Many of our clients spend a lot of time thinking about selecting the right “buckets” to invest. Within a platform like Lending Club, that means selecting the right term and grades. We help managers think through the right expectation of returns within each bucket, and usually, this conforms to their intuition. But occasionally a loan investor is surprised at what we find, so we have created a tool for managers to get a rough idea of how platforms price their loans.
Let me first state the obvious: Lending Club is really good at pricing their loans, and they are continuing to get better at it – for the benefit of both the borrowers and the investors.
Below is a basic graph of Lending Club’s loan pricing as of Dec 2014:
Lending Club Loan Pricing
(You can use the sliders to choose the loan pricing date, click the play button to see pricing trend over time, and use the date selector to choose vintages from which to sample loss estimates)
The big takeaways are:
1. Positive Risk Premium: higher loss loans generally have higher interest rates more than compensate for the additional risk.
The slope of the line running through the plot shows the risk/return tradeoff. Interestingly, the slope has been getting steeper, meaning Lending Club is now rewarding investors more than before for buying loans with greater risk.
2. Positive Term Spread: 60m loans with the same interest rate generally have lower loss rates compared with 36m loans.
For example, the green 60 E dot (representing 60-month E-grade loans) is to the left of the green 36 E dot; this rewards investors for locking up their capital for a longer period with the 60m loan.
3. Higher Term Spread in Low Grades: the 60m/36m spread is larger for Fs and Gs.
The interaction between the risk premium and term spread means investors want to be paid extra for investing longer in the riskier loans.
While it’s naive to think everything above the regression line is a good buy, those buckets do tend to reward investors better. By definition, some buckets must perform below average – but the discrepancies have been narrowing over time.
Overall, a well-designed origination program rewards investors for taking on risk, whether it’s duration risk or higher downside default risk – and this is what we generally see in Lending Club’s loan pricing.