1...... Securities Act..... 4

2...... Blue Sky Laws..... 7

3...... Securities Exchange Act..... 8

4...... Investment Company Act..... 9

5...... Investment Advisers Act..... 10

6...... Risk Retention Requirements..... 12

1...... Usury Laws..... 14

2...... Other Financial Institution Regulations..... 15

3...... Issues Related to Third-Party Use of Bank Charters..... 16

4...... State Licensing Requirements..... 17

1...... Truth in Lending Act..... 18

2...... FTC Act and UDAP Laws..... 18

3...... Fair Lending Laws..... 19

4...... Debt Collection Practices..... 20

5...... Privacy Laws..... 21

6...... Electronic Commerce Laws..... 22

7...... The Dodd-Frank Act and Consumer Protection..... 22

• with a 36 month maturity (and would be happier if LC offered 12 month loans) - this is primarily to avoid being long duration - i do want to do a review of the rate difference that LC charges for 3 vs. 5 year loans to see if i think it is sufficiently steep 
• where the borrower has a debt-to-income (DTI) ratio of 20% or less - i understand the DTI is based on self reported income so i take this filter with a grain of salt
• where the revolving balance utilization is 50% or less - the reason why i like this particular metric is that (a) it is based on third party information (i.e. credit reports), (b) it demonstrates (at least in my mind) a wise use of credit and (c) it indicates that the borrower has credit availability in the event that it is needed in the future (either to repay the LC loan or to address unexpected circumstances)
• where there have been 2 or less credit 'inquiries' in the past 6 months - i view this as a sign that the borrower is not desperate for credit
• where the borrower has no public records (i.e. has never filed for bankruptcy) and has no reported delinquencies in the past 2 years

i also don't invest in "G" rated notes for the simple reason that, according to LC, the historical returns on "G" rated notes is lower than "F" rated notes. assuming that "G" rated notes are in fact riskier than "F" rated notes, investing in "G" rated notes would violate every risk/reward principal such as investing on the efficient frontier, etc.¹

i don't suspect that the above referenced filter differ too much from what others would consider fairly common sense filters.  there are also a number of other filters that people may employ but for one reason or another, i choose not to

however, i think the following filter does differ from what many other investors think and also greatly reduces the availability of loans that i will investment in.  the filter is "Loan Purpose" - according to LC (as of today), 78.15% of borrowers apply for a LC loan with the express intent of paying off credit cards or consolidating their loans.  i simply don't invest in those loans. 

this may sound crass but in my experience, human behavior does not easily change.  yes, there will be individuals who recognize that their previous spending is unsustainable and are now truly committed to reducing their debt burden.  but since p2p lending should not be thought of as loans to individuals but rather as an investment in an asset class, i am of the view that most people who have incurred significant levels of debt and now require more debt to retire old debt will have difficulty changing the behavior which has resulted in their current predicament. 

so with respect to "Loan Purpose", i screen for borrowers who at least purport to be using the loan proceeds for "home improvement projects", "business loan", "major purchase" and a few others.²  certainly some will say that my pool of borrowers is adversely selected meaning that they are borrowers who could not obtain credit through 'traditional means'.  on the other hand, i view these borrowers as people who (A) can't be bothered with the hassle of obtaining an unsecured bank loan (if that's even possible these days) and (B) could finance their purchases or activities through credit cards but are savvy enough to explore alternative/cheaper financing solutions.

once i apply the filters mentioned above, i generally fund all available loans at the minimum amount ($25).  because my filter does eliminate a vast majority of available loans, i find that i am only able to fund about 10 loans a day and of the loans i choose to fund, i find that about 50% actually end up being issued.³  as a result, it has taken a number of months to build my portfolio (and i continue to add to the portfolio on a daily basis).  currently, my portfolio has a weighted average interest rate of 13.64% comprised of the loans with the grades shown below.  the portfolio is still relatively young but so far, i have not had a loan enter a 'late period' and continue to re-invest payments as i receive them.  unfortunately i haven't taken the time to actually calculate my returns on this portfolio.  the reason why the 'net annualized return' of 9.12% quoted by LC with respect to my account is not accurate is that i have funded other notes on LC utilizing other strategies include one that turned out pretty badly. when i get around to calculating the actual return for this strategy, i'll be sure to let you know.

Composition of my LC Notes using the strategy described above

Prosper Strategy

as mentioned above, the strategies i employ on LC vs. prosper are very different.  with respect to prosper, i don't currently invest in any newly issued notes.  please don't read this to mean that i have any issues or concerns with prosper's note underwriting or origination - i don't have an opinion at all on which platform does a better job of screening potential borrower and assigning scores/interest rates

rather, one strategy i chose to employ early on is to invest in seasoned notes - notes that have been outstanding for more than 2 years and where the borrower has not previously had a late payment.  of course, in order to buy these notes, there needs to be a secondary market for propser or LC notes.  in fact, both propser and LC retained folioFN (which also operates as a more traditional online broker) to develop a secondary platform on which people can buy or sell previously issued notes.

after signing up and navigating each of the secondary platforms, it was obvious that the prosper secondary platform was the only one i could use to implement my strategy.  unfortunately, as i'll try to describe below, quite a bit of manual labor is still required. 

shown below is the UI for the prosper secondary platform.  as you can hopefully see, i don't screen for potential investments by rating.  rather, i look for notes that have 11 months or less to maturity and that had original terms of 36 or 60 months (i.e. they have been outstanding for more than 2 years).  i also only look for investments of $15 or more (otherwise i get too many results that i would individually need to screen through).  finally, i screen for loans that are currently priced at a 2% premium (or less) to their original price

user interface for prosper's secondary trading platform

after i apply the filters mentioned above, i then go through each loan individually to and look at the payment history.  each loan listing will show all the payments that have been made by the borrower and indicate whether the payments have been by made by automatically (i.e. by debiting a bank account) or manually (either by a transfer initiated by the borrower or by check).  an example of what i am talking about is shown below:

screenshot showing borrower's payment history

 


as mentioned above, it is a manual process to screen each note (which i hope prosper and folio address with an API) but once i confirm that a borrower has not previously missed a payment, i then bid the note based on my fund's return objectives (taking into account the remaining maturity of the note).  for those of you who don't know, prosper's secondary platform is similar to ebay.  note sellers can either choose to list their notes at a fixed price or can choose an auction method (subject to a reserve price).  given the filters that i've set and the fact that i am not overly aggressive with my bids, it has taken some time to build my portfolio and i still have funds to be allocated.  however, as it stands, my portfolio is comprise of notes with the grades shown below.  

current allocation of prosper notes by grades

the average yield to maturity of the notes i have purchased is 13.55%.  there is currently one note that is now in collections and unfortunately, it is a rather large position relative to the portfolio.  assuming it is written off, my returns to date will be in the low single digits.  however, i intend to keep implementing this strategy for the forseseeable future and will keep you posted as to my results.

anyway, i hope you have found this post interesting.  as always, i would be very interested in hearing your thoughts about these investment strategies of any other issuers related to p2p lending or crowdfunding

**********

1. The following chart is from the LC website as of today

2. i am fully aware that "Loan Purpose" is a self reported field but for the reasons stated, i've decided to accept this risk

3. for those who don't know, even while loans are being funding, LC (and Prosper) continue to review the borrower and may decide to to allow a loan request to be funded even if investors have committed to fund the loan

So Step 1 of my analysis is to try and realistically answer questions 1, 3 and 4 (question 2 will be addressed later) - in order to answer these questions, i try to (a) determine the year in which i think an exit is realistic (either by a sale of the company or a subsequent round of financing into which i can sell), (b) estimate the earnings of the company in that year and (c) determine an appropriate P/E ratio for the company¹

i generally don't have much basis for making the assessment in sub-step (a) other than what information the company provides.  absent any specific guidance from the company, i typically model out a 4 year investment horizon. i feel that 4 years is an appropriate amount time for a company that is seeking an angel investment to either sell itself, raise another round of financing (into which i would be able to sell my shares) or fail

sub-step (b) (estimating earnings) is in and of itself a challenge which i'll try to address in a future post - again, i rely on the company's projections and also model my own projects using what i consider reasonable estimates for growth rates (both of revenue and expenses)

finally, in order to complete sub-step (c), i simply use publicly available resources to find an appropriate ratio based on the industry that the company is situated²

after determining the exit strategy and 'terminal value' (i.e. how much the company will be worth at the time i hope to exit), Step 2 of my analysis is to determine the IRR on the investment (based on the price of the investment and assuming results of Step 1 are accurate)

generally speaking, angel investments are either in the form of equity or convertible debt.  in the case of equity, it is straight forward to determine the cost of the investment.  however, in the case of convertible debt, a few additional assumptions are necessary which i will address when reviewing an actual investment

the purpose of Step 2 is simply to check if the investment will generate a return above a certain threshold - in my case, i've set the threshold at Step 2 of 60% p.a. (or roughly a 6.5x cash-on-cash return assuming an exit in 4 years)

finally, in Step 3, i apply a 'probability matrix' to determine the range of possible returns -  this step involves coming up with 48 different return scenarios by varying (a) the dilutive effect of subsequent rounds of financing, (b) the time frame before i am able to exit and (c) the value of the company at the time of exit.  i then assign a probability to each scenario and determine if the probability weighted return still satisfies my return objective (15% p.a.)  since i am coming up with 48 scenarios in which the company actually survives, this leaves 52 scenarios in which the company fails (and my investment is a complete write off).  based on the literature, a 52% failure rate by start-ups is probably too low if one looks at the entire universe of startups.  however, because i am investing through crowd-funding portals that (purport to) vet the companies i am comfortable (at least for now) with this assumption.  with some time, there should be more statistics available that demonstrate the success/failure of companies that raise funds through various crowd funding platforms so i'll be able to tune this assumption accordingly

the following are my typical scenario adjustments - however, i'll tailor the adjustments depending on how much volatility i believe there is in the potential outcomes:

• with respect to dilution, since i don't reserve money in order to participate in subsequent financing rounds of a company, i assume that my initial investment will be diluted by 10%, 25%, 50% and 75%
• with respect to time of exit, i create scenarios where i will be able to exit in 3 years, 5 years and 8 years
• with respect to value of the company at exit, i adjust the value determined in step 1 by +10%, -15% and -25%
  

of course, Step 3 only works if i can appropriately assign a probability to each scenario.  given how little control i will actually have over the company, i currently assume that each outcome is equally possible (i.e. the is a 52% chance that the company will fail and a 1% chance that one of the other scenarios will occur) - i know this is a pretty simplistic approach so any input you may have will be appreciated

Application of General Framework to Company 1

• i buy too high
• i sell too low
• i sell winners too fast (loss aversion)
  
• i hold on to losers too long
• i am very prone to confirmation bias (the tendency to search for or interpret information or memories in a way that confirms one's preconceptions)

angel.co
circleup.com
fundable.com
gust.com
microventures.com
seedinvest.com
[please add to the list in the comments section]

http://www.angelresourceinstitute.org/
http://www.angelcapitalassociation.org/

One question that i am sometimes asked is "how do you know that the interest you are earning on a p2p loan adequately reflects the risk you are incurring?"

As mentioned in my prior post, part of my day job involves reviewing and analyzing asset-backed securities (ABS).  Within the universe of ABS are securities backed by consumer credit - typically credit card receivables.  However, earlier this month, Springleaf Financial was able to issue an ABS backed by consumer loans similar to loans issued by Prosper and Lending Club - more information on the Springleaf transaction can be found in this Reuters article.

According to the reporter, the "BB" S&P rated notes was priced to yield 5.5% p.a. with an expected maturity of 3.3 years.

What does this mean and how can we use this information to determine whether or not p2p loans provide good value to investors?

Let's start with the assumption that the investors buying the "BB" rated notes are sophisticated investors and after considering various investment opportunities, these sophisticated investors have determined that exposure to "BB" rated ABS backed by consumer loans should produce a return of 5.5% p.a. for 3.3 years of risk.

Next, let's try to proxy what 3.3 year "BB" risk translates to in terms of a probability of default (or expected loss).

According to S&P's historical data from 1981 through 2010, over the course of a year, 0.95% of "BB" rated bonds defaulted¹ - on in other words, a "BB" rated bond survived for one year 99.05% of the time.  Using basic probability theory, a 3.3 year "BB" rated bond should survive to maturity 96.91% of the time (or should be expected to default 3.09% of the time).  This of course translates into an expected return of 5.33% p.a.² for the "BB" rated ABS issued by Springleaf.

Now, let's try to compare this to Prosper and Lending Club loans

Of course, S&P does not rate any of the p2p loans and there is no mapping between an S&P "A" rated credit vs. a Prosper "A" rated credit vs. a Lending Club "A" rated credit etc.

However, each borrower is required to provide their FICO score in order to qualify for a loan - and a FICO score can be used to derive a probability of default.³  Interesting, the newly created Consumer Protection Financial Bureau published a study in September 2012 and as part of the study, they derived the probability of default from borrowers' FICO score and the result is shown in the chart below:



Its hard to see on this chart but i found the following information online:⁴

FICO Score	Probability of Default
670-679	14.50%
680-689	11.80%
690-699	9.70%
700-709	7.70%
710-719	6.40%
720-729	5.30%
730-739	3.90%
740-749	3.20%
750-759	2.40%
760-769	2.10%
770-779	1.90%
780-789	1.40%
790-799	1.00%
>800	0.90%

If we are trying to compare p2p loans with "BB" rated ABS backed by consumer loans, we should be investing in p2p loans that have ~3% chance of defaulting.  This translates into investing in borrowers with a FICO score of ~750.

The following is information provided by Prosper⁵ and Lending Club⁶:

Prosper Grade	Average FICO	Lending Club Grade	Average FICO
AA	808	A	747
A	761	B	709
B	728	C	692
C	719	D	683
D	699	E	682
E	679	F	676
HR	683	G	670

As always, please let me know if you have any questions or comments

• Recall that the Bank hedged its interest rate risk most likely with counterparties that required the Bank to post collateral. As interest rates continued to decline, the Bank experienced significant cash outflows as counterparties made their margin calls. Because the City does not post collateral (which could have been rehypotheticated), the Bank must utilize other sources of funding which are increasingly expensive as its own credit quality has deteriorated.
  
• Moreover, because the City has been downgraded to ‘junk’ status, the Bank cannot be certain that it can collect the 50 million dollars if the City were to default and as a result, the Bank is required to write-down the value of its asset (commonly known as a CVA adjustment).
• Finally, regulators keep pushing the bank to incorporate specific provisions of Basel III which are designed to mitigate the risk associated with having un-collateralized derivatives balances. Because of the additional capital that must be held by the Bank, its return on equity is significantly impacted.

1. It needs to fund the margin requirements on its own interest hedges

2. It needs to write down (or at least reserve) some or all of the $50 mm due to the credit riskiness of the City (CVA charge)

3. It is (or will be) required to hold a significant amount of additional capital against the position when certain provisions of Basel III are implemented.  The associated lower return on equity will put downward pressure on the Bank's stock price.