This thought piece makes the case for the advantages of investing in loans facilitated by online marketplace lending platforms, as well as offering investors a few things to consider before doing so. Historically, investing in the consumer credit asset class has not been readily available, but online marketplace lending allows investors to access spreads previously only available to banks. The return-to-risk ratio is also very appealing to investors, and with a large addressable market, there is plenty of room for this asset class to grow. However, before considering investment, it is important for investors to understand how default rates affect the potential return stream, and how those default rates can change due to macroeconomic circumstances.
Why Invest in Online Marketplace Lending?
The online marketplace lending asset class represents a unique and large opportunity for many types of investors seeking a high-yield, low-volatility return stream. The opportunity is unique in that there are very few other asset classes that offer a return stream with such a relatively high return to volatility ratio. In addition, there historically has not been an easy channel to invest in consumer credit before the advent of online marketplace lenders. The opportunity is large because online lending platforms are disrupting traditional credit card lenders for a slice of the nearly $1 trillion of current outstanding revolving consumer debt.
“Online lending platforms are disrupting traditional credit card lenders for a slice of…nearly $1 trillion”
Most consumer credit online marketplace lenders are offering debt consolidation or refinancing products. In other words, they are marketing to borrowers with outstanding credit card debt that is being rolled over at each month-end, and that is typically subject to a very high interest rate (up to 36% APR). Online lenders also offer term loans as opposed to revolving credit. With a term loan, borrowers pay a fixed monthly payment that includes both principal and interest of their existing balance for a fixed amount of time, typically 36 or 60 months. By refinancing and/or consolidating multiple high interest rate credit card balances, borrowers can both save money on interest charges and get on a plan to pay down all of their outstanding debt over a fixed amount of time.
The following chart from Lending Club illustrates how these loans provide value for both borrowers and investors. As explained, borrowers save money on interest, and investors have access to a high-yield, short-duration return stream. The difference between the average interest rate charged to borrowers (13.8%) and the average annual return to investors (6.9%) equals the effective annual default rate.
Online marketplace lenders are able to offer lower interest rates than large banks and credit card companies because they have a much lower cost structure than these incumbents. They have no physical branches and much lower regulatory costs, with end investors supplying the capital. The platforms are simply technology-driven marketplaces connecting creditworthy borrowers and investors with capital.
The size of the addressable market for credit card refinancing is significant. In the following chart, Lending Club analyzes all outstanding credit card debt, and removes non-revolving balances (borrowers who pay off their balance in full each month) and subprime balances (borrowers with FICO scores < 600). Thus, even by targeting only prime borrowers who are revolving a balance and paying interest charges every month, there is still a $465B addressable market for these loans.
Turning to the return of this asset class, the following chart shows the return to maturity for Lending’s Club’s vintages. Note that the value for each year is the IRR investors would have received if, for example, they bought every loan that Lending Club issued in 2009, then let all of those loans run off to maturity, which would take three years for the 36 month loans and five years for the 60 month loans. The chart omits the last few years’ vintages because they are still in flight, but these recent vintages are also tracking between 5-8% return to maturity.
Marketplace lending platforms only started emerging around 2007, and had very small volumes in the first few years. To examine a longer return history for this asset class, we can consider the largest pool of unsecured consumer credit in the US: credit card lending. The following chart shows the average interest rates and default rates for credit cards in the US back to 1995. The spread between these two lines is the gross return for the asset each year. Of course, this assumes no operating costs, origination costs, etc., but it is a decent proxy to gauge the cyclicality of returns in this asset class.
The next chart shows that the default rate on credit card debt varies closely with changes in the unemployment rate. This is because the main catalyst for defaults in this asset class is the unexpected loss of income, which leaves credit card holders unable to service their debt.
Impact of the Great Recession on Default Rates
The relatively high yield and low volatility of marketplace loans relative to other liquid, tradable fixed income products has attracted a wide range of investors to this asset class. Earlier we showed the historical returns on various Lending Club annual vintages. We also showed a longer-term picture of default rates across the entire spectrum of credit card borrowers. Lending Club is only making loans to borrowers with 660+ FICO score in their standard product, and 600-660 in their near prime product. A recent Federal Reserve study sought to quantify the impact of the Great Recession, centered around 2009, on default rates for unsecured consumer credit. They measured the default rate on credit card balances segmented by FICO score for each year from 2001 to 2011. The table below shows the annual default rate on credit card balances by FICO score for those years:
The next chart shows the above data in terms of the increase in default rate by FICO bucket from the pre-crisis average (2001-2006) to crisis peak (2009).
Margin of Safety
Online marketplace lenders offer loans in different grades, which correspond to different levels of risk, and thus different interest rates. They consider many factors when assigning grades to each borrower, including FICO score, years of credit history, total number of accounts, recent delinquencies, etc. The following chart shows the average historical interest rates and average returns by grade for prime Lending Club loans.
The chart shows that there are different default rates by grade, and default rates generally increase with higher interest rates. With this information, investors are in a better position to understand the margin of safety for their loan portfolios, because they can clearly see how increasing default rates would result in lower or even negative returns.
An examination of the above data shows that there is a higher margin of safety for A grade loans relative to G grade loans. For A loans, the average interest rate to borrowers has been 7.3%, and the average annual default rate has been 1.4%, leaving a 5.3% annual return to investors (after an assumed 60 bps servicing fee). Defaults could increase an additional 3.8 times from their baseline before the net return would drop to zero. By contrast, for F/G loans, annual defaults would only need to increase by 40% from their historical baseline before the net return drops to zero.
Risks of Online Marketplace Lending
The risks of investing in online marketplace loans can be divided into: 1) the risks due to macroeconomic conditions that influence borrower behavior, and 2) the risks specific to purchasing loans from online platforms.
Macroeconomic conditions can impact returns in multiple ways. First, prevailing interest rates can change. To date, platforms have appeared eager to maintain a constant spread relative to benchmark interest rates; when the Federal Reserve raised rates in December 2015, many marketplace lenders raised rates in lockstep. But this won’t necessarily always be the case. Platforms raise and lower rates at will, in an attempt to balance the supply and demand of borrowers – who are seeking debt consolidation at a reasonable price – against investor appetite to fund loans at a relatively attractive interest rate.
Macroeconomic risks also include changes in the unemployment rate in the US, as well as changes in aggregate consumer income. On the margin, a negative shock to the aggregate income of prime borrowers in the US is a negative for returns in this asset class, as seen previously in the chart comparing the unemployment rate to default rates on credit cards.
Finally, aggregate credit availability in the prime sector has a major impact on borrowing and ultimately default rates. Credit availability is cyclical; generally speaking, as the economy enters a recession, credit becomes very tight as lenders seek to defend their balance sheets and are unwilling to take risk by extending credit. When credit is tight, lenders keep a low ceiling on acceptable debt-to-income levels, and it is difficult for borrowers to quickly lever up and take on unsustainable amounts of debt. However, in the late stages of a recovery phase in the economic cycle, credit conditions are usually at their loosest, and prime borrowers may find themselves able to take on additional unsecured debt even with high starting debt-to-income levels. The result is that borrowers are able to quickly lever up, but may arrive at unsustainable debt service coverage levels.
Turning to risks specifically related to lending via online marketplaces, the chief risks that investors voice typically center around, “What happens to my investments if the platform itself enters a period of financial stress or bankruptcy?” Investors would be wise to perform careful due diligence on each potential investment platform to determine 1) to what extent the loans it holds are remote and protected from any bankruptcy filing by the platform, and 2) what backup servicing arrangements exist if the platform is no longer able to service the loans.
Online marketplace lending has been consistently growing and offers an incredibly compelling value proposition for both borrowers and lenders. Investors are attracted primarily to the return-to-risk ratio of this asset class, viewing the return stream as very appealing relative to other high yield fixed income options, as well as potentially much less volatile relative to liquid fixed income investments. Some of the main risks investors must consider include what margin of safety they have and how much defaults could increase before eating into principal, as well as how macroeconomic conditions will affect default rates. Overall, Evolution expects this asset class to continue to grow and to attract sophisticated investors who understand the unique value proposition of marketplace lending.
 https://www.lendingclub.com/info/demand-and-credit-profile.action. Includes all loans issued 2007-2015.