Sunday, September 30, 2012

Choosing Loans on P2P lending sites

Since I set forth in the realm of P2P lending, I read about how people choose notes, thought this through, and now I have something to share!

First, do not believe the ratings given by the P2P lending sites (from now onward,  I shorten it to sites to save some typing). Sure, they may use some sophisticated methods to determine the borrowers rating, and they may even have the incentive to be conservative, since they receive 1% of all transactions, i.e. the more a borrower pays over time, they more these sites make. But personally I would set my own standards since I sometimes do not agree with their models.

My current lending club filters are set as the following:

  • 0 delinquencies in the past 2 years.
    I don't want anyone who has been late or had a default recently. 
  • Max 2 delinquencies in the past 7 years.
    Same rationale, but since 7 years is a long period of time, I'd be more lenient. 
  • No public records in 10 years.
    I don't want anyone who had declared bankruptcy. 
  • Loan amount below 20k.
    Higher the amount, higher the risk. 
  • Loan term must be 36 months or shorter.
    Track records have shown that 60 months loans typically go bad much more frequently, exceeding their rate premium.
  • Must have a job, and must have had the job for more than 2 years.
    A steady income is essential for repaying their debt.
  • Debt to income ratio must be below 35%.
    Too much debt then the guy is in a shit hole. He will probably get overwhelmed soon. 
  • Loan purpose must be debt consolidation.
    This one is actually interesting. When I started out, I gave loans to people that want to start a business. But then I thought about it, more start-ups fail than succeed. And to justify the risk, the loan must be convertible, then one can reap profit if a start-up actually makes it. Plus, if someone is willing to take a debt consolidation, at least he does care about his credit history and does not want to make late payments. If in the future he ran out of money again, he might do another round of consolidation. 
Secondly, do not be too risk averse. Many people only buy notes that are rated A or higher. Well, that will cap your return. Sure, notes with lower ratings might have more defaults, but usually the rate premium more than makes up for that. You do get a higher expected variance on individual loans, but then if you diversify, statistically, you will always come out ahead if you invested on lower grade loans. In addition, higher grade loans often gets paid back early, which eats into your return since you have to wait another 10 days or so for your new loan to get reviewed and issued. Personally, I aim for a nominal rate of 16%.

Thirdly, do not invest more than 25 dollars on a single person unless you have more than 20k to invest in this P2P game. When you use lending club's tool, it will often assign investment amounts of more than 25 dollars to a certain loan in order to achieve the desired over interest rate you want, so be careful! The reason for this is that having more money per loan or per borrower, greatly reduces your ability to diversify, and is hugely detrimental to a successful investment. If you can not find enough loans to invest in, it's better to wait than investing multiples of 25 on a single loan. As for the 20k limit, it is there because once you hit 20k, you would have 800 notes each worth 25 dollars, and I think 800 is a large enough number that the chance of you being "unlucky" is very very slim, additionally, the time it takes to manage 800 notes is fairly substantial and you probably do not want to increase this number any further. 

Currently, I have about 7.6k invested in lending club, 600 invested in prosper. Prosper was more of an experiment I ran before I solidified my P2P lending strategy, it currently has a return of about 8.8%. I opened two accounts in lending club, one ordinary and one IRA. I did not follow my rules once in lending club and bought 2 notes on the secondary market that had the same borrower, of course since it is the secondary market, it is not that easy to filter on notes, now I am paying for the consequences: both of them are in grace period and I do think they are heading for default. They are only worth 40 dollars, but that is enough to wipe out most of my returns on the ordinary account that has a balance of 2.6k. Both accounts in lendingclub are currently showing between 16% and 17% returns. 

I will keep you updated on how my P2P lending experience.

Tuesday, September 25, 2012

Consumer Lending

It's been a while!
I was on a recruiting trip lately, and work has been a little heavy :)

Let's talk about consumer lending today. Consumer lending is the generic term used to describe lending to a someone to make purchases that they can't afford in cash, theoretically. The most common form of that is a credit card, essentially, the credit card issuer, usually a bank, offers the card holder a line of credit from which he can get an unsecured loan. By unsecured, it means that there is no collateral, and if the person fails to pay his debts, nothing physical can be taken away from him. (of course, his credit report will be heavily hit by delinquencies, but that is not technically physical).

How does consumer lending concern me, you ask? Well, it's pretty lucrative. Look at the credit card APR, they are 9.99% on the extreme low end and up to 35% on the higher end. Being unsecured, the risk of lending is significantly increased, which dictates a higher return, otherwise, who'd be willing to get involved in this kind of business?

Consumer lending is not strictly limited to banks. A couple of websites came into existence around 3 years ago, offering the opportunities for individual investors to get involved in the business of consumer lending. They call it the P2P lending, but whatever. The idea is that individual investors can elect to fund loans to borrowers, at a rate ranging from 5% ish to 25% ish. The underwriter of those loans are typically the websites themselves, as they will rate the loan and charge 1% of all transactions. The minimum contribution amount is 25 USD, which means you can invest in a couple of hundred loans with less than 10k.

Until a few years ago, this entire consumer lending business hasn't been very popular at all among individual investors, and it is easy to understand why. Firstly, the risk of each loan is pretty high. For a bank like Chase, which has very strict risk controls and utilizes who-knows-how-complex models to decide whether to approve someone's credit card application, the annualized default rate is approximately 6%. Now individual investors do not have the amount of resources available to assess every borrower's risk level, and therefore probably will have an even higher default rate. Secondly, given the high risk level, it becomes imperative for the lender to diversify, but it would be pretty hard to do if every single loan is approximately 10k, since then the requirement on capital is often prohibitively high. Thirdly, the transaction cost is going to be pretty high if one tries to diversify. For an individual to conduct all the researches about all his prospective borrowers, he will have to invest a large amount of time and possibly money, which effectively eats into his return. And lastly, the liquidity is probably less than ideal, i.e. one can not turn the investment into cash in a timely manner.

What changed all these are the websites like lendingclub and prosper. They kind of tackle the high risk issue by limiting borrowers to what they deem to be "prime" borrowers, i.e. people who are very likely to repay their debts. The need for diversification is dealt with by allowing investments at an increment of 25 dollar. The built in filter function reduces the time it takes to browse through notes significantly. And lastly, they introduced secondary markets for notes charging an extra 1% of all transaction value.

I think consumer lending is a fairly promising, although one must keep a clear mind. Here, I'll list some caveats.

  1. The return is often much lower than the websites promise. The nominal interest rate of my notes is 16% ish, but I am fully prepared to get only 6% ish in reality. The reason being that defaults are pretty common. 
  2. Another problem is that interest income is charged at your highest marginal income, which translates to roughly 38% for me. That further reduces effective income. But then, you can mitigate this by putting consumer lending into your IRAs. Personally, I think this is by far the most effective way of utilizing my 5k a year limit since the growth of this money is completely based on interest income. 
  3. In general, consumer lending is far less mature than other forms of investment, such as stocks or regular bonds. And by getting rid of banks as the intermediary, you effectively are losing the "pooling" function of the bank, therefore greatly increasing risk. 
  4. It is less liquid than ordinary bonds. The secondary markets for consumer debt notes have a much less volume, and sometimes takes a while to sell. In this aspect, lendingclub is generally much better than prosper, as once I tried to sell 5 notes at cost, and they sold within a day!
Because of those "drawbacks", I would not put majority of my money into consumer lending. My personal target is 20% of my entire portfolio. 

In the next post, I will discuss my personal approach towards choosing loans. 

Tuesday, September 4, 2012

The big question: Risk vs Return, Part 6

Having discussed the risks and returns of two types of traditional investment vehicles, now let's conclude this somewhat long series :)

Now I am a young person, with a steady income, not very risk-averse, and have a financial goal that I want to meet in about 5 years' time. So my personal asset allocation would be this:

international stockus stocklong-term bondintermediate-term bondconsumer lending

Now I have not discussed consumer lending yet, for now, just understand then as short-term, high credit risk bonds.

So I have a 50-50 split between stocks and bonds.
I am not sure about how this allocation will turn out to be, since I am myself a new investor even though I've done my research. As a general rule, the more risk averse you are, the more you should allocate towards bonds. Even though bonds just had a gigantic decade long bull market, I am personally rather pessimistic as to bonds' performance over the next decade.

I've some data here that you might want to consider when you decide your own asset allocation. Keep in mind, the most important factor here is your time horizon: if you have 20 years or even 30 years, you will be much better off with riskier allocation as they generally return more over time.

Stock percentageBond percentageAnnual return 1926-2011

The assumption here is that you invest in very broadly diversified stock and bond funds with zero expense ratio, like funds that track MSCI US index for stocks or Barclays US Aggregate Float Adjusted index for bonds. Of course, no fund is without expense ratio, therefore, your return will always be slightly lower, probably by less than half a percentage point if your fund is relatively low cost. 

The conclusion should be that the more stocks you have, the higher return. So what about risk? Now here it is:

Stock percentageBond percentageNumber of years with loss

So generally the number of years that a loss occurs increases as you allocate more of your asset in stocks.

This should hopefully help you decide how to allocate your assets. :)