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The Large Impact of Early Defaults on ROI

by Peter Renton on January 9, 2012

I have been keeping a daily track of my NAR on all my Lending Club accounts now for almost a year. I have also been doing this for my Prosper accounts since they introduced annualized return numbers back in October. During this time I have been able to observe the negative impact that defaults have on the annualized return calculations.

My Roth IRA account at Lending Club was opened in April 2011 and was fully invested by October. So, this account has an average note age of around six months with the oldest notes being almost nine months old. This account is invested in high interest/high risk notes: D-G grades. So I expected many defaults and so far I have had three. It has been interesting to see what these defaults have done to my NAR calculation.

Here is a screenshot of this account from three months ago when there were no defaults followed by one from this morning showing the impact of three defaults on my NAR.

October 2011 Lending Club Roth IRA

January 2012 Lending Club Roth IRA

Three defaults have dropped my NAR roughly 4%. In fact, it is a little worse than that. My NAR the day before my first default was 18.53% and last week after receiving my third default it was at 14.48%.

My First Lending Club Default Dropped My NAR 2.26%

The first default back in October saw my NAR go from 18.53% down to 16.27% in one day. Now, I expected this but for a new investor a drop like that may come as somewhat of a shock. But when you think about it, this makes sense. The total principal loss of say $24 impacts your returns far more when you have only made $180 of gains.

For comparison, last week my wife’s Lending Club IRA (that I recently took off PRIME) received another default (the 35th default in this account) and the NAR went down exactly 0.09%. This is because the account is over 18 months old and it has had around $10,000 in interest received, so a principal loss of $45 has very little impact on the overall return.

The Lesson: Don’t Freak Out About Defaults

I hear from many new investors who are utterly dismayed when they receive their first default. They go back over the loan listing and wonder where they went wrong. But when you are investing in p2p lending, even if you stick with just A-grade notes, defaults are going to happen. And in the early days of your p2p investing they will have an oversize impact on your ROI.

While defaults are never welcome, I have learned to accept them. As long as my overall returns remain strong I barely give them a second thought.

For an interesting look at projecting ROI check out this post from Nickel Steamroller yesterday.

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{ 17 comments… read them below or add one }

Bilgefisher January 9, 2012 at 4:16 pm

I have seen defaults from people with 50+ non late payments. Life happens and a p2p loan payment is an easy thing to cut for many folks.

Jason

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Dan B January 10, 2012 at 7:27 am

Very true. I’d say it’s almost guaranteed to be the first thing that is cut in a crisis. But we all know the risks so…………

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Peter Renton January 10, 2012 at 10:05 pm

@Bilgefisher/@Dan, Any unsecured debt is an easy thing to cut in a crisis and I think p2p lending would be on an equal standing with credit card bills when needed. The big difference, of course, is that with p2p lending you have a fixed payment and a credit card you have more flexibility in the monthly payment.

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Dan B January 11, 2012 at 4:20 am

Peter………No,. it is precisely this type of incorrect deduction that led to the gross miscalculations in the projection of default rates during the early days of p2p. Continued payments towards a credit card affords the borrower a continuing line of credit (i,e. uninterrupted & immediate access to fresh cash, &/or whatever potential cash on credit one may have left). Furthermore, it is very easy to essentially make a minimum payment that is almost all interest, then extracting the same amount from the same credit card within a day or so. On the other hand, making a p2p payment does not in any way give you access to fresh cash…………which is the most important thing when facing a financial crisis. Therefore p2p payments are the first ones to be ditched………….not credit cards.

As if any evidence is necessary to confirm the above, one can look at credit card default percentages for ANY group of borrowers during 2008-2009, then compare those to the almost 40% cumulative default rates suffered by Prosper p2p on loans of that era. P2p was always higher.

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Terry January 11, 2012 at 10:33 am

I’m new to this, and I have my first “late” at >30 days already. The person has made NO payments. I ‘ve had 2 “in grace period” notes, one of which was paid before it went late, the other of which I’m waiting on now. I looked at the late note, and there wasn’t anything I would have changed — even after revising my filters a lot, this one still would have been acceptable to me. So, I agree, I’m not going to worry about it at that level. But I did register on FolioFn… I haven’t researched how to offload sketchy notes yet… I guess it’s time to start. Thanks for all the valuable info Peter!

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Charlie H January 11, 2012 at 11:19 am

Indeed a credit card bill will always be paid before a LC or P note will be paid because the credit card is a line of credit. The borrower can buy groceries and put gas in the car with a credit card. A LC or P note…. not so much.

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Roy S January 11, 2012 at 12:30 pm

I agree with Charlie and Dan here. In 2008 and 2009, I was hearing of people paying the CC prior to their mortgages for the exact reasons Charlie and Dan have already stated.

The hope here is that most of the people who are taking out p2p loans have credit scores more reflective of their financial personalities. Credit scores are heavily weighted towards people making their payments. Pre-recession, it was easy to access more and higher credit lines or take out a second mortgage on the artificially appreciated house they were living in to finance their unsustainable lifestyle. People were paying credit with credit and over-leveraged. The recession took down a lot of those people. Now their credit score should be where it should have been all along. So I really don’t see the default rates getting to be as bad as they were during the early days. I’d be more concerned once the economy starts to pick up again. By that time, most bankruptcies will be wiped off the credit profile and their bad payment history will get better, and people will start living on credit again. And the credit scores will start to be inflated as a result. If Prosper and LC can’t compensate for these inflated credit scores in their models and interest rates, then we’ll revisit the early days once the boom turns to bust. It may not be as bad if, like in previous recessions, peoples’ houses don’t decline as much as they have the past few years. This recession was a double whammy since the bubble in the economy was in the housing market, and that’s where the average person/family has the majority of their net worth.

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Charlie H January 11, 2012 at 1:42 pm

And for those people with negative equity, the smart move was to pay the CC before paying the house, let alone before a P2P note.

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Dan B January 11, 2012 at 2:10 pm

Roy S………Very true. I know a couple of people who have taken the exact paths & lived the circumstances you’ve described.

Charlie/others………From what I understand there were basically 3 mistakes that were made in the early assumptions of p2p default rates by both companies. One was the use of credit card & personal loan data to estimate p2p losses. The second was the assumption that the “social” element, such as it was, would function as a deterrent to borrowers walking away. We all know how that worked out. And third, was the use of zoppa.uk’s phenomenally low historical default rates/data (which continue even today, though I don’t know how) to estimate default rates. This last mistake was understandable because it’s a direct apples to apples comparison even though we’re talking about UK borrowers. Last time I checked, Zoppa was still managing a under 1% default rate after 6 years in operation! Now that is a real accomplishment!

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Dan B January 11, 2012 at 2:43 pm

Terry…….I’m not Peter but I will give you 2 pieces of unsolicited advise. As silly as it may sound, don’t take the lates or defaults personally. When I first started out I pretty much did. Many otherwise intelligent investors have driven themselves around a bend by examining & re-examining problem notes. It’s not worth it & accomplishes little if anything at all. Unless your default percentages are in excess of average, just let it go. And secondly, diversify until you get to at least 500+ notes.

As for selling notes, I have a lot of experience there. I’m assuming you’re a Lending Club investor because Prosper doesn’t allow the sale of “late” notes, last time I checked. My advice to you is that if you’re going to sell a problem note, then sell it early & price it aggressively, Late notes are extremely tough to sell unless they contain special circumstances (like someone who has missed a payment, but is still paying, or someone who is under a pre-arranged payment plan) Other than those examples, late notes don’t usually sell unless they’re being offered with discounts of 50% or higher. “In grace period” notes are much easier to sell, but still normally require discounts that can range anywhere from 10-25%, depending on a variety of factors.

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Dan B January 11, 2012 at 10:05 pm

In the previous post, that’s zopa.uk………….not zoppa.

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Peter Renton January 12, 2012 at 5:24 am

@Dan, I just read an article last month that said Bank of America’s annualized default rate on their credit cards was 5.67% of total balances outstanding in November last year. Lending Club’s number is below 3% and while I don’t have Prosper’s numbers on hand I think they also compare favorably to Bank of America.

I know that both Lending Club and Prosper have based a lot of their underwriting policies on the credit card industry. But these days they have a pretty decent history of loans that they can use their own data as a good predictor or payment/default trends. This will become more accurate as we move forward.

@Terry, It is unlucky to get a late payer who has made no payments but most long time p2p investors have had this happen. You simply can’t predict with any certainty how any one particular borrower will perform.

@Roy, No question in my mind that the bigger risk for p2p lending is when the economy starts booming again. People have short memories and will start to ramp up spending again once we return to more prosperous times.

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Charlie H January 12, 2012 at 8:54 am

Peter a good article would be looking at Zopa.
How are they different then LC/P
How are they the same?
Difference in the type of borrowers on the platform?
Default and debt Laws different in the UK?

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Dan B January 12, 2012 at 10:55 am

Peter…………That’s now, not then. Besides we’re talking per annum here. And as you well know, I was referring to the default rates of the early p2p loans from the 2007-2009 era BEFORE the adjustments were made to the 3 factors that contributed to the higher early default numbers……………not the p2p loans today.

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Peter Renton January 12, 2012 at 11:49 pm

@Charlie, I have thought about doing an article on Zopa – it is on my blog ideas list. They have done a truly amazing job of mitigating defaults so that would be worth it in itself. I am trying to get a good buddy who lives in the UK to open an account so I can get some first hand feedback.

@Dan, I know you were referring to the early (dark) days of p2p lending at Prosper where default rates were significantly higher than credit cards. But I just wanted to get some current numbers out there for the casual observer.

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Dan B January 13, 2012 at 11:35 am

I don’t understand how it’s possible for Zopa to have started the business from nothing, grown it over the 6+ years & consistently have gotten the type of ridiculously low default numbers they’re been getting the entire time. And the returns to investors have been decent as well.

What I’d like to also hear more about is that other UK p2p company (whose name escapes me) that has the insurance fund set aside for defaults. Peter, you know the company I’m referring to correct?

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Peter Renton January 14, 2012 at 3:03 am

@Dan, I think Zopa really have some top management who know what they are doing. Keep in mind, they basically invented this industry back in 2005.

The company you are referring to is Ratesetter and they have something called a Provision Fund which is setup to provide investors with their money back in the case of a default. They have paid out on all defaults this far. You can read more about it here:
http://www.ratesetter.com/lending/credit_process.aspx#PF

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