Over the weekend Lending Club released its loan data for the first quarter of 2015. For those who are brand new to this investment, Lending Club releases new data about six weeks after every quarter completes. The rest of the loans (IE: those issued before last quarter) update their payment status every month.
Sites like NSR then take this data and package it for the public, and interested parties like myself can dig through it and discover how Lending Club has changed and how past quarters of issued loans are performing (what percentage are defaulting, etc).
Interest rates have continued to drop.
As a result of this new release, I was reviewing the performance of my filters and happened to glance at NSR’s Canned Charts page showing the interest rates of the most recent month. Comparing them to last quarter, I was surprised to see that rates have continued to drop. The interest rate on the average B-grade loan had dropped from 10.45% to 10.09% in just three months.
I then took a step back and examined how loan rates had adjusted in 2014 and 2015 combined. The results were pretty stark.
In his interview in February, Lending Club CEO Renaud Laplanche had confirmed that interest rates had been dropping at Lending Club over 2014, but I had no clue the impact was this large. The average return at Lending Club has fallen over 1.5% in the past five quarters alone.
Borrower Rates on B-E Grade Loans Have Tanked
Pulling back the examination period to two years ago (March 2013), the hardest hit have been grades B through E. The very hardest hit loans are C-grades, having fallen 2.5% in the past two years:
That said, pretty much every grade has been impacted. Here is a sheet cataloging how every loan grade at Lending Club has changed in the past two years.
- A-grade rates have dropped 0.7%
- B-grade rates have dropped 2%
- C-grade rates have dropped 2.5%
- D-grade rates have dropped 1.9%
- E-grade rates have dropped 1.9%
- F/G-grade rates have increased 0.8%
The F/G-grade increase would have been something for investors to celebrate, but they represent just 4% of the loans Lending Club issues, and act as more of a loss leader to get investors interested. In contrast, 96% of the loans Lending Club issues have had dramatic reductions in their interest rates.
Interest Rates at Lending Club since SEC Approval
Things really come into focus if we pull the date back to the first quarter of 2009 when Lending Club emerged from its quiet period with approval from the SEC.
This chart reveals two things. First, how Lending Club has consistently decreased interest rates since late 2012. Second, how they had increased them just two years before that. Lending Club raised interest rates over 3% from late 2010 to mid 2012. Lending Club’s current average interest rate of 13.2% is not a historic low. That belongs to the last quarter of 2010 when the average loan was issued at 11.7%.
Is the Current Rate Decline Slowing Down?
An interesting picture forms when we examine the percent change between quarters and add an overall trendline:
Lending Club largely kept their rate the same in 2009 and 2010. But they began to shake things up in 2011, dramatically increasing rates until 2013 to increase investor demand. Since this point, it has been nothing but a consistent reduction in the overall rate as their needs switched to enticing more borrowers.
Lending Club’s push into lower rates may be slowing down.
That said, the trendline on the far right of the chart is beginning to curve back towards the horizontal axis. The reduction in the first quarter of 2015 is the smallest it has been in a year, and suggests that Lending Club’s push into lower rates may be slowing down.
The Relationship of Interest Rates and FICO Scores
What’s really fascinating to me is how the average of all these quarterly changes is just +0.03%. 2015’s rate decreases are historically matched point-for-point by rate increases. So it’s possible to make the conclusion that Lending Club is simply very dogmatic about its loan standards, and that things on the whole have been consistent for the past six years running.
But that’s really not the full picture, as seen if we overlay the average borrower rate with the average FICO score of these same borrowers:
This FICO number is the average borrower’s credit score. It is a measure of how risky the overall investment is at Lending Club. People with higher credit scores (like 760) are safer investments. Those with lower credit scores (like 660) are riskier investments.
See how the blue and black lines evenly cross each other in the middle of the chart? For five of the past six years there has been a strong inverse relationship with interest rates and the average FICO. If Lending Club increased the risk of their investment by dropping the average FICO, investors would be rewarded in tandem with increased interest rates.
Interest rates and FICO disconnect
But in 2014 something changed (highlighted in yellow). Lending Club began to lower interest rates without adjusting FICO at all. Basically, for the first time in their company’s history they began to decrease the reward for investors without decreasing the risk.
What does this mean for investors? Default rates generally stay the same while interest rates go down. In short, a substantial decrease in our overall return. In his interview, Laplanche did suggest that the new lower rates create more “positive selection” by borrowers that lessens the overall default rate for investors.
“By [lowering interest rates] we believe we can generate more positive selection. For example, this means people who now take a 10% loan offer, but who would have rejected a 12% offer, are typically also higher quality borrowers. So the belief is that part of the rate cut will be absorbed by lower defaults. Even though interest rates have dropped by something like 1%, the reduction in investor returns should actually be less than that.”
Renaud Laplanche, CEO of Lending Club
That said, it remains to be seen if this positive selection pans out out as hoped. In all honesty, these are uncharted waters for Lending Club.
Investor Returns Have Fallen Almost 2% in Two Years
If we take the average borrower rate and subtract 6.5% in defaults and 1% in fees, we can compare it to the current return investors have yielded per quarter to suggest where things may be headed:
The blue “Current ROI” line swings up at the end because borrowers have not had a chance to default on these newly issued loans. The black line is a rough guess of the return investors earn once loans have been paid back or defaulted. This line has seen a 1.88% decline since mid 2013. The new normal for Lending Club investors may be an average return of just 5.7%, and this return could even drop a bit further in the coming year.
In the past, people like myself have cited peer to peer lending’s average return of 5-9% depending on how much risk is taken on (loan grades selected by investors). So if we take the new average and again add 2% boundaries, we get a projected investor return of 3.7% to 7.7%.
Peer to peer lending has changed.
Much of this is speculation. A more accurate projected loss curve should be available in 12-18 months. That said, I think investors need to be acutely aware of these new lower interest rates. Peer to peer lending has changed. Folks shouldn’t enter this investment assuming a 7% return when they actually go on to receive 5.5%.
[It’s important to note that applying a 6.5% default rate across the board is a very inelegant method to predict returns on completed loans. That said, 40% of the loans at Lending Club have a 5-year term, and the default rate for these is much higher than the 5% average for 3-year loans, so I feel 6.5% is a decent (if slightly generous) place to start. If somebody can provide me with a more nuanced projected default rate, I will gladly update the above chart.]
2015: The Year of the Borrower
This article could come off as highly critical toward Lending Club, but that’s not really the case. Instead, I see Lending Club responding naturally to the pain points of their industry. The reason they increased interest rates from 2012-2013 was to increase investor interest. Once investor interest was effervescent and dollars were committed to funding new loans, the new barrier toward growth for Lending Club has been finding new borrowers, and the continued lowering of rates for the past two years is their effort to address this new need.
Indeed, 2015 could rightly be deemed the Year of the Borrower in peer to peer lending. People with credit scores around 695 are qualifying for $13,000 unsecured loans with a fixed rate of 13%. Amazing. These new rates are sure to be warmly appreciated by people who turn to Lending Club for help to get out of debt.
I do wish Lending Club was communicating this reality better to investors. This could be done by sending a simple email to their investor population that outlined the reasons for the new lower rates, along with an honest expectations around future returns.
Overall though, investors need to realize that this investment exists within a market, a continually shifting balance between investor supply and borrower demand. We should not assume that performance during one year is representative for how things will be forever. We may be frustrated that Lending Club no longer gives us C-grade loans at 15.8%, but they do this because there are many investors who are eager to pick up C-grades at the new 13.3% rate.