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.