COVID-19 Coronavirus Portfolio

This is a COVID-19 coronavirus portfolio of trading ideas generated in the last two months. The portfolio aim is to identify and invest in new trends in commodities or sector ETFs generated by either government policy monetary policy response or “shelter in place” lockdowns.

Covid-19 coronavirus portfolio - world map - 20200416

This collection of trading ideas was setup somewhat quickly as a tactical portfolio in response to the COVID-19 Corona Virus situation. The fundamental portfolio theme is that the market has been almost instantly split into winners and losers, Some industries have simply been decimated overnight that they can’t function as viable businesses for the immediate future. For example, even Warren Buffet completely sold all Berkshire Hathaway’s US airlines in April 2020. The aim of this tactical portfolio is to think about trading ideas that can generate winners in the “new normal”.

COVID-19 coronavirus portfolio – Option Volatility

Volatility is very high in most commodities and sectors, so it is critical to use option trading strategies for high volatility environments. Specifically Implied Volatility Rank (IVR) is in the range of 75% to 100% for many ETFs this month. Simple one leg option strategies such as buying out of the money calls in high volatility products will likely not do well. The “go to” trade on ETF options has typically been to buy long dated deep in the calls (LEAPs greater than 9 months out). This means that the majority of premium paid is intrinsic not extrinsic (time) value – the extrinsic value will likely reduce over the course of several months as the current volatility premium likely goes lower. To help with any downside, call spread overwriting and put butterflies on the same ETFs. There was also call spread overwriting in major tech indexes to hedge some downside in tech ETFs that do not have any options. Where no ETF options were available, actual ETF equity positions were taken, but sized appropriately at less than 10% of portfolio size.

COVID-19 coronavirus portfolio – Trade Ideas

The exact thinking behind the ideas need more detailed separate blog posts to fully justify their inclusion. However this tactical portfolio blog post is just to give the trade ideas, their high level implementation and any hedging strategy. This following ideas show the sector, idea rating (buy/hold/sell), the conviction level (low/medium/high) and a high level idea description.

New trades with “Buy” where started in the last 45 days. If a “Hold” is included in this portfolio that means it was already owned, but think performance would improve because of COVID-19 Corona Virus environment. The aim would be to hold most of these for 2020, or until stopped out.

Each paragraph describes a trade idea within a sector (including trade direction), rating (Buy/Hold/Sell) and overall conviction level.

Real Estate and Liquidity

Real Estate (Long). Hold/Buy. Medium. Select international opportunities mostly due to strong USD creating weaker local currencies and lower prices on local real estate. Here “local” means local to a target country in question, specifically Canada and UK whose currencies have been beaten up quite a bit due to flight to safety buying of USD. Keeping liquid in USD to maybe a currency conversion later in 2020 for a property purchase. Not rushing into anything. Actively writing a new Ebook for US investors on future opportunities with international real estate in 2020 and beyond.

Metals

Gold (Long). Buy. High. Gold is one of the best performing assets YTD in USD, and rebounded very quickly with after an initial March 2020 sell offs. The rebound was a direct response to the FED stimulus packages for the general economy. Gold is trading at 7 year highs in USD (near $1700) but importantly gold has made already made new all time highs in just about every other major currency such as Euro, UK Pounds, Canadian Dollars (etc). Select currency and 20 years on this Bullion Vault to chart historical gold price in each currency. Bought deep in the money calls on physical gold ETF (GLD) with an approximately 90 delta for Jan 2022. Aim is maintain a gold position, to ultimately replace with some actual physical gold, when the current spot to physical price premium subside. Aside from just the physical metal, gold miners should benefit from lower oil prices and therefore have reduced input costs, that should increase earnings per share in 2020 and beyond. Gold miners are up about 30% since purchase of Jan 2021 deep in the money calls in both major (GDX) and juniors (GDXJ). These are potentially multi year longs.

Silver (Long). Buy. High. The gold/silver ratio is at about 113 which means that silver is historically very undervalued compared to gold. Interestingly the silver price is approximately tracked the Dow (DIA) year to date, being down about 15% – so it does have more of an industrial market supply and demand component. Gold tends to function as a true safe haven, but silver can influenced by industrial supply and demand from economic conditions. Silver can definitely sell off in a general market downturn, where as gold is holding its value better. However if there is to be a significant gold bull market, silver will tag along for the ride, but may take more time to turn around. Trade was bought physical silver and silver metal (SLV). Bought deep in the money calls with an approximately 85 delta for Jan 2021.

Uranium mining stocks (Long). Potental new uranium bull market for 2020s. Uranium producers and explorer stocks have been one of best performing sector and are up YTD – beating general indexes. Uranium equity could definitely get caught in a wide market downtown, but has tracked higher physical uranium prices that have increased from low $20 to $32 in last month. Ideally this is a very specific sector mining play that should be a play on the physical price of uranium, and should not be correlated to the general market. We play this with a small position in a very small ($4 million market cap!) and brand new ETF of uranium producers URNM. This could be a multi year trade, but the risk reward setup seems good.

Energy

Oil drillers (Long, short vol). Buy. High. Added new full size positions in OIH. Made bullish call last month on OIH was trading at around $4. In OIH sold cash secured $3 puts in July 2020 and Sept 2020, because the implied volatiliy was insane (over 100%), and combined with half a position in long OIH stock. This position bounced nicely, so bought back the short puts for good profit, then hedged the remaining stock with a wide put bufferfly in July 2020. Sold 40% out of the money call in July 2020 to help finance the put butterfly a bit. This is neutral to long ish bias on OIH until July, but it has run up a lot in April so it is sells off in May (seems likely to take a break) then the put buttefly will make some good money, even if the OIH stock loses money. Note that OIH has had a 20:1 reverse split this month, so the $ option strikes mentioned above will need to be multipled by 20 to compare to a current OIH chart.

Oil explorers (Long, short vol). Buy. High. Added new full size position last month on XOP (same timing as OIH trade). Bought a deep in the money for Jan 2021, then overwrite with call spread for May 2020. The call spread recently had both legs in the money and was only 2 weeks to go to expiration. Therefore overwritten call spread was rolled to Jun 2020 for a minor debt. The aim is to maintain the deep in the money Jan 2021 call, and keep overwriting for the rest of the year. If XOP goes up a lot we will capture majority of move. If stays same we can get some income from the high volatility in the call spreads (if they expire worthless). If goes down we will lose, but much less than stock. One advantage is if XOP price goes down fast the implied volality will go up, and so the deep in the money call will stay bid. Note that XOP has had a 4:1 reverse split this month, so the $ option strikes mentioned above will need to be multipled by 4 to compare to a current XOP chart.

Natural Gas (Slightly long, short vol). Hold. Medium. The natural gas etf (UNG) is hard to hold long stock for several months, due to the current contango in natural gas futures. Contango is when near month natural gas futures trade lower than far month future prices. (UNG) maintains its natural gas price exposure by constantly rolling contracts – specifically buying more expensive far month futures contracts, by selling the expiring (and cheaper) near month contract. This enforced rolling built into the product, creates a long term drag on prices while natural gas is in contango (look at any multi year chart of UNG). This is a less extreme version of the same problem with USO contango this week – when the oil price went negative (!). Since owning (UNG) stock is not a good idea, the setup is usually buy a long term calendar call spread, and also selling near dated call spreads on (UNG). This takes advantage of high implied volatility with limited risk, but can still benefit if prices are higher or neutral. This does sacrifice large profits if (UNG) spikes higher quickly and cannot roll fast enough into the price increase.

Natural Gas Producers (Long). Buy. Medium. US natural gas equities have been beaten up in 2020. Clearly there are is a huge over supply of natural gas and a massive worldwide demand shock for energy. (FCG) tracks an equal-weighted index of US companies that derive a substantial portion of their revenue from the exploration & production of natural gas. Approximately 15% of its portfolio is in MLPs and the remaining 85% to equities. Interestingly the (FCG) attempts to recovers some of its 0.6% management fee by securities lending, and it does have a dividend yield but that will likely disappear to much smaller amount in 2020. However to place this in some historical context, many US natural gas equities are trading at the lowest price for 20 years. For example, buying natural gas producers index (FCG) for $5.50, when its all time high is about $155 in July 2008. The US natural gas producers sector at these prices is low enough to be a binary trade. Either the majority of the US energy complex is going bankrupt and this is a slow grind lower for many years (“lose”). Alternatively some energy demand returns, the survivors consolidate and a restructured sector operates at higher price levels at some point in the next few years (“win”).

Equity

Cloud Computing (Long). Buy. Medium. More e-business activity (e.g. Shopify) for starting new businesses and tools for people working for home. This is long equity ETF but focusing on cloud technology (CLOU). Actively trying to ignore struggling parts of economy (e.g. airlines, manufacturing, automative, consumer financing etc). Positions in CLOU and other tech ETFs will be actively hedged with QQQ OTM call spreads.

Mortgage REITs (Long). Buy. Medium. MReits were trading at significant discounts to book value in April 2020 This was definitely a speculative buy with high yields around 11%, especially because dividends could be heavily reduced in next year. However if MReits can simply maintain their value, and allowed to DRIP for a number of years (even at these levels), then they can add some welcome yield and maybe some capital appreciation. MReit ETF (MORT) is a high yield trade great for a portfolio position in an IRA, because it can be allowed to DRIP long term. This is relatively risky play, and only medium conviction. There is no simple way to hedge this using options, so will only take a half position size to manage the risk.

Solar ETF (Neutral). Sold. Medium. Fortunate enough to sell Solar ETF (TAN) around $34 after the bounce back up to $37 in early March 2020 (not the top, but about 20% off the high the way down). This was a risk off trade, which preserved some capital initiate some of the other new ideas in this portfolio.

Emerging Market Equity (Short). Buy. High. Emerging market companies that have debt denominated could have a hard time paying it back, with economic shutdown and currencies depreciating against USD. Emerging market equity like Brazil (EWZ), Mexico (EWW) and India (INDA) have not bounced back as fast as the main US equity markets. For example Brazil has traded in an approximate range of $21 to $26 over last month, down from a Feb 2020 peak of (this is a “L” market chart, not the “V” market chart). Two trades here were 1) out of the money Long Put EWZ butterfly in May 2020, fully financed with short call spread on India market (INDA). This was neutral to bearish. 2) in the money Long Put EWZ butterfly in May 2020 for a debit, and no short call spread. This was more bearish. Brazil equity market has proven to be weaken than India in April 2020 so that seems like a good trade choice approaching May 15th 2020 expiration. INDA trade should expire worthless. Brazil trade already in the money and likely to still be there closer to expiration.

High Yield Corporate Debt (Short). Buy. High, now Medium. Corporate credit quality is being impacted by an unknown amount due to corona virus shutdowns, so that uncertainty would cause high yield corporate bond ETFs to trade significantly lower in the next couple of months. Entered an in the money (ITM) put butterfly as a limited risk reward way to short high yield bond ETF (HYG) on 17th March. HYG was at about $77 then went down 10% in a hurry to around $70. The risk was managed with the limited risk trade structure of an ITM put butterfly, but still got “taken to the cleaners” by the announcement that the FED would be buying junk corporate bonds. This policy announcement caused a huge HYG rally in April from about $70 to $80. Unless there are signs a sharp move down in high yield this week, it will be closed this week approximately 10 days before 15th May expiration – losing about two thirds of original trade capital this week. This is to preserve one third of the remaining principal from a losing trade, as a put butterfly that is now out of the money will decay much faster into expiration. A classic example of a good initially profitable good trade entered for the right reasons, but taken out by unprecedented policy decision. Trade was a loser, but have successfully managed the short risk by not having an unlimited short risk trade on.

Crypto

Cryptocurrency (Long). Hold. High. Bitcoin (BTC) and other alt coins (e.g. XMR). Holding not adding any more.

Liquidity and Hedging

Peer to peer lending – Lending Club (Neutral). Sell/Hold. High. Already dialed back risk here several years ago due to lending club management issues. However this month turned off auto re-investment of cash into new notes. Definitely do not want any more exposure to consumer credit for next year or so. Peer to peer is a small position, but turning off re-investment seems prudent until can figure out what is going with the general consumer lending (does not look good in short or medium term).

Cash (Long). High. Long USD for investment opportunities and saving up to get properties with low LTV. On existing international property businesses we are looking to open small home equity line of credits on properties with low LTVs in local currency (assuming local bank allows it). A small amount of debt exposure in local currency is effectively a long USD position (since we are based in USD). If the local currency for a country where we own property declines significantly we may consider paying down mortgage principal from USD cash.

Hedges (short, combined with underlying positions). Buy. High. Index call spreads overwriting out about 2 months. similar idea to covered covered calls, but with limited risk reward so that if the market does go massively higher are not losing so much (and can probably roll out of it in following months). Selectively combining put butterflies with hedges.

COVID-19 coronavirus portfolio – Summary

This tactical portfolio was created relatively quickly. The main themes were long metals and energy, with some technology and potentially some real estate later in the year. There are also some relatively aggressive hedging and other complimentary short positions. This is a long/short portfolio, that would be much more heavily hedged if world goes “risk off” again. Having good entry points in April 2020 should definitely help holding positions for longer term. The other main theme is keeping very liquid and not over allocating to make sure money is available for opportunities. In summary, only trade if you want to, not because you have to.

Lending Club bad news

Unfortunately Lending Club bad news has created a storm in the last 2 weeks:

Lending Club Bad News Reaction

Very briefly a summary of the top issues is:

1) Lending Club staff altered application dates on $3 million worth of loans to make them meet investor critera (shaking confidence in internal procedures)

2) Also Lending Club’s internal inquiry found that $22 million of loans that were sold to an investor didn’t meet their specified criteria (i.e. investor was sold lower quality loans than specified)

3) CEO failed to disclose his interest in a fund that Lending Club was about to invest in (conflict of interest)

4) Dept of Justice investigating Lending Club’s internal practices (being investigated by the government generally not good for business)

Before getting started here it is worth giving a very quick overview of what Lending Club does. Lending Club (LC) is a peer to peer lending website that allows you to “be the bank” to get a better return on your money than letting it just sit in the bank. You lend your cash lump sum to many different people, but only giving a small micro loan (a $25 “note”) to each one to spread the risk. For example a typical note might be used by someone to pay off their credit card (at say 15%), while you get a decent return (of say 8%) on the money loaned. It is like running your own bond portfolio, where you can have low or high risk credit quality and have default risk on the more risky loans. We refer to the primary market as loan origination, that is new loans purchased directly with individual borrowers on the Lending Club platform. The secondary market means buying and selling existing loans from other investors on the Folio FN trading platform.

So what does Lending Club bad news mean for our investments ?

What does the recent string of Lending club bad news in the last 2 weeks mean for our investments ? It is hard to predict if the company will go bankrupt because we don’t have enough information to prove that. However we do need to have a strategy for handling our existing investments in multiple scenarios. This lays out some thinking from an investment perspective and specifically how we are reacting to these developments (obviously your opinion may be different).

This bad news raises a lot of open questions, such as:

  • Will lending club as an entity survive ?
  • If the company goes bankrupt what does that mean for lending with existing loans ?
  • In event of a bankruptcy how will existing loans be serviced ?
  • Does this affect the existing loan quality in our portfolio ?
  • What is the strategy if the Lending Club secondary market (buying and selling existing loans) becomes totally illiquid ?

Will lending club as an entity survive ?

Since they have been profitable in 2016 this would seem to be promising for their long term survival. Lending club were also on the public relations offensive this week – with an email telling everyone not to panic. Not sure if that is comforting or not!

These are a few relevant excepts on bankruptcy from that email:

What happens if Lending Club goes bankrupt?First and foremost, we are not going out of business. Lending Club has a strong business, a large balance sheet and we are here to stay. We have $868 million in cash and securities, which could cover our costs for a long time. Second, Lending Club has no claim to the payments you receive from borrowers, since each Note is tied to a loan, and loan payments are passed on to Note holders. Third, with a $10.2 billion loan portfolio that generated over $18 million in revenue in the first quarter of 2016 alone, we could profitably service the existing Lending Club platform as a standalone business, even if we didn’t facilitate a single new loan. Finally, and I am only mentioning this because some have asked, if all else failed we would transfer our loan servicing obligations to a third party backup servicer. We have a longstanding contract with a third party to service loans in the event Lending Club can’t, so that you’d continue to receive borrower payments (regardless of LendingClub Corporation’s status). See our prospectus for more detail .

Clearly Lending Club is bullish on their own existence. However if their business model (fees from loan origination and interest payments) drys up then these earnings could be greatly reduced. This is likely why the stock price was hit so badly on May 9th – the current stock price is a way to value investors perception (right or wrong) of future earnings streams. Temporarily the market seems to agree with the Lending Club bad news, so we have to make a decision on who is right without having any insider information. So the right response is to reduce exposure if the risk taken is not clear.

As peer to peer lending is more than a decade old, there is actually a precedence for platform risk. That is the risk that the online peer to peer lender originating and servicing your loan will go bankrupt and cease to exist. Last year a relatively small swedish peer to peer lender called TrustBuddy went bankrupt – with investor losing their investments. To be fair the Trust Buddy way smaller and less advanced than Lending Club, and it appears this is not directly comparable in scale or loan quality – however it could be an insight the binary nature of losing the entire investment. In the US because the industry is well regulated but not protected against company bankruptcy, that is up to the company to create suitable bankruptcy provisions and for the investor to research in advance if those provisions are adequate.

Peer to peer lending is a great idea, but a major bankruptcy of major US player would severely shake the industry. This is not likely, but if it did happen investors would like have little recourse, so you should always size your investment appropriately to your net worth (probably less than 5%). If you are US based then keeping your peer to peer lending exposure across the two main providers Lending Club and Prosper would help spread some of the platform risk.

In bankruptcy will existing loans be serviced ?

It is not entirely clear what happens to the loan servicing in the event of Lending Club bankruptcy. Unless you are looking at systematic fraud with the lending club loans, then in theory the existing credit quality of the portfolio should not suffer too much – i.e. you lent “person to person” and that person still (presumably) has to the ability to pay the loan back independent of what happens to Lending Club.

So lets investigate what Lending Club themselves say about their bankruptcy provisions – from the Lending Club prospectus – page 15 :

Our arrangements for backup servicing are limited. If we fail to maintain operations, you will experience a delay and increased cost in respect of your expected principal and interest payments on the Notes, and we may be unable to collect and process repayments from borrowers. We have made arrangements for only limited backup servicing. If our platform were to fail or we became insolvent, we would attempt to transfer our Loan servicing obligations to our third-party back-up servicer. There can be no assurance that this back-up servicer will be able to adequately perform the servicing of the outstanding Loan. If this back-up servicer assumes the servicing of the Loan, the back-up servicer will impose additional servicing fees, reducing the amounts available for payments on the Notes. Additionally, transferring these servicing obligations to our back-up servicer may result in delays in the processing and recovery of information with respect to amounts owed on the Loan or, if our platform becomes inoperable, may prevent us from servicing the Loan and making principal and interest payments on the Notes. If our back-up servicer is not able to service the Loan effectively, investors’ ability to receive principal and interest payments on their Notes may be substantially impaired.

This basically says that there is some provision for loan servicing, but it is not guaranteed and a bit fuzzy on the actual implementation. Although the likelihood of bankruptcy is low (given current Lending Club financial snapshot) – if it did happen then the outcome for loan portfolio is not clear. If Lending Club did go completely bankrupt completely, and the back up service provider was unable to service loans – then presumably then there would be some kind of class action lawsuit. But that would still mean that any principal was tied up for a few years and potentially might get back only pennies of the dollar. Another possibility is that another company could buy and service your debt, but probably not on favorable terms.

Importantly Cash sitting on a Lending Club account is not FDIC insured, so if you are not planning to actively reinvest then extracting cash at every opportunity would seem like a good idea. This is better than letting it sit on the account for a number of months, because it would be directly exposed to Lending Club company credit risk.

Liquidity Risk

Another risk that is not as bad as bankruptcy, is that the secondary market stays very illiquid. For selling in the last year 2015 the market was relatively liquid where we could liquidate about 1% of our portfolio in a day at par or above. There is the very likely potential that is remains illiquid for many months, so getting your money back at par any time seems unlikely.  Historically we haven’t experimented with selling notes beneath par, so it would interesting to see if there is no volume trading, or people just want better prices. The other option is long term holding until loan expiration over the next 3 to 5 years (and hoping bankruptcy does not happen). So potentially couldn’t get back principal for a number of years, but still received loan interest payments.

As a refresher the primary market (loan origination) has originated about $18 billion in 1.5 million loans since inception.

On Tues 17th May a snapshot of the secondary market showed about 538k TOTAL offers to sell loans:
362k at par or more (i.e. about 69% of total offers to are at a premium par)
169k at par or less (i.e. only about 31% of total offers to sell are under par)
63k at 1% or more discount to par (i.e. only about 12%)
35k at 2% or more discount to par (i.e. only about 6.5%)
21k at 5% or more discount to par (i.e. only about 3.9%) – there is some real junk in here, hardly any offered down here are current

So to put it another way 93.5% of loans are offered for a maximum discount of 2% to par (or less). It is also worth noting that more than two thirds of the offers to sell are for more than par or exactly what the loan is worth. So just looking at this quick snapshot it does not appear that the Lending Club secondary market is imploding. However where loans are actually selling (not just offered) could be a different matter, which will explore in the next few weeks as we try to sell.

Important footnote – the TOTAL offers above includes all loans including those that are marked at “late” or “in default” as well as “current”. This means that some of these low offers are trying to sell some real junk at a discount to par, versus market closer to par which is usually “current” loans.

Conclusion – what are we actually doing?

Last month (April 2016) we have been able to buy at a normal rate in a new account – but given the above revelations last week as of right now we are not buying any more. We are aiming to reduce 50% of exposure. Ultimately you need make your own decision based on your own risk tolerance. Our decision is to reduce investment down to a level where it would not be a significant financial issue for us if  either all loans became illiquid or Lending Club went bankrupt. However we will keep minimum account size of greater than $20k USD to get diversification benefits. Historically no account with that amount or greater has lost money in the history of the platform  - but clearly that historical statistic would not protect you in a binary bankruptcy situation. So in conclusion we are lowering exposure, not totally exiting, but exposure is significantly 70% lower than May 2015 (one year ago).

This decision is based on our interpretation of the (lack of) bankruptcy protection from the lending club prospectus. If you want an counter view point of another very active Lending Club investor Peter Renton who has a few $100k in lending club and other peer to peer lending sites you can read his detailed opposite opinion.

We will also keep any existing long term exposure in retirement accounts for tax efficiency, and liquidate all taxable lending club accounts. The aim is to not have any long term taxable Lending Club accounts after this year. However this is purely for long term tax efficiency on returns, not related to the small risk of Lending Club bankruptcy (there is nothing we are aware of that treats IRAs as having less credit risk than taxable Lending Club accounts).

In summary we are now actively offering entire portfolio for sale, but will stop liquidating at 50% of our current exposure in May 2016. The basic tactic is to increase discount by 0.25% per day up to max 2% to see how it goes – but results will be slow. Fortunately liquidated about more than 50% last year, and even though we still feeling a bit over exposed at the moment - it could be in a significantly worse situation.

Since we are actively liquidating a portion of our accounts, we will have to see how deep the secondary market is for loan reselling. Comparing our trading results for the last week, the secondary market appears to have dried up quite a bit since last year (2015). We’ve had about 1000 notes up for sale at par for about 2 days last week between 9th and 10th May and have only sold 10 notes total. This can be contrasted with liquidity when we were selling last year which was about 20 notes a day (on average). Originally now all notes are offered at 1% over par to accommodate the 1% transaction fee (so this is effectively selling for par minus fees).

So we have recently changed strategy offering at 2% discount to par (really 3% discount with the transaction fee) over 5 days – this has managed to sell about 80 notes. So secondary market is illiquid, but not seized up. Since we are aggressive toning down exposure will keep this running for a few days and see how well it goes. We might reduce the discount to sell at a lower rate when get closer to our final exposure target.

For the record, the final aim is to reduce Lending Club holdings to a maximum of about 2% of our total net worth.

Reducing Lending Club exposure

Lending Club (LC) is a peer to peer lending website that allows you to “be the bank” to get a better return on your money than letting it just sit in the bank. You lend your cash lump sum to many different people, but only giving a small micro loan (a $25 “note”) to each one to spread the risk. For example a typical note might be used by someone to pay off their credit card (at say 15%), while you get a decent return (of say 8%) on the money loaned. It is like running your own bond portfolio, where you can have low or high risk credit quality and have default risk on the more risky loans.
Lending Club’s website is here.

We have been executing a Lending Club (LC) Portfolio for the last 4 years which has been nicely successful, to the point of almost being boring – not much happens except interest payments (which are A GOOD THING) and limited defaults which are manageable and expected.

A brief portfolio history is that from 2012 to 2013 we increased Lending Club exposure significantly from USD cash savings, and were full allocated in Dec 2013. We then left the allocation at the full amount for about 20 months. However we have recently taken the action to liquidate about 60% of our exposure from Sept 2015 to Nov 2015.

This is based on several factors:

- Lending Club IPO fever from Dec 2014 has cooled off somewhat, with a declining stock price and worries on future regulation. Although Lending Club’s ongoing marketing means that the peer to peer lending is becoming much more main stream, and there is wider participation reaching individual investors. There hasn’t been a big consumer credit bear market yet, with lots of the general public involved (in 2009 peer to peer lending was more a niche market). Therefore it will be interesting to see what happens if/when everyone decides they have to liquidate their Lending Club account at the same time.

- We use the stock ticker JNK (junk bond fund) as a proxy for Lending Club style risk – its not perfect because LC is consumer credit debt and JNK is corporate debt, but it gives a relatively correlated benchmark to make decisions from. The credit market environment (distinct from the stock market) was not that volatile from 2012 to mid 2014, so we have been lucky to be in a good time period for Peer to Peer lending. However there has been a steady credit sell off since June 2014, and in early 2016 JNK has just entered a technical bear market (typically defined as a 20% or more decline from the most peak). Therefore we decided to dial back the risk. The following chart shows the story:
Lending Club Liquidation Q4 2015 - 20160202

- Our portfolio size would take an estimated 3.5 months to exit comfortably at 1% premium in the current (relatively) decent market conditions. Our lending club allocation relative to the rest of our portfolio was getting to the size were it was “too big to fail” – i.e. given that we’d done pretty well for 3 years, if it all went horribly wrong from here and we hadn’t yet taken any profit along the way, we’d feel pretty stupid. After reducing exposure by 60%, the LC portfolio would have to fall by 25% for us to loss the profit already generated. That magnitude of move is possible, but The LC portfolio is now at a size where we’d be comfortable riding that out. Interestingly if you want to attempt to quantify how possible that move might be, you can look at JNK listed options to assign an approximate probability of that 25% decline happening by 2 years time. See screenshot below showing JNK options:
JNK Options Probability of 25 percent decline by 2 years time 20160202
On 2nd Feb 2016 JNK price is $32.55, a 25% discount to that price is $24.41. So looking at approximately the same price strike in Jan 2018 options (about 2 years away) shows that the $24 put option has a -0.2136 delta. As a quick shorthand traders often use the option Delta as an approximation for the probability of that option finishing in the money (ITM). This means that JNK has about a 20% chance (approximating 21.36%) of finishing in the ITM by Jan 2018 (2 years time). Therefore if you believe that JNK is a reasonable for proxy LC debt, then you could estimate a 20% probability of losing 25% of your portfolio value in 2 years. The option market is usually pretty accurate, but its not a perfect methodology because it depends on how correlated you think JNK is to LC debt – but it’s a decent start at a quantifiable risk estimate (so you can decide if you are comfortable with the risk).

- We were finding it hard to allocate enough new cash with our (admittedly) strict criteria. Put simply there is not enough liquidity to do what we want to do, and since we do not want to compromise on credit quality, we are taking our ball and going home. Interesting in 2012/2013 we could not allocate the notes fast enough with the same criteria, but now there seems to be a big slow down in current liquidity for larger portfolios especially if you start being slightly more strict with the criteria. A good guess would be that the liquidity slow down might be due to automated APIs automatically bidding on note inventory.

- We are ramping up our Nova Scotia real estate investments which are some what market timing sensitive based on FX rate opportunity. Therefore we are simply being opportunistic – effectively this is profit taking from peer to peer lending and reallocating the capital to that real estate strategy.

- The LC account is a taxable account, so it would be beneficial to start slowly re-allocating some assets over to an IRA (some already have been) to get the long term tax free impact of compound interest. In the early years, holding the portfolio the different in compound interest is not as great, but over several decades the impact of taxable (standard account) v. non taxable (IRA account) returns would be significant. See lending club’s chart included below and accessible here:
Lending Club Long Term Taxable v Non Taxable Returns - 20160202

Re-balancing strategy

So how was the portfolio re-balancing done ?

Trading out of notes on LC is done using the FolioFN secondary market trading platform which actually charges a 1% transaction fee, so we always place our notes for sale at a 1% premium or greater. Effectively selling for a 1% premimum is like selling a note for par value (principal + pending interest) after taking into account the 1% transaction fee. We experimented with premiums of 2% to 5% and to be fair some small bids were hit, but it would probably have taken about 2 years or more (!) to exit the number of notes we wanted to get rid of.

In brief this was the exit strategy to sell 60% of LC portfolio:

1) Put entire portfolio up for sale at 1% premium on the FolioFN secondary market trading platform. Initially estimated we can liquidate notes about $1000 a day at a 1% premium, so we estimate it would take about 60 days to reduce the exposure. In the end it took about 75 days, but actually generally not a bad estimate. The platform is not super liquid, but there is enough demand from secondary market place – presumably from US states where people cant buy the first time around in the primary market.

2) Monitor every 2-3 days for about 75 days until the portfolio was 40% of its original size (60% exposure reduction). Finally delete all pending sell orders from the FolioFN trading platform.

3) Then re-balanced the portfolio to our required credit quality mix using Lending Club’s automated trading feature. This took about 35 days.

4) Monitor final results to confirm portfolio is correct size and credit quality mix. This was completed by 30th Dec 2015,

Total process from steps 1 to 4 took about 4 months to fully execute, but did successfully exit all notes at par (1% premium) or better. Time will tell if this was a good move, however it seems like prudent risk management/reallocation for now.