August 6, 2012 – On Lending Club defaults (and their effect on your Portfolio)

According to LendingClub, the default rate for all loans can be found on the following page.

At a glance, it appears that the default rates appear to be relatively low. For example, the default rate for “D” Grade loans is shown to be 6.9%. To some extent, this chart is misleading. The useful and more realistic default rate is much higher – based on the fact that this table from Lending Club includes all loans, even the ones that were just funded and have had no chance to default. This is especially important to keep in mind at a time such as now, when the number of loans funded by Lending Club is exploding exponentially.

Below is a chart showing the default rates of the different grades with different brackets of recently originated loans excluded. This chart also excludes all of the loans under the category “Does not meet current lending criteria”.

Default Rates on Lending Club – CLICK TO EXPAND

Based on this chart, its apparent that the actual default rate is much higher than the rates shown by LendingClub. When relatively recent loans are excluded, the default rate goes up. This is the natural consequence of the fact that as a portfolio of loans ages, loans tend to go bad due to defaults.

So how high of a default rate can one withstand and still have satisfactory returns? The following is a quick, “back of the napkin” style calculation and case study showing how the real default rate influences a portfolio in its first year.

The two examples below assume the following: A $10,000 loan portfolio of purely D grade notes. The average interest rate for D notes is 16.6%. Let’s also assume that 8% of all of the notes funded pay back quickly with little to no interest collected.

1st Case: Let’s assume that you’re not using P2P Analytics and that you’re picking notes close to the average performance for D grade notes. In this case, your default rate for the first year would be about 6%.

*This 6% number is guess-timated in the following way: D grade note default rate with 2012, 2011 and 2010 loans excluded is 16.2%. It is likely that if you excluded all loans younger than 4 years old, this 16.2% number would be slightly higher. For the sake of simulation, lets assume that when a portfolio reaches final maturity, the final result is that 6% of the original loan batch defaults yearly. Albeit, this is a fairly high default rate, but this number is chosen to be on the conservative/pessimistic side. Of course this is also excluding several of the complexities, such as the fact that loans default at various points of payment*

In this case, out of $10,000 invested, you lose $600 in defaults in the first year. Out of this $9,400 remaining, interest is only collected on $8,600 (due to the fact that 8% of loans pay little to no interest because of rapid debt paydown). In this case, one’s total income is $1,427 minus defaults, computed with 16.6% interest. Total returns for the year are about 8.2%.

2nd Case: Let’s assume that you’re using P2P Analytics to select your notes. According to a previous post, its reasonable to expect that the default rate on a portfolio of D grade notes should be reduced by half. This would mean a default rate of 3% per year. In this case, with the same 8% rapid paydown included, one’s annual return would be 11.7%.

Again, this is a quick calculation just meant to demonstrate a different way to think of defaults. If you would like to subscribe to the P2P Analytics note selection distribution, please follow the link at the top right of this page.

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6 Responses to “August 6, 2012 – On Lending Club defaults (and their effect on your Portfolio)”

  1. Russell Pierce says:

    Check NickelSteamRoller. They seemed to reach a different conclusion regarding inclusion/exclusion of data based on the “Does not meet current lending criteria” column.

  2. jasonejacks says:

    I wasn’t aware of this, thanks for posting it. My overall point with this post is to illustrate how the actual default rate is notably higher than a first glance at Lending Club data suggests.

    In the future, I will include these notes in calculations presented.

  3. Ron says:

    There is clearly a difference between projected defaults based on current processes, policy and macroeconomic conditions and what has happened historically (ie during the recession). Default rates have been steadily coming down over time…

  4. Roundup of Social Lending News – August 11, 2012 - Social Lending Blog says:

    [...] P2P Analytics - ON LENDING CLUB DEFAULTS (AND THEIR EFFECT ON YOUR PORTFOLIO) [...]

  5. William S says:

    Dear Jason,

    I have a question regarding this part of your post:
    “In this case, out of $10,000 invested, you lose $600 in defaults in the first year. Out of this $9,400 remaining, interest is only collected on $8,600 (due to the fact that 8% of loans pay little to no interest because of rapid debt paydown). In this case, one’s total income is $1,427 minus defaults, computed with 16.6% interest. Total returns for the year are about 8.2%.”

    In this part, you say that about 8% of the original investment is repaid rapidly and interest is not generated on that. However, as an investor I would not leave that significant portion of my portfolio to just sit there for 1-11 months (depending on when it was actually repaid) but I would reinvest it immediately. Therefore, in my mind that 86% ( with 6% default and 8% rapid repayment) of this $800 would still generate a return. After doing this a second time with the 8% rapid repayment of the $800, I would get $9343 of interest generating funds worth a total of $1551 in interest or 9.51%.

    Also, the other factor I think about is how long the investment sits in the “In Funding” and “Review” stages also affects the actual return. (I had a loan sit in that stage for multiple weeks before it was ultimately cancelled somehow). Is there any way or has a way been developed to clarify this?

    Last part, do you know if the listed interest rates are APY, APR, or something I don’t know about? I am thinking whether the original investment may be compounded monthly, weekly, or even daily in order to maximize potential earnings calculations and strategies.

    Thanks for the taking the time to read and answer!

    Best,
    William

    • jasonejacks says:

      You are correct – the reinvestment of the repaid in full funds would increase your returns. My overall point of this article (albeit loosely presented) was to show that default rates are substantially higher than Lending Club suggests and that you can still generate good returns off of Lending Club regardless of this fact. All of the yield percentages were presented in simple APY format.

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