Have the loans written so far in 2016, on average, been assigned higher interest rates that would compensate investors for the higher delinquency performance?
You've asked a seemingly simple question and I apologize in advance for giving a complicated answer.
My opinion is "no", the rate increases don't yet compensate lenders, but then I'm a lender, so may have a biased view, and there are many issues. Some of them are discussed below.
To compensate lenders means to make lenders' "return" adequate, so we have to talk about return.
First, any calculation of "return" for a loan portfolio is going to depend to some degree on predicting the future. Some of those loan payments will be made, and some will not. You should note that the chart above shows "delinquency" which does not directly affect return. We have to wait to see how much of that increased delinquency turns into "default", and whether we're in a bump, or a deteriorating trend. Delinquency is an early warning system for portfolio health, but doesn't lead directly to knowing where we'll end up.
Next, there are many different ways to calculate return. We used to debate them here, but that's a waste of time. Each method has its own merits. They differ in two fundamental ways. First, the philosophy. Different people set out to accomplish different things. Second, implementation. Most approaches require estimating future payments, and there are a variety of details surrounding how one does that.
LC started with a very simple calculation they called NAR. It was based on what has happened so far, ie the payments and the chargeoffs. It would be a reasonable estimate of return if all the loans in your portfolio made all their future payments, but that is way optimistic, so NAR is too high for most purposes, especially for young loans and young portfolios. As loans age, NAR slides down toward something less optimistic.
To improve on NAR, LC added a term which adjusts for loans that are late. They call this ANAR. The idea is that if a loan is late, there is some considerable probability that it is going to chargeoff, so lets take part of that chargeoff right now. They treat the expected value of future chargeoffs as if they occurred right now. They based the expected value on only the number of days the loan is late. Simple, and a good first step. However, ANAR makes no adjustment for loans that are now current. We know that a considerable fraction of them won't make all their payments, so ANAR is still optimistic, especially for young loans and young portfolios. ANAR still slides down over time, as its overly optimistic presumptions are replaced with reality.
The ROI computed by the excellent NSRPLATFORM.COM web site is very close to LC's ANAR. I show some of their numbers below, because many of you are familiar with these numbers, and that will give you a point of reference.
For my own work, I use a different kind of calculation, called IRR. It computes a return number based on ALL cash flows, not just the ones that have already occurred. For past payments, I use the history files to tell me which payments were made. For future payments, I use the expected value of each payment, ie the amount of the future payment multiplied by a probability that the payment will actually be made. These probabilities get smaller and smaller as we go farther into the future. I base the calculation of these probabilities on LC's historical loss rates, and some of the credit variables of the loan. The intent is to compute a return which is a good estimate of where I'm going to end up. If the loans match the historical loss rates, I should be able to predict return far in advance. This kind of return estimate doesn't slide down over time, like NAR and ANAR.
However, if loans perform differently than they have in the past, then even my IRR will change with time. We have some hints that several quarters of recent vintage are performing worse than historical data, so my IRR is likely also optimistic for these recent vintages.
Finally, the chart.
The orange curve: Simple. It is the dollar weighted average of interest rate (WAIR) for LC's portfolio for the quarter in question. You can see that interest rates came down big time in 2014 and 2015, and have recently moved up some. 2016Q3 will be even higher, due to LC's most recent rate increase.
The blue dots: These show what WAIR would have been if LC had been using today's interest rates. You can see, for example, that interest rates were most recently raised too late for Q2 loans. Q3 loans will have significantly higher rates. ... but in the big picture, the recent increases seem modest.
The yellow and green curves: These curves show investor return, measured two different ways, as described above.
Toward the left side of the chart, many of the payments are already made, so there aren't a lot of future payments to estimate. The left side is mostly cast in concrete now. That washes out the different estimation philosophies of the two calculation methods, and the yellow and green curves look about the same. Yellow is higher, but that is mostly because IRR is inherently compounded, where as NSR's ROI is simple interest. If you compound NSR's ROI, the numbers come out very close.
Even tho the two methods begin with a different philosophy, for old loans the numbers come out almost the same. That's why I stopped arguing about which method is "right"!
Toward the right side of the chart, something different is going on. The green curve is wildly optimistic, because it takes no account of the possibility that some fraction of future payments on current loans will not be made. If I recompute the green curve a few weeks from now, it will be lower on the right side, for sure, because some dude somewhere will have stopped paying. If you recompute the green curve a couple of years from now, it will almost surely be below where the yellow curve is now.
The yellow curve is a serious attempt to use all we know to avoid that kind of optimism by calculating and using probabilities that future payments will be made. However, this depends on those probabilities being fair estimates of future paying. We know, from the delinquency statistics, that the last several quarter vintages are performing more poorly than the historical average. Unfortunately, we don't know how much more poorly they will perform. We will learn that in the coming months.
The yellow dotted line is a projection of the sort of thing that could happen, if the underperformance we see produces significantly increased loss rates for these vintages.
LC has told us that they've made some underwriting changes, which we should expect to improve Q3. We don't know what those changes were, except in the vaguest terms, and don't know how effective they will be. We'll have to wait several weeks to get the first hints of Q3 performance.
