very costly legal battle to reach that decision. However, one comforting factor is that it does not appear that LendingClub's outstanding debt is significant in relation to the amount of outstanding member loans. As of their most recent quartely report there were $122.5 million of outstanding member loans. However, they do not have nearly that much in debt. Therefore, even if lenders were the last in line to collect from LendingClub, they would still stand a good chance of receiving a significant portion of their investment.
At this point it seems as though LendingClub is not certain what events would transpire during a bankruptcy. We really don't have many options other than to wait for additional guidance. Also, we can continue to monitor their financial statements to make sure they have enough cash to continue operations which would decrease the likelihood of a bankruptcy in the near term. Stay tuned for future updates.
Saturday, June 11, 2011
Lending Club Overview
As the first post on this blog, I would like to provide a brief overview of exactly what LendingClub is and how it works. Lendingclub.com is a platform for "peer-to-peer lending" which means it pairs investors with individuals who need loans. The main advantage of this method of lending is that it allows the actual investors to receive the high interest rates of personal loans rather than banks who traditionally underwrite these types of loans.
First, I will explain the way LendingClub works. Borrowers who are looking for loans of up to $35,000 fill out an application with the details of their employment history, salary and intended use of the loan proceeds. Additionally, they consent to a credit check. Finally, they choose whether they would like to repay the loan in 36 or 60 equal monthly installments. Then LendingClub uses a formula based on the borrower's credit history to assign a credit "grade" and interest rate to each borrower. Interest rates currently range from around 5.5% all the way up to 24.5%. All of this information is compiled into application summaries which are posted on the lending platform. Then investors browse through the summaries to find attractive investment opportunities. One of the great things about lending club is that once an investor decides to invest in a specific loan they can then decide how much they want to invest. This amount can vary between loans to limit exposure to more risky investments and increase exposure to relatively safer loans. You can choose to invest any amount you would like in each loan in multiples of $25. The minimum investment in any given loan is $25 and the maximum investment is the entire value of the loan.
Due to the risky nature of the personal loan business, LendingClub has developed incredibly strict criteria for borrowers to be approved to take out a loan. They reject over 90% of all applicants based on their credit reports. This means that, while the loans are still considered speculative and very risky, the borrowers are reasonably qualified to take out a loan. Since its inception in May 2007 the average return across all loans on the platform has been 9.64%. This means that if you invested in all of the loans ever issued, even taking into account defaults and fees, you would have earned an annualized return of 9.64%. However, the 9.64% annualized return includes many loans that are less risky and only pay 5-10% per year. By selectively choosing only the higher yielding loans it is possible to earn significantly better returns. For example, if you invested in all of the "G" category loans (which is the riskiest rating category and thus the highest yielding group of loans) you would have earned a 14.49% annualized return since the inception of LendingClub. Additionally, a relatively new statistic released by the site shows that 100% of lenders who have invested in more than 800 notes have had positive returns on their investment. Nobody who has invested in over 800 notes has lost money.
In order to maintain the platform and screen loan applicants LendingClub charges a service fee of 1% of all monthly payments that you receive. This fee is well worth the service and does not make a significant impact on your returns. LendingClub states that the service fee reduces returns by 0.71% on 36-month loans and only 0.45% for 60-month loans. I will explain the math behind these numbers in a later post.
Overall, I think LendingClub is by far the best investment opportunity available to the relatively young investor who is just starting out. One reason is that the low minimum ($25 per loan) allows you to diversify across many different loans. This means that all of your eggs will not be in one basket even if you don't have a lot of capital to invest. Also, investing in LendingClub is as time intensive as you want it to be. If you are busy you can set automatic investment plans which simply invest in notes that meet your criteria automatically which doesn't require any monitoring or time commitment. Even with this type of system you can expect average returns of 9.64% which is significantly better than most passive investments. Or, if you would like to take an active management role in your portfolio, you can be more involved and read through every loan description before making a decision. This could potentially improve your returns if you are able to spot loans that are more likely to default and avoid investing in them.
Introduction
This blog is designed to provide insight into the relatively new world of peer-to-peer lending. My goal is to work with the readers of the blog to learn as much as possible about LendingClub in order to minimize our risk and maximize our returns. I will be posting many articles about the way LendingClub works, investments strategies that I have found to be useful, as well as articles about certain risk factors and hopefully ways to mitigate them. I would like this blog to be as interactive as possible. I encourage readers to share their opinions and insight in the comment sections of each post. Additionally, please let me know if there are any specific topics that you would like to know more about. I will do my best to research those topics and post information that you will find useful. I also welcome guest posts so please feel free to submit any original LendingClub related posts that you think would add value for the readers.
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