Lending Club and other peer-to-peer lending platforms have gotten a lot of attention in recent years because of the promise of double-digit income returns that can obtained by lending money to borrowers at a generally high rate of return.
My review of the Lending Club platform is that investors are once again somewhat intoxicated by the idea of high returns and are ignoring the fact that: (1) Lending Club relies upon Kroll to supply half of its ratings of borrowers, and Kroll predicts the lowest rate of default in the entire industry; (2) the debt is unsecured—that is, fully dischargeable in bankruptcy and likely not worth the hassle of collection in the event of default; (3) some investors are grumbling about high default rates now, which makes me really worried about what will happen during the next recession; and (4) the interest paid out through Lending Club is taxed at your regular income tax rate.
Lending Club’s Real World Pre-Tax Performance
The results for the typical Lending Club investor does depend upon the grade of risk that the investor is willing to assume. The available interest rates range from 5% to 27%, depending upon the risk of the borrower.
Each Loan is graded A through E on a sliding 1 through 5 scale.
The classifications A1 through A5 are for borrowers with the lowest risk of non-payment, and this class yields interest between 5.31% and 7.96%.
The B1-B5 class gives investors interest rates between 9.43% and 11.98%.
The C1-C5 class gives investors interest rates between 12.61% and 16.01%.
The D1-D5 class gives investors interest rates between 17.47% and 21.85%.
The E1-E5 class, which is the riskiest classification of investors, gives investors interest rates between 22.90% and 26.77%.
The general recommended strategy for maximizing returns is to load up on B class and C class loans with a small sprinkling of compelling D class loans to target total returns around 10%. If you limit yourself to only A class and B class loans, you can do all right but you’ll largely end up with returns under 7%. Once you get into the C class of loans, you’ll start to see a default rate creep up towards 10%, but the interest rate payments are high enough to leave you with higher total returns than if you merely limit yourself to only the A and B class.
I recommend only sparingly investing in the D class and E class of Lending Club borrowers. This is where the common sense and human nature component of the analysis kicks on.
For those who D and E class borrowers who have to pay 17% to 27% interest, they have already defaulted on prior commitments prior to the one that they seek from you. Also, common sense kicks in. People don’t like to borrow $5,000 for something only to pay back $25,000 over the lifetime of the loan period. Remember, all lending club loans are unsecured loans that are dischargeable in bankruptcy. Borrowers don’t really care to pay 25% interest. They will ignore it, and if pursued vigorously, file for bankruptcy. Lending Club doesn’t tell you the default rates for the E class, though there are various angry Lending Club E class investors that are upset with a default rate in excess of 40%.
In short, if you invest in A and B class loans, you will earn returns of 6-7%. If you purchase the optimal mix of B class loans and C class loans with a sprinkling of A and D loans, you can optimize your Lending Club portfolio for returns in the 10% range. If you load up on D and E class loans, you will be back to those 6-7% returns that the A class portfolio receives because the default rate will be so high.
Lending Club’s Loan Grading Policies
The subprime mortgage crisis occurred, in part, because borrowers with high debt and non-recession resistant cash flows took on monthly payment obligations that could not be honored. These borrowers were able to obtain better-than-warranted loan amounts and interest rates because the banks preferred to use ratings agencies that would predict the lowest default rates for the banks.
As the recent article “Marketplace Lending’s New Ways Look A Lot Like The Old Ones” indicated, Lending Club seems to be picking up the big bank habit of relying up on loan graders that give them the grades that they want.
One ratings agency, Moody’s, analyzed a portfolio with a likely default rate in excess of 10%, and was discarded from the Lending Club’s rival Prosper’s system altogether and now only issues ratings for a single-digit percentage of Lending Club’s borrowers.
Ratings service Kroll, which predicts the lowest rates of defaults, is the rater of choice for 50% of all peer-to-peer lending deals. This should be a major red flag for those who outsource their thinking about a borrower’s particular risk profile and instead relies upon the accuracy of what the rating agencies provide. If you rely on the projected default rate that you see on Lending Club, there is a 1 in 2 chance that it was prepared by Kroll, which projects a lower default rate on average than all of its rating agencies peers.
Peer-to-Peer Lending’s Taxation as Regular Income
New investors to the peer lending markets may be surprised to learn that the tax rate for the interest that they receive on their loans is taxed at the federal and state rate. It is not inconceivable to draw up a scenario in which affluent investors pay a cumulative tax of over 40%–i.e. if they invest $100,000 into a basket of notes that pay out 7% interest, or approximately $7,000, they might only end up with a post-tax return in the $4,000-$4,500 range on their investment. This is a substantial handicap and disadvantage for those who choose to investing in peer-to-peer lending.
Lending Club’s Recovery for Defaults
Lending Club, rather than you as the investor, has the exclusive contractual right to pursue recovery in the event of a default—which Lending Clubs records as a “charge-off” against your account.
Although Lending Club has the theoretically right to collect, this does not mean that Lending Club will actually do so. If a person or entity relies on peer-to-peer lending, and is not a part of the lowest risk classifications, there is a fair chance that you are acting as the lender of last resort.
As the ancient maxim goes: “You can’t squeeze blood out of a turnip.”
As a practical matter, Lending Club would have to spend $2,500-$4,000 in court fees, attorney fees, and collection fees seeking recovery. If the person who defaulted does not have any equity in assets, such as a house, a car, or a bank account, then there is no point in pursuing the litigation because you can’t get a lien against any real or personal property to satisfy the judgment.
Alternatively, bankruptcy is also a realistic option for those who default.
Although the borrower’s contract with Lending Club requires the borrower to pay Lending Club’s court, attorney, and collection fees associated with the default, the real-life result is that the lender usually eats these costs because individuals unable to pay back loans are usually also unable to pay back the costs that accumulate as a result of being unable to pay the loan.
If you see a charge-off on your lending club account for a default, there is a very high probability that those funds are permanently lost and will not be repaid via any collection activity. However, there is no official data that discloses the typical recovery rate for a charge-off, which perhaps is in indicator of Lending Club’s limit success in this arena.
In the event that Lending Club does recover any funds via coordination with a collection agency or litigation, you will be charged a fee between 30% and 35%.
Lending Club’s Default Rates During A Recession
Bankruptcies get written off a borrower’s record seven years after they receive the discharge. That means that, for borrowers who defaulted heavily during the financial crisis of 2008-2009, their data points are no longer of the overall credit profile that you are considering. Some states permit consideration of defaults (regardless of whether or not in the bankruptcy context) for up to ten years, but because Lending Club wanted to roll-out a consistent national platform, it relies upon seven-year credit records to comply with even the most restrictive of credit profiling state laws such as those in Connecticut and California.
It is fair and just that troubled borrowers have gotten a fresh start in life, but the data that the investors consider is flawed because the prior seven-year period does not include a recession.
If there are some portfolios with B and C class notes that have a default rate of 10% and portfolios of D and E class portfolios with default rates in excess of 30% right now, what is going to happen when a deep recession strikes?
People write about Lending Club investing as though it is a fail-safe way to earn money, primarily because nearly all conceivable loan portfolios have yielded positive returns over the past seven years.
But I am uneasy that Lending Club (as well as Prosper and others in the peer-to-peer lending industry) has adopted the pre-recession big bank habit of favoring ratings agencies that tell them what they want to hear—i.e. evaluations of borrowers that projects a low default rate, thereby inducing more users to the site that want to loan money.
I also think investors, still starved for income due to low interest rates, are setting aside common sense because the recent returns have been generally positive.
We are talking about unsecured debt. If someone is at a point in life where they are borrowing money at a 12% interest rate, they are not going to be afraid of neglecting to pay—it would be a waste of Lending Club’s resources to hire an attorney to go after a few thousand dollars, and plus, the debtor can always turn to bankruptcy to have this money discharged. The true nature of the difficulty in collecting an unsecured debt from someone who is eligible for bankruptcy may not teach the hard lessons until the next recession.