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.