Friday, November 20, 2015

The Sym Philosphy on Consumer Loan Selection

Welcome to my P2P lending blog!  When my colleagues asked me to begin writing a P2P blog my first instinct was to refuse.  Volumes have already been written on the subject and an ever growing number of people are devoting their careers to following the P2P lending industry.  I am reminded of the California gold rush and I find no small irony in the fact that the two largest P2P lenders in the world today - Prosper and Lending Club, were founded in California.

But having managed a P2P Fund over the past two year and having reviewied dozends of platforms for potential investment I think now there is far more to say than has been said. P2P platforms come in all shapes and sizes.

One way to classify P2P platforms is by whether the platforms focus on consumer loans or business loans. Consumers as a group behave differently than businesses as a group. Here are some of the rules when I look at consumer-based P2P platforms :

1. The risk/reward curve flattens, perhaps even turns downward.  What does this mean in practice? It means there's no real good reason to select pools of higher risk class D and E loans.  You get no real pickup in yield but the likelihood of default dramatically increases.

2. High quality ranking (i.e. A), does not necessarily mean most likely to repay.  In practice, the default rates I've observed with my "A" quality loans has been actually higher than in my "B" quality loans.

3. Watch the DTI - Debt to income ratio is an important item.  It measures the amount of the consumer's monthly debt payment to the consumer's monthly income. The higher the DTI, the lower the consumer's disposable income, and the greater is the liklihood that the conusmer will have difficulty with loan installments.

4. Short term doesn't necessarily mean lower risk - On the one hand, it's true that more things can go wrong in the long run than in the short run.  On the other hand, all else equal, the consumer borrower with a five year term will have a lower DTI than a consumer borrowing with a three year DTI.

5. Jobs matter - Certain types of jobs are inherently more stable and more secure than other types of jobs. For example, civil servants, university professors, police officers, fire fighters, accountants, doctors, lawyers and medical technicians have either highly specific skill sets or benefit from built-in job security.

6. Don't judge a book by its cover.  For example, many "A" loans are actually "B" loans, but due to the platform credit scoring system are graded "A."  At the same time, many "D", "E" or "F" actually have better credit fundamentals than the grade indicates.  They are bargains.  They offer a relatively high rate of interest, coupled with a relatively low probability of default.

7. Platform lending criteria are extremely important. The story of Prosper and Lending Club reminds me of the Charles Dickens' Tale of Two Cities.  Both platforms started at about the same time.  However, in the early years Prosper had a consistently poor lending model.  Investors experienced poor returns and returns that were not consistent with the rated credit quality.  Lending Club in contrast, delivered solid returns.  In recent years Prosper has signficantly improved its credit process.  How you do you judge a platform's lending criteria?  Firstly, you have to look at the returns over time.  This is why I almost never invest in platforms with a short operating history.  Secondly you have to ask questions of platform management and read the platform materials carefully.  Quality platforms will disclose their credit statistics transparently and will document their credit procedures.

8. Pay attention to credit history. Platforms should report credit bureau information on the conusmer borrowers.  You can see history of missed payments (delinquencies) and in the US, "public filings," meaning that the consumer had filed for bankruptcy and debt relief.  One school of thought is that the conusmer has learned a hard lesson and going forward will manage credit much better.  This is in part why E and F loans can perform better.  Many of the conusmers in this category understand well the need to improve their credit scores.  On the other hand, many of these consumers have unstable credit profiles.  I tend to avoid the lower ranking loans and I almost never buy loans when I see more than 1 or 2 delinquencies in the last 10 years.

9. It's a numbers game. The conusmer loan business is driven mainly by statistics.  Lenders have a limited set of information and they use highly automated processes.  Credit decisions are made by computers based on statistical banking models.  Every lender expects there will be a certain number of bad loans in each portfolio.  The key to success is that the lender is receiving a rate of interest that compensatest for the defaults.  So for example, each borrower pays 10%.  Each year 2 of each 100 loans goes bad (i.e. a 2% default rate).  Using simple math, the lender generates 8% per annum return. The important thing is that the lender should have a widely diversified portfolio so the lender's return is driven not by the performance of individual consumers, but by the statistics of the overall pool.  The more loans that are in the pool, the better. For this reason many platforms enable investors to take advantage of automated filtering tools that basically enable investors to simply "buy the index."

Peer to peer loans available on quality platforms such as Lending Club and Prosper enable many investors to gain access to an asset class that over many years has served banks well. The key risk for investors is that the P2P platform changes its credit processes over time and fails to deliver returns consistent with the estimated risk level.  Pay close attention to platform performance, diversify your portfolio.  Spread your investments among several platforms.  Or better still - find a good P2P fund.  More and more of them are coming to market all the time.

Note:  Your money is at risk whenever you invest in P2P loans, so invest carefully ask questions and invest only what you can afford to lose.  Returns from P2P loan pools may vary widely over time, depending on macro economic conditions. 

Feel free to e-mail if you have questions or concerns.