p2p lending strategies
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
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
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:
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.
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
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