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| PLW recommends Lending Club |
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New investors who sign up via this link
earn a $25 bonus from Lending Club |
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Tell Friends
Everybody is either a borrower or an investor, and many are both! |
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| Yes! I would like to receive a quarterly analysis of peer lending site performance |
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Minimize Risk with a Conservative Portfolio of Low Risk Notes through Peer Lending |
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Benefit from the bank model that has created wealth for centuries |
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The biggest problem with peer lending is that we have all been conditioned to think of loans as risk, not investment. Consider then that for over 2 years not one of the top rated Lending Club loans has been charged-off. That's zero losses, and that's one of the reasons we recommend Lending Club. The investors who select the highest credit rated borrowers to invest in are happy to accept an 8% return in lieu of a 12% return or higher. Other people understand that a calculated number of people in the next to highest credit bracket will default, and that by selecting a portfolio of loans averaging 14% they can net 10%-12% returns. And that's part of the beauty of the Peer Lending model. |
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We provide a roadmap to building the model that is right for you. By understanding six simple aspects, you can construct a smart, low risk portfolio. |
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Millions of people with excellent credit are paying credit card companies 18%-30% per year. |
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Millions of people with excellent credit scores are tricked by credit card companies into paying fees and interest that adds up to as much as 30% per year. High investor returns start here - they are made possible by the over 40 million people who carry credit card balances month to month and pay exorbitant interest rates. |
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Banks won't offer people with excellent credit low interest unsecured loans because they make so much money on their credit cards. |
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The term "tight credit market" sounds like a news story-line until you take your good credit to the bank and are either turned down, or are offered a loan at a very high rate. The very best credit rated borrowers can get money from Peer Lending for about 8% interest, which is very competitive. (These people have such good and predictable payment reliability, many investors are happy to make that loan - I explain more below and under the "Maximize Return" tab). To underscore the value made possible by Peer Lending, one of the largest single groups of people who borrow from Lending Club are Bank Employees! |
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Why Smartly Constructed Peer Lending Portfolios are Low Risk: |
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For people who are interested in a very secure 7-8% return, we recommend looking to Lending Club's "A" grade loans. In two years and thousands of loans, Lending Club has not had any charge-offs in this category. I still recommend 100+ notes in any portfolio, but history suggests that this is a highly reliable investment class. For people who want to target 12% or greater returns, I recommend following the portfolio strategies below. People who don't follow the simple 5 step process can realize a poor return or even lose money. The people who lose money blame peer lending, but it's just the lack of information available to help them succeed. The funny thing is this - Peer Lending is new, but the sites that offer Peer Lending are prohibited by the SEC from providing a roadmap for customers to follow. |
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| Components Of A Low Risk Peer Lending Portfolio. |
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| a. The predictability of defaults: The credit card industry is based on something that most people don't understand, the predictability of default rates by FICO score level. When default rates are predictable, it's easy to set the loan interest rate, deduct the default rate, and have an expected return. |
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b. Diversification: The only way to have the expected default rates work in your favor is to have at least 100 loans, and preferably many more. This is just letting statistics work in your favor, minimizing the impact that any one default has on your portfolio, and enabling your portfolio to arrive closer to the industry standard default levels. |
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| c. Job stability: People who have maintained their credit history at near perfect levels are not likely to let that slip if they can prevent it. There are several things that can cause financial hardship, such as a natural disaster, a divorce, a catastrophic illness, etc. My theory is that almost any of these things can be overcome if the person can hold in to his/her job. With a job you have health insurance, and with a job that has staying power people can usually make it through tough times. Look to the people who, on judgment, are in jobs that can weather the tough economy. |
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| The First Meta Factor: Predictability of Default Rates by FICO Score: |
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| a. |
The consistency of the delinquency and default trends are amazing, and are the basis of the credit card industry's business model. |
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| i. |
People with nearly perfect FICO scores rarely default, and people with awful FICO scores default pretty often. That's what the score is for. |
| ii. |
Have a look at the default percentage chart - notice that the average default rate is 5.4% (shown at the bottom). That's a high number and cause for concern. |
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Now notice that the default scores for people with FICO of 760 or better is less than one half of one percent! Now this is interesting. |
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You can't help but notice what happens as the FICO score gets smaller, defaults skyrocket. No wonder Lending Club only deals with people at 660 FICO and above. |
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| b. |
Prime borrowers have much less volatility in tough economic times. |
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| i. |
Defaults increase during an economic slowdown, but notice in the chart that the increases are many times greater in the sub-prime area versus prime. It's the same but worse for mortgage market. |
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The usual behavior in an economic slowdown is for the delinquencies to go up to twice the historical average for 2-3 quarters. Note that this is a delinquency rate, which is usually 2~3x higher than the more critical metric, default rates. |
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One reason we recommend Lending Club is because they are factoring in a pronounced recession, and are assuming that delinquencies will go up to 3 times the historical average for 2 years (this would be unprecedented, but yet again quite a few things are these days).Lending Club has increased borrower interest rates accordingly to preserve 100% of lenders' returns. |
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| c. |
Credit card data for decades provides a basis for default modeling. |
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| i |
This 36 year historical chart helps explain why the scale of the defaults even in a recession twice as bad as any in the last 36 years, still allows for statistical modeling and predictability of default rates. |
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Note the Credit Card delinquencies started rising in the late nineties, and they became on average much worse through the 2000's, as credit card companies realized that the predictability of default rates enabled them to push credit farther down the FICO score ladder and still manage profits. They also made a decision to try to focus profits on the transaction revenue, and not the spread between cost of money and the rates paid by cardholders. |
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| The Second Meta Factor: Diversification to Minimize Risk |
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| a. |
Use statistics to your favor. The more loans you have the more you can follow the historical average default trends and minimize your chances of falling below (and above) those trends. |
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| b. |
Here's how it works - if you know from the data that at a given FICO score, 4% of borrowers default on their loans, what this really means is 4,000 out of 100,000 people will default. |
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| i. |
That's daunting, but important to understand that if you just get 25 loans, you would expect 1 default per year. However, because you have a small sample size, you could end up with 2-4 defaults per year, as you were unlucky in your sample group. |
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Similarly, you could be very lucky and have zero defaults in a year. |
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The point here is to understand that the fewer notes you have the more variability you have in your actual default rate. Variability is risk, so minimize it... |
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| c. |
Expected Return Curve: In the chart, I show the approximate range of returns people see in peer lending, in what is the "Expected Return Curve". The area under the curve represents all probable combinations of number of loans and respective returns. |
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This is a simple statistical curve of overall returns based on the frequency of default rates. It shows that by increasing your number of loans you have a greater chance of falling within one standard deviation from the average, which is just a clinical way of saying that you have a better chance of hitting the expected return. |
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Specifically, this chart shows the expected returns for a person with and investment equally divided between 400 loans to be between 9% and 11%. Similarly, if the same person had an investment divided among 100 loans, their range could be between 7% ~ 13%. Again, this is because you are taking more of a chance that a few key borrowers will or will not default. |
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| The Third Meta Factor: Job Stability Selection to Minimize Risk |
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| a. |
People with good credit will work hard to keep it. One of my primary theories is that people who have maintained a good credit score (for the seven or so years that the credit is tracked) will continue to maintain their good credit unless they lose their job. |
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| b. |
Credit rating systems do not account for job stability. A curious element of the credit rating system is that it does not take job stability into account. If a person has floated through many jobs over the years but always managed his payments on time, he will have the same high credit rating as someone in a government job for 15 years. |
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| c. |
Who is at risk? In an economy where people are losing jobs at a record pace, the people most likely to lose their jobs are the ones that have: |
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Shorter tenure in their current job |
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Work for companies that are in industries hit particularly hard by the recession (Automotive, financial, development) |
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Have a core skill that has been hit hard by the recession (Financial analyst, construction worker, retail sales) |
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| d. |
Find the survivors: I suggest looking for people who have the indications that both their company and their position will survive tough times. For example, my favorites are: |
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Government employees with long tenures |
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Health care workers |
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Long tenured people in stable companies |
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| e. |
Move the curve right: By carefully selecting the loans and the profiles of the people you loan to, you effectively move the curve to the right, increasing your expected overall return. |
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| Liquidity Enables Access and Options |
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| a. |
Just in case you want your money back, Lending Club enables liquidity by structuring loans in the form of Notes which can be sold on their partner trading platform, accessed directly from the Lending Club site. |
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| b. |
People buy notes from the trading platform because the borrowers behind the notes have a payment history, which is another reduction of risk in creating a portfolio. |
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| c. |
To ensure notes sell quickly, some people will offer the notes at a slight discount, which historically sells out very quickly. That's not a problem because they've already earned at an annualized rate of 9% to 13% on their money, and forgoing one of those percentage points to enable quick access is not a very big penalty. |
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| d. |
Simply select the "trade" tab on the Lending Club site and follow the prompts. |
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| Impressive Safeguards Provided By Lending Club |
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| a. |
One of the reasons that we rank Lending Club to be the least risky of all the peer lending groups is the additional safeguards they have in place. They have put a comprehensive package together that is quite compelling. |
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| b. |
Borrower Fraud Safeguards |
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| i. |
Identity verification |
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Credit report review |
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Fraud scoring |
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Decisioning (borrower membership is denied or granted) |
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Grading (borrower is assigned a grade and corresponding interest rate) |
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Manual review of loan application |
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Income verification (random check) |
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Employment verification (random check) |
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| c. |
Default Prevention and Collections Department |
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| i. |
Lending Club uses auto-debit out of the borrower's account: this typically reduces defaults by 150 basis points (1.5%) compared to a situation where the borrower needs to send a check or initiate a wire. |
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The negative hit on the credit report should be qualified: in the case of PRIME consumer lending, this is a much bigger incentive because people have worked hard for their credit score and will do everything to save it. A negative hit would stay with them for 7 years and could cost them tens of thousands of dollar in higher interest and mortgage rates. |
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The negative hit on the credit report should be further qualified by the fact that those are SMALL loans. It would be stupid to take a credit score hit for the sake of defaulting on a $5k to $10k loan. |
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Lending Club involves strong collections practices a lot SOONER than others: Their collections group takes over the accounts after 15 days, and they send to outside collections typically within 30 days. It is proven that the earlier the collections agencies get in, the higher the chances to collect are. |
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Lending Club uses a collections brokerage system that has proven significantly more effective than just sending loans to one or two agencies. |
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Lending Club reminds borrowers of the personal affiliations they have with lenders in an effort to motivate the payback of the loan. For example, a borrower is more likely to make an effort to repay a loan if he knows the people suffering are from his hometown, or from his university. |
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Lending Club also lets borrowers know that these are individuals they are hurting (stealing from) not institutions. |
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| d. |
Company Viability Safeguards |
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| i. |
In the event of Lending Club failing and closing its doors, the existing loans are managed by a back-up processor. |
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The back-up processor performs all the tasks that Lending Club does today to collect the payments and make the payments to lenders, for the life of the loans. |
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 2009 Rosso Cavallo, inc. All rights reserved. The peerlendingwealth.com site, and its parent company, Rosso Cavallo, Inc. make no warranties, expressed or implied. Financial investing involves risk by nature and you need to evaluate your options with your own financial advisors. Questions or comments can be addressed to info@peerlendingwealth.com |
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