p2p lending -- risk / reward analysis

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

Putting it all together, we can 'conclude' that investing in "BB" rated ABS backed by consumer loans has similar credit risk to investing in p2p loans graded "A" by both Prosper and Lending Club.

So - the million dollar question is....what is the yield of an "A" rated Prosper and Lending Club loan?

Again, we can look to historical data published by both Prosper and Lending Club.

In the case of Prosper, "A" rated loans yield 6.25% p.a. and in the case of Lending Club - 5.61%

Conclusion

This analysis is certainly not an apples-to-apples comparison but i think its at least fruit-to-fruit.  Compared with investing in a "BB" rated ABS backed by consumer loans, investing in a p2p loan with a similar credit profile provides an incremental pick-up in yield (in the case of Prosper loans) or at least very similar returns (in the case of Lending Club).

However, unless you are a large institutional investor, you probably will not have an opportunity to buy "BB" rated ABS backed by consumer loans.  So if you want to invest like a large institutional investor and earn similar returns for incurring similar risks, p2p lending may be your best option.

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

****
There are certainly some shortcomings of this analysis including:
  • the data i used for deriving default probability from a FICO score didn't specify the time horizon for which the probability of default is applicable (remember, survival probability always goes to zero....)
  • the average returns reported by Prosper and Lending Club are not broken out by loan maturity (and p2p loans can be 1, 3 or 5 years)
  • neither Propser nor Lending Club assign their grades based solely on FICO scores - i would expect representatives from Prosper and Lending Club would argue that their "A" rated loans have a much lower probability of default than implied by FICO scores

1. S&P data is for corporate bonds

2. i've assumed a zero recovery

3. as you probably know, unfortunately, FICO (f/k/a Fair Isaac Corporation) does not publish such information

4. i understand that default probability is derived using validation odds charts/tables - i'm just taking what i found online as reasonable assumptions.  for example, another source states that the default frequency for a borrower with a 720 FICO score is approximately 1.6% and increases more than five times when the FICO score to 620.

5. Using data provided for seasoned returns as of Dec. 31, 2012 for loans originated July 2009 - February 2012

6. Lending Club doesn't publish (or at least i wasn't able to find) a Lending Club Grade --> Average FICO score table but you can approximate this information by downloading their loan data


 

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Comments

  • 2/21/2013 9:59 PM Peter Renton wrote:
    Interesting post. Now, I have no idea where the CPFB obtained their data but my experience is that those default rates grossly overstate the defaults rates at the p2p sites Lending Club and Prosper. Keep in mind, these sites reject the vast majority of applicants even with FICO scores over 670 so the credit profile is likely much more conservative than the CPFB study.

    While I have not done a straight study of default rates of different FICO bands at the p2p sites my gut tells me that the rates there are roughly double what is claimed there. Which would mean a FICO of 710 or so which equates to a lower credit grade and a much higher interest rate than what you quoted.
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