What Returns Do You Expect Going Forward?

[macroman7799]

I think to a substantial degree banks are getting preferred choice of loans and would not be willing to take many of the loans going through the retail platform, at least not on the terms that they are being offered.

Do you have any evidence?

LC has many times said it doesn't happen.

You're not the first to suggest this, but none of the other folks had any evidence.  Just sour grapes, conspiracy theory, etc.

Evidence, no. It is my opinion. That's why I qualify my statement with "I think".

Really I don't expect to purchase fractional shares of loans at $25 each exactly on level terms with larger players that have a bigger share of the action. I also know that as an individual I am avoiding a lot of expenses that the larger players have and can't avoid.

If I want to participate in the bank's end of P2P I'll buy banking stocks.

[rawraw]

Since LC still receives the retail based funding they need even though returns continue to diminish, there is little incentive for them to implement change to benefit the investor.

They receive most of their cash from institutional investors, and most of that from banks.  Why banks are satisfied with such low yields is beyond me, probably because I'm not a bank.   ... but we have to consider that these days we're competing with banks.

Because banks have enormous leverage that amplifies returns.

A bank often just wants a 1 percent return on assets. Then the 80 percent leverage produces a good ROE. Most Lending Club people are fully funded by equity.

[Rob L]

Since LC still receives the retail based funding they need even though returns continue to diminish, there is little incentive for them to implement change to benefit the investor.

They receive most of their cash from institutional investors, and most of that from banks.  Why banks are satisfied with such low yields is beyond me, probably because I'm not a bank.   ... but we have to consider that these days we're competing with banks.

Because banks have enormous leverage that amplifies returns.

A bank often just wants a 1 percent return on assets. Then the 80 percent leverage produces a good ROE. Most Lending Club people are fully funded by equity.

Let me describe my very simplified understanding how this bank leverage thing works and you (and others) correct my errors.

First banks acquire deposits from customers, say savings accounts, and pay their customers interest (say it's an online bank like Ally that pays a high interest rate of 1.6%, the national average savings account now pays 0.09%). Through the magic of fractional banking the bank may lend up to 10 times the amount of deposits it holds. So the leverage is 10:1. The bank's cost of the money it's loaning is 1/10 * 1.6% = 0.16%.

Now LC comes along and offers consumer unsecured whole loans to the bank that they can analyze and perform due diligence on prior to acquiring them. If the bank is very conservative and only acquires loans from super prime borrowers their median ROI from the OP table is 4.3% - 0.16% = 4.14%. I have some direct experience from a few years ago and banks at that time only bought super prime A Grade loans. Pretty sweet deal for hardly having to lift a finger. The bank's cost of acquisition of the loans from LC is trivial and LC services the loans for them for a fee (already included in that median 4.3% ROI from before).

The bank has a very low start up cost, has almost no investment in personnel, plant and overhead, can control the amount it loans out on a daily basis and can walk away from lending in the future at no cost anytime it chooses to do so. Basically the bank has simply outsourced almost the whole process making it extremely flexible. Additionally the bank benefits from whatever asset diversification these type loans provide and the leverage is against a broadly diversified portfolio of loans within the asset class (Big Short not withstanding, lol). If you are a bank what's not to like for a portion of your loan portfolio.

If individuals could borrow at 0.16% it would be a pretty sweet deal for us as well. 

It's worth mentioning that Goldman Sachs decided on a different business model for Marcus. I guess they thought the middlemen (LC and Prosper) cost more than they were worth and decided to take the whole process in-house. The jury is out on both models I suppose.

[rawraw]

You got it mostly right except the math to reduce the cost of funds. The banks creating money stuff is not the same as the amount of money they pay interest on.

If they have 100 in assets, they'll have something like 90 in deposits and 10 in equity. They'll pay 1 percent on the 90% and then have a required ROE of say 8% on the 10.they can also use some types of debt instruments in the 10 that are cheaper than equity

In general, banks have a net interest margin of 3 to 5 percent. This is the difference between loan yields and interest costs.

[jrl]

You got it mostly right except the math to reduce the cost of funds. The banks creating money stuff is not the same as the amount of money they pay interest on.

If they have 100 in assets, they'll have something like 90 in deposits and 10 in equity. They'll pay 1 percent on the 90% and then have a required ROE of say 8% on the 10.they can also use some types of debt instruments in the 10 that are cheaper than equity

In general, banks have a net interest margin of 3 to 5 percent. This is the difference between loan yields and interest costs.

It's a lot more complex than that, mainly only checking accounts have reserve requirements. Also, much smaller banks don't have a reserve requirement.

https://en.wikipedia.org/wiki/Reserve_requirement#United_States

This may help understanding: https://en.wikipedia.org/wiki/Money_multiplier#Table

Basically, The Fed is trying to encourage more lending, but most banks don't want to, so now most banks are flush with reserves, which they aren't required to lend. This is why inflation remains subdued.

Seen another way, Bank A lends to LC customer X, which is also a customer of A. If X deposits that loan into a savings account at A, then A can loan out that whole amount again.

[Fred93]

First banks acquire deposits from customers, say savings accounts, and pay their customers interest (say it's an online bank like Ally that pays a high interest rate of 1.6%, the national average savings account now pays 0.09%). Through the magic of fractional banking the bank may lend up to 10 times the amount of deposits it holds. So the leverage is 10:1. The bank's cost of the money it's loaning is 1/10 * 1.6% = 0.16%.

No. A bank may not lend 10x the amount of deposits it holds.

Fractional reserve banking is widely misunderstood and incorrectly described on the internet.

It is NOT some magic thing that lets banks multiply up their returns.

Banks take in X in deposits, and are then allowed to lend something like 0.9 X.  The remaining part of the deposits is held in reserve.  That is fractional reserve banking.  A fraction of what they take in as deposits must be held in reserve.

The talk of multiplier effect comes from academic economists who think about the effect of these loans on the money supply.  That's an entirely different discussion, and those equations don't apply to the bank's returns.

When talking about the bank's returns, note that the bank has to pay out interest on those deposits ... ALL of those deposits, the entire X.  Right now interest rates are low, so the bank pays out maybe 1% interest on X deposits, but it is still on the entire X.  No magic multiplier.

The bank receives interest income on the amount they loaned out, which is 0.9 X .  This is LESS than X.  Not some magic multiplier MORE.

In this sense banks are EXACTLY like you and me.  I don't lend out ALL the cash I have.  I reserve some for a rainy day.

In the above discussion I presumed the reserve requirement was 10%, but in actual practice it is not a single number, but thousands of pages of rules.  The reserve requirements are different for different kinds of accounts (ie saving vs checking) and for different kinds of loans (ie mortgages vs line-of-credit) and for different kinds of investments (ie treasuries vs other kinds of bonds vs money the bank has deposited at the federal reserve).

You are correct to say that banks are paying very low rates on deposits these days.  The rates vary wildly between 0.05% at some stock brokers to 1% or 1.5% at other institutions, with the occasional bank offering teaser rates on CDs over 2%.

So you can see that what banks earn is actually LESS than the difference between the incoming and outgoing interest rates multiplied by the amount of deposits.  It is certainly not some multiple of this difference.

So where does all the talk of a "multiplier" effect come from?

When economists think about the money supply, ie the available amount of money for all of us to use, they note that making loans CREATES money.  It works like this.  (To keep this simple, lets assume the reserve requirement is 0%, and I deposit $1 in my account.)  Money in my account allows the bank to lend money (perhaps you borrow $1 for the new home you're building).  You don't spend that all right away.  The day you take out the loan, you deposit the money in your bank account.  Now there are two bank accounts with $1 in them.  But now the bank has $2 on deposit and has loaned out only $1, so they can make another $1 loan to Joe.  He begins by putting that in his bank account, and the process repeats.  The amount of money in all our bank accounts is larger than the amount of money we started with.  Even when you eventually take money out of your account to pay your architect, this just gets deposited in the architect's account, so is still counted in the total of all bank deposits.  (Might be at a different bank, but economists don't care, as they study the economy as a whole.)  In this simple example, the reserve requirement is 0% and the multiplier is infinite, as this can go on forever.  In actual practice the reserve requirement is greater than 0, say maybe 10%, so the multiplier is something like maybe 10.  In general, the multiplier is the reciprocal of the reserve requirement. 

It is important to understand that this notion of a "multiplier" is not science.  It is just a heuristic that economists have devised to explain the effect that lending has on the economy as a whole.  It teaches, for example, that one can have some control on the money supply by controlling bank reserve requirements.  This is of interest to economists, but mostly not to you and me.

More info (without conspiracy theory hype) at...
https://en.wikipedia.org/wiki/Fractional-reserve_banking

[Rob L]

Okay I think I've got it but I'm still left with a couple of questions.
What is this bank "leverage" thing and how is it obtained.
Do banks presently have so much cash on deposit that basically any method a bank can find to loan that money is attractive? In a world of mid 3% fixed mortgage rates I guess that makes sense.

[jrl]

In this simple example, the reserve requirement is 0% and the multiplier is infinite, as this can go on forever.  In actual practice the reserve requirement is greater than 0, say maybe 10%, so the multiplier is something like maybe 10.  In general, the multiplier is the reciprocal of the reserve requirement.

As I referenced above, most non-checking accounts in the US have no reserve requirement, but it's a moot point because most banks have excess reserves anyway.

The problem with fractional reserve banking is that most of our money is just digital 1's and 0's. In no way can all of the debt ever be paid off. The system requires ever larger loan volume just to prevent deflation, which would be bad for everyone with loans, but good for everyone that's debt free. It's a scam to debase the currency. The Federal Reserve System could last another 100 years, or it could fail tomorrow. It will eventually fail though, just like every other time this system has been tried. (But "this time it's different!")

Bringing it back to the topic. Since the excess reserves are such a problem, the banks don't mind the somewhat stable returns with low overhead they can get from LC. It's a "if you can't beat 'em, join 'em" mentality. Just like how the tobacco companies are investing in vape companies, the banks are covering their rears by partnering with "alternative" lenders. People think big business is a competition, but it's more like a cartel, they all get along and work with each-other, to shut-out any competition by small players. Another good analogy would be cable companies, they don't compete for turf. In this city (NYC) there's 3 cable companies, but none of their service areas overlap. You have no choice between them, although you can choose the phone company (Verizon) or satellite companies. LC is like the cable company offering phone service, or phone company offering cable service. They still need to work with each other in order to provide a good level of service. In the case of Verizon offering TV service, most of the channels and networks are run by the cable companies. It's all a big club, and we're not in it.

[rawraw]

Okay I think I've got it but I'm still left with a couple of questions.
What is this bank "leverage" thing and how is it obtained.
Do banks presently have so much cash on deposit that basically any method a bank can find to loan that money is attractive? In a world of mid 3% fixed mortgage rates I guess that makes sense.

A bank has leverage because it has much more liabilities than equity. It's allowed to do this due to a mixture of capital regulations and deposit insurance, which means the depositors don't consider it risky to lend to the bank.

When you make a deposit in a bank, that is a loan. They then use your loan to fund assets at higher rates than they pay you. Even if the spread is 2 percent between the two, the fact that they are only 10 percent equity amplifies the returns

The reserve requirements being talked about here is more a liquidity issue. It just means you can't invest a certain percentage of the deposits. But this is really a rounding error, with many banks having very little reserves.  It's fairly easy to make the number very close to zero in practice

[Rob L]

Okay I think I've got it but I'm still left with a couple of questions.
What is this bank "leverage" thing and how is it obtained.
Do banks presently have so much cash on deposit that basically any method a bank can find to loan that money is attractive? In a world of mid 3% fixed mortgage rates I guess that makes sense.

A bank has leverage because it has much more liabilities than equity. It's allowed to do this due to a mixture of capital regulations and deposit insurance, which means the depositors don't consider it risky to lend to the bank.

When you make a deposit in a bank, that is a loan. They then use your loan to fund assets at higher rates than they pay you. Even if the spread is 2 percent between the two, the fact that they are only 10 percent equity amplifies the returns

The reserve requirements being talked about here is more a liquidity issue. It just means you can't invest a certain percentage of the deposits. But this is really a rounding error, with many banks having very little reserves.  It's fairly easy to make the number very close to zero in practice

Okay, thanks. Now I think I really understand. Equity is "my money" in the game. I take on a lot of debt (customer deposits, "other peoples money") and make loans with it that are my assets ("other peoples money owed to me and secured for them by FDIC"). A relatively small amount of "my money" controls a much larger amount of "other peoples money", hence the term leverage. Profits or losses relative to my assets are dominated by the returns I'm able to get using "other peoples money". In a way my equity has little to do with my profits. My misunderstanding was that there was some leveraging of the amount of "other peoples money" involved. It is not.

[rawraw]

That's right. Once you understand this, you'll see why banks are so conservative. Small swings in assets can completely wipe out their equity

[Rob L]

That's right. Once you understand this, you'll see why banks are so conservative. Small swings in assets can completely wipe out their equity

Going back to why LC loans are attractive to banks. Very simplified example with crude approximations. If I invest my money, say $40M, in LC loans at 4% APR my return on that investment is 4% (I have no leverage). If a bank's equity is $40M but its assets are $133M that cost the bank 1% APR, and the bank invests 90% of those assets ($100M) in LC loans at 4% APR then the bank's return on its $133M assets is 2.7% APR (NIM) but its return on $40M equity is more like 8.1% APR (Leverage is 3X). Banks can play very conservatively and still do quite well. Thus the preference for A Grade loans and an explanation of why banks find them attractive and individuals not so much.

[rawraw]

You are now a bank expert

Now a bank does have overhead associated with those deposits (branches, servers, websites, etc), but you get the idea.  And Lending Club allows geographic diversification and consumer lending, which tends to be hard for small banks to do at scale.  Most banks do mostly commercial