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. 

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