I was using Lending Club to buy some notes the other day and noticed something very interesting. Take a look at the following images…
Did you see what I saw? Look at images A and B. You see that I can choose between a 9.74% interest rate at a 0.47/1 risk ratio or a 16.95% interest rate at a 0.79/1 risk ratio. (In truth there’s a whole spectrum of choices in between.) From these images, it seems clear that the higher the risk ratio, the more risk you are taking on. That’s all good until you look at the images in C and D. Note that the risk ratio is the same whether I’m investing in an A-rated loan or an E-rated loan. That risk is a high 1/1.
This leads to a very curious case when you compare images B and C. The B image seems to show less risk and a greater return. Why would anyone want to invest the way that image C shows?
I found this curious, so I asked Lending Club. It turns out that the answer is one of diversification. You’ll note that risk ratio in images A and B is the result of three loans. In images C and D there is only one loan. The lesson here is that Lending Club’s risk ratio is determined by a combination of loan risk itself and diversification. If you have enough money to put into loans at one time that risk ratio will be very low.
Lending Club admitted that this can be seen as a little interesting in the way I described it. They also said that they were looking into updating how the risk ratio works. I proposed that the risk ratio instead reflect the risk of the current set of loans on my whole Lending Club portfolio. I’m curious to see if they take my suggestion.
What do you think? How should Lending Club report risk? Let me know in the comments below.
Well, the risk calculation should take into account both the number of loans in the portfolio and the quality of the borrower. Obviously, if you have a portfolio of just 1 E loan compared to a portfolio with 3 E loans, while both may carry the same type of risk due to credit quality, the fact that you have it spread out across 3 loans instead of one should lower the risk. You have a better chance of that one single loan defaulting compared to all three of your other loans defaulting.
That being said, a 1 E loan portfolio should have higher risk when compared to a 1 B loan portfolio instead of just showing the risk value as 1/1 since it should take into account the default rates based on credit quality.
I’m no math wizard, but I bet it wouldn’t be terribly difficult to change the calculation to include a combination of the number of loans and credit quality.
Very interesting – I had not noticed this.
I was having a hard time getting a handle on default risk, particularly for small value portfolios, like the ones you are discussing. The trouble is that historical default rates don’t really apply until you have a statistically significant number of loans. I’m not sure if you’ve seen my P2P Default Simulation results but they helped me to gain a better understanding of the risks. Basically, my analysis showed that when you only have a few loans, since any default would result in a large percentage of your portfolio being lost, you’re better off investing in lower grade loans. As you get more and more loans, the diversification tends to moderate the higher risk of the lower grade loans, again making them preferred. Obviously the defaults at Lending Club won’t necessarily follow the historical default rates, but the results were still surprising to me.
Mike, what is the formula you used to get the value of each outcome in your monte carlo simulation?