Does LC Suffer Fools Gladly?

[rawraw]

You got it right nonattender.

6% is simply the number I settled on in 2013 when I started with LC (scout's honor).

Return of 6% is a good goal.  But I have a couple thoughts about it.  First, setting return thresholds that do not take into account the market can lead us to increase or decrease or risk tolerances over time.  While 6% is surely less at risk of this than a target of 15%, if the 10 year treasury went to -2%, then achieving a 6% return may lead to some bad outcomes.  I prefer to view returns relative to a risk index.  So instead of targeting a 6% return, I'd advise trying to target a XXX basis point spread to the index. Slightly different but I think it is more prudent.

Second, how is 6% defined?  Is it based on the worst year during a recession, a rolling 3 year period, etc?  Assume we had a situation where you earned 50% for 6 years, lost 20% every 7th year, and then repeated this.  Would you get out when we went below 6%?   Typically lenders talk about "through the cycle" returns.  While I don't have the magic answer, I think it is correct that leaving a LC investment just because it falls to 0% one year could be a very suboptimal strategy.  We humans like to chase returns and it costs us a lot.  The example  I love is that retail investors get roughly half of the returns the mutual funds they invest in get.   So if the mutual funds I buy and sold over a year get 10% return, I normally get 5%.  This is due to me selling when things go down and buying when things go up.   While the percentage changes each year,  it is very consistent that retail underperforms even the underlying asset due to these behaviors.

[nonattender]

While I don't have the magic answer, I think it is correct that leaving a LC investment just because it falls to 0% one year could be a very suboptimal strategy.  We humans like to chase returns and it costs us a lot.  The example  I love is that retail investors get roughly half of the returns the mutual funds they invest in get.   So if the mutual funds I buy and sold over a year get 10% return, I normally get 5%.  This is due to me selling when things go down and buying when things go up.   While the percentage changes each year,  it is very consistent that retail underperforms even the underlying asset due to these behaviors.

https://www.youtube.com/watch?v=mypHpsSoF8o

[nonattender]

I'm not so sure FHN is a good example.  A good rule of thumb is that any bank with C&D loans >20% is not a safe bank stock (I doubt they had this much for the tech crash etc).  Unfortunately it seems like all the real estate fintech guys are jumping into C&D lending. I sure hope it isn't a train wreck.

Where does 6% come from?  But I agree with your conclusion about lower grade notes. I don't see much incentive to invest in them.

I gotta admit I was totally unaware of C&D Loans>20% implies unsafe bank stock thesis. FHN imploded most recently because it ventured into national mortgage lending during the housing boom. Afterward, Fannie and Freddie crammed their stupidly underwritten mortgage loans back down FHN's throat a little at a time so as not to bankrupt the company over the past 7 or 8 years. Anyway, if you have an example of a safe bank stock or two over the span of circa 1992 to date I'd really like to know. I'd seriously consider investing.

Lived in and around FHN's target market, off and on, for years, and never invested, though they do still send me $200 bribe offers every few weeks to open a checking account or a "competitive" (~0.04%) MMA.  I think they're losing marketshare to RF and STI...  There are a number of reasons for that, one of which is lack of decent technology, but another is that Republicans swept into local government in a lot of the major metropolitan areas in the South in which FHN operates - and those guys are cutting finance costs, shopping around, and, in general, dismantling the monopoly/municipal deals that FHN enjoyed for decades during Democrat administrations.

Purely on price, FHN is really expensive at the moment, ~25% moreso than most "peers".  I'd have sold it, too, if I had owned any.  On the other hand, they just took a big chunk of Tri-State Bank, which historically served an almost exclusively African-American population, so, maybe FHN is about to start rolling out a big marketing push for the lower (fee-rich) socio-economic end of the their regional market, which they have traditionally totally ignored for deposit activities but for whom they were very happy to write mortgages, as you noted.

Anyway, if you want to play "bank picking", start a thread, I'll play.  I've been doing it awhile now already as prep for the next ~8 years.

[Rob L]

Purely on price, FHN is really expensive at the moment, ~25% more so than most "peers".  I'd have sold it, too, if I had owned any.

Well, that was my conclusion. Thought the Trump-effect run up was overdone (for this specific bank at least). I could understand a bump to $17.50 but not $20.00. It was at $15 before the election. I still own a few shares that were dividend reinvestments and their sale would have been short term gain when I cashed out. Might sell them after the year is up and find another bank with stronger fundamentals and less volatility. I don't know enough about bank stocks to contribute much to a thread. If you've done post-election homework you're willing to share I'd certainly find it interesting.

BTW, I was born and raised in Memphis and have close family in Knoxville. Don't get back home much any more.

[SLCPaladin]

But there are ways to minimize the impact of stress.  Can the borrower pay? How much wiggle room do they have?  How stable is their job?  These are very basic things us as retail investors can focus on regardless on what LC is selling.  The only thing that is different here, is that LC could not sell us junk but sell our next door neighbor junk.  Even though we aren't buying, it does impact the platform risk for us.  Hence why I don't like secret loan programs.

I think this gets to the heart of the issue. Even if I somehow manage to not pick up "the bad loans," to the extent that overall platform returns decline due to poor underwriting (e.g., perhaps it's the next door neighbor who buy the lesser quality notes), I am nevertheless at risk if returns dip too much for everyone. This is because the platform relies on lot of participants being in the market. At some point, investors, retail or institutional, may decide that returns are insufficient to keep deploying cash. That might be 6% for some, but I tend to think that 5% is a floor. I'm getting 3.1% in FDIC-insured CDs, so a couple hundred basis points above that doesn't sound too enticing to me given the additional risk.

If that happens, the marketplace breaks down and LC's business model stops working. I've always felt that LC should be raising interest rates right now because the downside risk of having too high interest rates (fewer borrowers apply for loans) seems greater than rates being too low (platform could experience capital flight). It seems to me that even with Discover and Goldman Sachs dipping their toe in to the market, there still would be demand from borrowers even if rates were raised across the board.

[SLCPaladin]

For the record, I also don't like "secret loan programs." Thanks to non-attender for explaining the history of this. I am, however, excited to hear more about LC's refinance auto-loan product. I tend to think it is good for LC to experiment with this sort of innovation, so long as they are upfront and transparent about it, and only if they do it in a way that doesn't put other lenders in jeopardy. Personally, I would be very interested in investing in an LC loan secured by a mortgage or an auto title.

[Rob L]

This is in reply and agreement to much of what has been said above so I'll omit quotations for brevity. When I said LC's underwriting was broken I may have misspoken or been misunderstood, but it's really simple. Divide the world into low risk and high risk borrowers. It's a fuzzy line but that's ok, go with the flow.

My crystal ball envisions a future where banks (Discover, Marcus, and those that follow) dominate the low risk world. The banks et.al. are just as savvy as LC, meaning LC has no informational or underwriting advantage over them (maybe less; who wants to compete with GS quants anyway?). What happens? LC is only able to originate low risk loans at rates lower than what the banks find profitable. No problem; it's not LC's money they're loaning anyway. A year or two LC investors figure out their loans aren't doing so great. This is kinda like individual investors buying notes in whole loans that the institutions passed on in the first place. That never seemed to be a very smart thing to do personally. So as time passes LC becomes less and less able to compete for low risk borrower's business.

High risk is different. So many regulators are looking over banks shoulders they can't throw their FDIC insured depositors money out there as stupidly as was once the case. I don't see them competing for this business for a very long time. LC and other MPL's have this field to themselves, but what are they doing? They are making high risk loans at "near low risk" interest rates. I don't mean the interest rates are low in an absolute sense, but the projected returns per LC's own crystal ball are abysmal. Well, that's a great way to make tons of originations right now, but you hose your lending base at the same time. This returns to the "suffer fools gladly" theme. Eventually fools figure out the game and walk away from high risk loans, leaving LC with nothing. I don't understand why LC doesn't get it.

I am very much looking forward to rebuttal to this bleak thesis. I'd really like to remain optimistic, but I've got the above in my head right now. Can somebody put a smiley face on the future?

[nonattender]

For the record, I also don't like "secret loan programs." Thanks to non-attender for explaining the history of this. I am, however, excited to hear more about LC's refinance auto-loan product. I tend to think it is good for LC to experiment with this sort of innovation, so long as they are upfront and transparent about it, and only if they do it in a way that doesn't put other lenders in jeopardy. Personally, I would be very interested in investing in an LC loan secured by a mortgage or an auto title.

Yeah, I don't think it probably is much of a risk - though I don't know that, which I don't like - given the balance sheet, and I'm happy they're expanding into other product lines - and I understand that there are, in some cases, compelling competitive reasons to want "secrecy" re: new products.  But after the second time rawraw referenced "secret programs", I thought it might need an explanation.

That was all.

[JohnnyP]

I appreciate the explanation - thanks.

[rawraw]

This is in reply and agreement to much of what has been said above so I'll omit quotations for brevity. When I said LC's underwriting was broken I may have misspoken or been misunderstood, but it's really simple. Divide the world into low risk and high risk borrowers. It's a fuzzy line but that's ok, go with the flow.

My crystal ball envisions a future where banks (Discover, Marcus, and those that follow) dominate the low risk world. The banks et.al. are just as savvy as LC, meaning LC has no informational or underwriting advantage over them (maybe less; who wants to compete with GS quants anyway?). What happens? LC is only able to originate low risk loans at rates lower than what the banks find profitable. No problem; it's not LC's money they're loaning anyway. A year or two LC investors figure out their loans aren't doing so great. This is kinda like individual investors buying notes in whole loans that the institutions passed on in the first place. That never seemed to be a very smart thing to do personally. So as time passes LC becomes less and less able to compete for low risk borrower's business.

High risk is different. So many regulators are looking over banks shoulders they can't throw their FDIC insured depositors money out there as stupidly as was once the case. I don't see them competing for this business for a very long time. LC and other MPL's have this field to themselves, but what are they doing? They are making high risk loans at "near low risk" interest rates. I don't mean the interest rates are low in an absolute sense, but the projected returns per LC's own crystal ball are abysmal. Well, that's a great way to make tons of originations right now, but you hose your lending base at the same time. This returns to the "suffer fools gladly" theme. Eventually fools figure out the game and walk away from high risk loans, leaving LC with nothing. I don't understand why LC doesn't get it.

I am very much looking forward to rebuttal to this bleak thesis. I'd really like to remain optimistic, but I've got the above in my head right now. Can somebody put a smiley face on the future?

I don't think the above is necessarily true.  Let me try to unpack it

Assumption 1:  The world of credit is not bifurcated currently, but will be in the future.

I think the market has always been separated.  Perhaps the fintech story glosses over this fact, but there has always been a range of players.  While there is diversity among banks, ultimately they normally don't go very far down the credit spectrum.  Just think of the subprime crisis -- banks weren't the ones who were the purchasers.  They just originated and sold into securitizations.   That was too risky for them and they gave it to others. 

Assumption 2:  LC has an information advantage that the banks will soon get.

Last I checked (not sure if it is disclosed anymore), all the data LC used was mostly credit bureau data.  Where do you think the info edge comes from?  There have been banks making automated consumer loans forever.  Ever wondered how before fintech, you still got an auto loan offer while at the dealership?

Assumption 3:  LC will have to undercut banks on rate.

LC will certainly have to match market rates somewhat.  If they offer the same rate as a bank but it is easier for the customer, the customer will probably go with LC.  So why is LC destined to lose this competition with other lenders? 

[Rob L]

Assumption 1: The world of credit is not bifurcated currently, but will be in the future.

I think the market has always been separated. Perhaps the fintech story glosses over this fact, but there has always been a range of players. While there is diversity among banks, ultimately they normally don't go very far down the credit spectrum. Just think of the subprime crisis -- banks weren't the ones who were the purchasers. They just originated and sold into securitizations. That was too risky for them and they gave it to others.

Okay, the future is now and the world of credit is bifurcated and always has been. I would comment that the originators often did make guarantees regarding the returns of the loans that were securitized. In this way, they took on a significant risk that came back and bit them. If I understand it, LC does the same today but it's something I know very little about.

Assumption 2: LC has an information advantage that the banks will soon get.

Last I checked (not sure if it is disclosed anymore), all the data LC used was mostly credit bureau data. Where do you think the info edge comes from? There have been banks making automated consumer loans forever. Ever wondered how before fintech, you still got an auto loan offer while at the dealership?

Totally agree. LC has no underwriting edge.

Assumption 3: LC will have to undercut banks on rate.

LC will certainly have to match market rates somewhat. If they offer the same rate as a bank but it is easier for the customer, the customer will probably go with LC. So why is LC destined to lose this competition with other lenders?

Maybe they won't lose the low-risk loan competition and the market will be big enough for everyone. However, the competition has heated up and will probably continue to do so. Could LC survive and grow into the future by only originating low-risk loans?

On the high-risk side who is their competition?
If LC has little high-risk competition then why are they originating high-risk loans with such low projected returns?
Is LC being very conservative with its high-risk loan returns estimates because it's smarter and safer to overdeliver rather than underdeliver?

So many questions. Only time will tell.

[jheizer]

You would think that being all web based would b a positive for a lot of people now a days.  But most are catching/caught up there already.

Interesting story.  I have a friend who has known I have been in investing in LC from day 1.  The topic comes up now and then.  The other day he logged into his Amex account to pay his bill and saw their banner saying get a personal loan.  He was like that is a great idea I can pay off XYZ.  Clicked, got it, and done.  He had known about me and LC for at least a year at that point and he is a commercial property underwriter so not like it is some topic totally foreign or hard to understand to him.  But for some reason the amex banner made him go Hell yes. (It might have been an email and not a banner, but same idea of practically $0 acquisition cost borrower)  He didn't even compare rates to LC or anywhere else.  I'm not sure if it was the brand name or what that made the idea click and him borrow.  Hard to compete with that.

[rawraw]

1) Yes, but a lot of it was due to indemnification clauses in terms of fraud. If the loan has defects, it can be put back.  Like I've said on this forum before, comparing LendingClub to a mortgage originator is the best mental model I can find.

3) I don't think it's fair to say there is no competition for high risk. It's certainly less competition, but low rates have caused people who normally wouldn't lend in the space to enter. So you have hedge funds, pensions, and other institutions competing for yield.

Ultimately the above (LC being a mortgage broker) is why I never could justify the stock price, even at these levels. But the factors that make them attractive busines vs just one that provides attractive loans for me are separate. 

I currently expect companies like LendingClub to become more like a provider of services for others, like banks. Every bank in the country uses the same few core processors and people for their websites, but to the consumer it looks bank specific. It seems like most of these Fintech firms will go from customer acquisition models to software solutions for banks and others. But some will certainly stay with the current model, but it really needs a ABS market to sell into.  At least, this is how I think about it

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