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How to run your own bank

Both Prosper and Lending Club have been around for quite a while now and with the recent IPO debut of Lending Club on the NYSE, P2P lending has been getting ample amounts of press coverage.  However, both companies have been steadily gaining ground for a while and now have loan originations in the billions of dollars.  Along with the previous investment of Google in Lending Club, it is clear this new form of retail investing is here to stay.  Most of our readers are likely familiar with the operation of P2P lending, and what Prosper and Lending Club have done for the industry, but are probably less sure about how this type of asset class can be incorporated into their investment strategy – and more importantly the risk dynamic P2P lending adds to one’s portfolio.

Technically speaking, P2P lending falls under the fixed-income bracket of investment vehicles, putting them in the same category of generally boring, “safe” things like bonds.  These securities usually have fairly low returns, but at the same time are assumed to have less risk than equities and more predictable outcomes.  However, with P2P lending you have the possibility of seeing returns far greater than what you would see investing in bonds or CDs.  In fact, it’s possible to even beat out the average return on equities if you pick the right notes.  But does this translate instead to basically holding junk bonds or sub-prime loans?  As with any investment strategy, you need to manage your risk.  With P2P lending there are a few areas where this can be managed and built into your strategy:

  • Percentage of overall investment strategy
  • Note selection criteria
  • Size of individual note investment
  • Terms of notes (all notes are unsecured)

Both Prosper and Lending Club both have loan terms of either 36 or 60 months and deal in only unsecured loans at the time of this article.  This means the debit has no collateral, or in other words, no lien on any asset from the borrower as would be the case, for example, in a car loan.  Because of this if a borrower defaults on a note generally it is more difficult to recover the loss.  Both Prosper and Lending Club do have collection services which will contact the borrower and attempt to recover the late loans, however the only real repercussion for a delinquent borrower is a hit on their credit rating.  Notes that have charged off are sometimes passed off to other collections agencies, in which case you might be able to recover some of the loan value (although from my experience this is rare).  Additionally, it should be noted both companies have secondary markets where you can sell notes to other issuers, this gives lenders the flexibility to liquidate their account if they need to, although depending on the number of notes, this may take some time.  There are also limits on what notes can be sold.  Lending Club restricts the sale of notes that are overdue.

So what percentage of my portfolio should consist of P2P Lending?

As with any investment strategy, this depends on a number of factors and the risk appetite of the investor.  Generally I would allocate P2P lending as a subset of my equity holdings but with the caveat that P2P assets are by no means liquid.  It could take months for someone to sell their notes on the secondary market in order to take their account to cash.  With this in mind, P2P lending falls somewhere in between the riskiness equities and fixed income.  Depending on what your current investment strategy is, diversifying your equity exposure into P2P would be my suggestion.  Think of P2P lending as investing in another company within your equities portfolio.

Which notes should I select?

This is the most apparent mechanism to manage your risk and will be covered in a later article in more detail.  There are many great resources that you can utilize to develop your own strategy, or see what others are doing.  Both Prosper and Lending Club publish their historical loan data, this is hugely valuable when designing your own criteria to select notes.  There are dozens of parameters you can use to filter notes, including the industry standard FICO credit scores along with the proprietary rating mechanisms that assign an arbitrary grade to each note.  This data, if analyzed properly, will provide huge benefits.  By filtering and slicing this data, you can develop a note filter that will work for your risk appetite and deliver the highest yielding notes for your portfolio.  Investing time to develop a good filter will pay off dividends as your notes mature.  Also, don’t hesitate to invest in higher risk notes.  Although they obviously do carry a higher risk of default, with the right strategy they will outperform higher note grades.  As an example, below is an outline of one of the filters I use to drill down to the notes I invest in:

  • Loan Grade
  • Loan Purpose
  • State
  • Inquiries in the past 6 months
  • Debit to Income Ratio
  • Months since last delinquency
  • Housing status
  • Monthly Income
  • Public Records on File
  • Current delinquent accounts

So how much money should you invest per loan?  A good rule of thumb is to never invest more than .5% of your total account value.  In fact, I try to invest the minimal amount possible while keeping my percentage of outstanding principal as high as I can.  If there are a lot of notes on the market, I can usually get away with investing the minimum $25 for Lending Club without any problem.  However, if the markets start to get thin, I can increase that amount to keep my money invested instead of sitting idle.

Expected Returns

At this point I’ve been investing in both Prosper and Lending Club for over a year.  As an example, below are the returns I’ve experienced:
P2p Graph

Please note the returns for Propser and Lending Club individually do not take into account charge offs, total rate of return does however.  On average I’ve seen an annual rate of return around 11%-12% which is in-line with the models I used when developing my filters.  I include these figures merely as reference.  Each investor should invest in P2P lending as they see fit, and this type of investing isn’t for everyone. But for those who do, the 15-30 minutes spent each month is well worth it.

Resources

Here are some of the resources I’ve used when researching P2P lending:

http://www.lendacademy.com/ Excellent blog and other resources regarding P2P lending.  They also have an active forum community and put on an annual conference for P2P lending.

https://www.nickelsteamroller.com/ The best site in my opinion for P2P lending analytics.  Their interface allows you to develop your own custom filters and backtest with historical data.

https://www.peercube.com/ Another analytic site which has similar functionality to NSR.

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