I stood atop a vast mesa. Land stretched in all directions. Streams cut through banks of trees. Mountains marked the horizon.
The air was still.
I detected my prey.
It was yield.
That was back when I first encountered peer-to-peer lending.
The conditions then were not too dissimilar from those prevailing now.
Low interest rates made any type of cash-based savings disastrous. Gummint bonds were basically a no-fly zone. There was uncertainty about the U.S. economy, global stability, politics – you know, the usual suspects of financial gloom and doom.
My financial portfolio already featured a Zeppelin-sized helping of equity ETFs, surgically selected dividend plays and REITs/real estate. So my exposure to the most lucrative, liquid and utilitarian markets was in place.
But I still had some extra cash languishing in checking and savings accounts. Because of limbo-low real interest rates, it was making me all itchy and anxious. Like I was wearing a wool jumpsuit in a sauna.
So I hunted for yield.
Like a grizzled manbeast of yore, I could practically taste the sweet, juicy flesh of cashflow gnashing between my teeth. Unsheathing my great, sharpened staff, I harpooned investments in loans on both Lending Club and Prosper.
What follows is my tale.
Actually, what follows is more than that. We’ll smack around the particulars of what Lending Club (LC) and Prosper (P) offer and why we need them in our portfolios – plus some tips on how to P2P the right way… as in, nothing like I did.
Spare a Dime, Good Sir?
The credit card companies in the U.S. make a killing that would impress Genghis Khan.
Their business model is absolutely, diabolically gorgeous: lend relatively small sums of money to consumers (to buy S-T-U-F they don’t need) for a short period of time and charge ungodly interest rates on the loans.
Now, for us Financia Luchadores, paying interest on credit card debt is a foreign concept. But for most of our esteemed peers, it’s just a way of life. Credit card debt owed by the average U.S. household is around $15,000 – more than $700 billion across the economy.
So let’s pull our slide rules out of our pants and do a quick crunch of the numbers: The average U.S. household is paying around $2,700 in credit card interest each year! I told you it was diabolical.
Now let’s profit from it.
Since we get all teary-eyed here at FL thinking about losing $2,700 annually to something as harebrained as financing crap we don’t need that only clutters our lives, we need to turn this number around so we can see clearly. $2,700 is the annual income we’d expect to receive on a $90,000 asset spinning off 3% in yield. Ahh, that’s better.
And you know what’s really exceptional about this $2,700 per-household profit that credit card companies get? It somehow manages to defy the traditional economic seesaw of risk/reward.
Risk is the likelihood you lose your investment. Reward is what your expected return on the investment is. Higher risks typically demand higher rewards. But, with credit cards, the high profit rewards don’t seem to carry risk commensurate with their upside.
Consider this. The “risk-free” yield on a 3-year government bond is right around 1%. (A 3-year bond is selected for benchmarking because, as we’ll see and dissect in an upcoming post, Lending Club and Prosper loans have 3-year and 5-year maturities.)
The return on an average credit card is about 18 times that! Eighteen times!
You’d expect one hell of a high default rate to warrant that kind of premium, right?
Well, you would. But it just ain’t there. The charge-off rate on credit card loans (from the top 100 banks): 2.9%. Less than 3% of loan value goes bad.
Or, 97% of loaned dollars are repaid, including that cray-cray interest. Risk-adjusting our $2,700 per-household credit card debt doesn’t shave much off the top. It still gives us $2,619.
Those credit card companies got a little sumpin’ sumpin’ good going on.
Just to drive the point home for a nightcap and massage, FL plotted the last 40 years or so of data comparing average U.S. credit card APRs against average U.S. 3-year treasury rates. Naturally, there’s a big delta in favor of credit cards going all the way back.
But what’s really interesting about the graph is how the delta has risen over time. The APRs on credit cards have gradually increased relative to treasury rates. The spread has grown like a mob of hyenas around a lame wildebeest.
From 1974 through 2004, the delta was 9.33 percentage points. From 2005 through 2015, it had increased by nearly a third – to over 12.5 percentage points.
Why do I bring this to your undivided attention? Well, yeah, it is interesting in its own right. But really it’s because of the link between credit card debt, credit card APRs and LC/P notes.
Specifically, Lending Club and Prosper allow indebted consumers to consolidate their credit card debt (and some other types of debt) and take loans from you and me at ever-so-slightly lower interest rates to pay it down.
So the debtor wins by owing less in interest. We win by stuffing our faces with juicy, tender low-risk/high-yield investments. And society wins by virtue of the increased efficiency of the whole thing.
High fives all around.
Can I Really Expect 18 Times the Return of a Government Bond?
Probably not. But you can get close.
After embarking on my profit expedition and setting upon the glorious, juicy yields to be had from peer-to-peer loans, I did what any prudent investor would do.
Without any real investigation into investment strategies, empirical studies on returns or other analysis, I plowed a high-five-figure allotment into loans.
Stupid? Absolutely. Lucrative? Despite my best efforts, yes.
Lending Club is where I made my initial foray. And I’m pleased with the results in general. But I committed one critical error in my investments – one that probably cost me around 4 percentage points in returns.
My error: focusing my funds on lower-risk/lower-yielding loans.
I’ll discuss some empirical studies in an upcoming post that show this kind of allocation to be essentially the worst possible on both Lending Club and Prosper – and that show how to jimmy the risk/return equation on both platforms for FL-sized magnum returns.
Notwithstanding this mistake, after taking into account “charge-offs” (i.e., loans that go bad before maturity), my long-term returns have settled a bit above 5%. Or, around 5 times what I would have gotten with similar time-to-maturity government bonds.
As I said, this relatively low net return rate owes to my investment allocation decision, electing to focus on the “highest quality” loans in exchange for lower expected yields.
Virtually any other portfolio investing in the quantity of loans I purchased would be reasonably expected to have performed better. A 9% annualized return can be readily obtained, according to Lending Club’s data mining of its loan results.
That forgone gain is what I deserve for not being a bit more FL-style prudent with this investment. But my loss is your gain, so enjoy that wildebeest spare rib.
For illustration of the mistake I made, check out these two charts courtesy of LC. Notice how the “lower-quality” risk-adjusted yields are systematically higher.
That sound you hear in the distance? That’s me mercilessly socking myself in the throat.
My annualized returns net of charge-offs (what Prosper calls “seasoned returns”) are a bit south of 6%. Around 6x the returns that would have yielded from gummint bonds held to maturity.
Prosper advertises, based on its own data mining, that 8.89% seasoned returns are to be expected – so long as higher-yielding loans are included in the investment and the holdings are properly diversified.
What explains my relatively poor investment performance in P2P loans? Why the apparent irrationality in my note choices? Why not simply plunge my Benjis into higher-yielding, properly diversified notes that would have returned me a greater overall return?
I have no real excuse.
I’d seen the pretty charts posted above, despite committing no resources to the proper sort of investigation that’s FL-advised in money matters. I knew the benefits of “riskier” notes. Those charts are super-colorful. But my lizard brain amygdala took over (recall: I was out profit hunting; savagery and drooling were part and parcel of my search).
This is behavioral economics 101 in action, actually. It’s called irrational loss aversion, and it manifests when people over-value the benefit of not suffering a loss relative to the benefit of accruing a gain. Bad lizard brain. And, yes, you’re hearing more throat punches.
Yield to Diversity
Lending Club and Prosper both advise investors to commit funds to a high number of loans, keeping per-loan investments at or around the minimum $25.
This is sound advice to be heeded in all instances. There’s no compelling reason to sink more than $25 into a single loan, but there’s a nice benefit: By minimizing exposure to any single loan’s likelihood of default, the overall risk of the investment is driven downward. Thus, the same expected return rate and a lower level of risk. This is the kind of thing we love here at FL – pure economic efficiency.
The crucial question that follows is: How many notes do I need to invest in so I can take advantage of this diversification benefit? The more the better.
But the diversification benefits seem to begin tapering off after about 100 to 150 notes and basically flatten at around 400. Which means that an initial investment value of at least $2,500 is needed to take advantage of diversification on these platforms. An investment of $10,000 or more takes full advantage but doesn’t provide much additional bang for the buck(s).
For those who prefer pretty pictures, here are a few charts and graphs from LC and P.
Now we know we need to get some of these P2P loans in our portfolios, and we have taken the first step in selecting the best kinds of loans to buy.
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