p2p lending strategies

in my last post, i described my basic financial analysis strategy for reviewing an angel investment - but for those of you familiar with the g&j fund that i manage, you'll know that ~40% is allocated to fixed income investments and this post will be on the strategy i have employed to date in making my fixed income investments

currently, the fixed income portfolio is comprised of investments in consumer loans originated on the Prosper and LendingClub websites (some background on consumer loan/p2p investing can be found on one of my previous posts and a very good and compressive primer is available for free at lending memo)

before i begin describing my strategies, i want to highlight that much has been written on p2p lending strategies and many of the more prominent websites are listed in my blogroll - my favorites are lend academy, nickel steamroller and interestradar.  anyone who is interested in p2p lending should read through as much material as they can before developing their own strategy.

p2p lending strategies

based on my personal experience with navigating the sites and doing my own research, i chose to implement 2 completely different strategies

LendingClub (LC) Strategy

with LC, i have decided to primarily rely on LC's underwriting and screening but have applied a few filters of my own.

as a result, i only fund loans:
  • 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
 

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Comments

  • 3/15/2013 6:13 PM Peter Renton wrote:
    Interesting post Sam. I have two comments:
    1. By analyzing the data history you will find that the highest performing loans at Lending Club are the debt consolidation loans. I know this data is self-reported but the fact remains this category has performed well. So, I think you are making it harder for yourself by excluding that category.
    2. Your Prosper experiment is interesting. I have heard of a few investors focusing on seasoned loans with a good track record of payments. I have not done it because as you point out it is a very labor intensive process. I will be interested to see how you do if you stick with your strategy over a long period of time. Keep us posted.
    Reply to this
  • 3/15/2013 11:26 PM writing2reality wrote:
    Nice article; you have some very different Lending Club criteria! I have actually not seen many people utilize a filter excluding debt or credit consolidation loans. It would definitely be interesting to see how this strategy performs, and something I would be very interested in reading. Historically speaking there have been some definite struggles with those investing in small business loans.

    Good luck with your peer-to-peer lending investments!
    Reply to this
  • 3/16/2013 10:16 AM Sam wrote:
    Interesting article - I plan to watch this space to see how your portfolios perform.

    I find it interesting that you are comfortable with small business loans, but not with debt / credit card consolidation; while I don't exclude small business loans from my LC strategy, I consider myself to be taking quasi-equity risk in the borrower's business. If the business fails, can the borrower repay using own funds?

    Conversely, A, B and many C grade loans will have a lower interest rate than most credit cards, thus saving borrowers money. One or more banks have already determined that the borrower can afford a high monthly payment, so lowering this payment should result in less risk to the lender. I share your concern about borrowers incurring more credit card debt, but this, like the quasi-equity risk I take in small business loans, does not deter me.

    I would encourage you to try the LC secondary market. It is far more liquid than Prosper's and should allow you to build your portfolio more quickly than the Prosper secondary market. Once you get used to the interface, you should be able to identify notes which meet your criteria as quickly as on the Prosper platform. You can also try Interest Radar for this purpose, which is a great site.
    Reply to this
    1. 3/16/2013 11:59 AM samuel hu wrote:
      Thanks - i've been told about interestradar's tools but unfortunately haven't had the time to check them out yet - i definitely look into it more

      just using the filters that the LC secondary platform provides, i find that most sellers list their notes at a significant mark-up resulting in negative yields (which i don't think is possible on the prosper secondary platform)

      good luck with your investing as well

      Reply to this
      1. 3/16/2013 12:24 PM Sam wrote:
        Yes - there are a lot of negative yield notes on the LC platform. Sorting by markup or yield will help you avoid these
        Reply to this
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