Comments on: Can I Really Diversify My Lending Club Loan Portfolio?

By: Sun

Sun — Tue, 15 Jun 2010 13:01:54 +0000

That’s exactly what I meant. As for Lending Club loans, you can’t really find a point where you can get a higher return by adding less risky loans. Of course, you can always be careful when selecting loans even within the same grade by avoiding risky borrowers.

By: Nic

Nic — Tue, 15 Jun 2010 08:04:16 +0000

Hi,
in my opinion your argument is only valid to a limited point.
You can perform risk mitigation on LC even when all your loans show the same expected return and the same default rate. To understand this, it is necessary to understand the difference between expected loss and unexpected loss. Expected loss is the average loss you assume, prob. by using the stated default rates. E.g. when you invest only in risky borrowers with a poor rating(a default rate of 5%) your expected loss will be 5%. So when lending to 100 borrowers it is quite probable that you will see 5 defaults. But these 5% are not the risk, as you have to expect it. The risk is that you will see higher losses, e.g. 10 defaults. These additional 5 defaults are called “unexpected losses”, which are also called risk (as risk is the deviation from the expected result.).And as borrowers are not completely correlated (as they show a large amount of idiosyncratic risk), you can diversify between borrowers, reducing your risk to the systematic risk, which is quite low for consumers. – Unluckily there are more risk resources, as there exist also model risk and parameter risk. – These are the risks that the assumption of the expected default rates provided by LC are wrong – maybe by purpose to attract investors(I do not hope so..) or just because they do not have enough experience and use only the data from a credit bureau and not from their own population. This risk is substantial and you can’t diversify within LC. And, what is in my opinion the highest risk at LC- the probability of default of LC itself. (I would guess a default probability of about 5%/year for the next 3 years) This can’t be diversified of course by investing in LC alone. And if LC defaults, you will have substantial problems to receive your money back, as you borrow to LC not to the borrowers directly(unsecured notes…). So this risk and this expected loss should also be priced in. P2P lending in US is therefore, based on notes issued by the platforms(i guess the sec is responsible for this approach), a very unattractive investment.
Just my 2 cents.Nic

By: Darren

Darren — Mon, 14 Jun 2010 21:41:29 +0000

Agreed. Loans can’t be diversified from the standpoint of different asset classes that move in opposite directions because they’re all the same asset.

A person signs up for a loan, and you receive principal and interest in return.

The only diversification that is done is reducing the possible rate of default, which is done by choosing loans with lower returns.

In this sense, it’s like a bond fund with different bonds with various grades and maturities.

By: Colin Henderson

Colin Henderson — Wed, 09 Jun 2010 14:10:49 +0000

RE: “Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

I would argue that to the extent there is systemic risk across all Americans from economic misfortune you have a valid point. P2P lending ought to be a component of overall portfolio diversification, not the only component in a portfolio.

Having said that I would say you can still get some diversification across different risk profiles within P@P lending by placing small amounts across many borrowers. This provides some risk mitigation from an unexpected borrower freefall such as Detroit etc.

By: Sun

Sun — Wed, 09 Jun 2010 02:20:07 +0000

I don’t have any doubt that you can reduce risk. Within the same loan grades, you can reduce risks by being more selective and avoiding those risky loans. However, this isn’t the traditional diversification in investments that brings lower risk and higher return. In Lending Club loans, lower risk seems to me always means lower return.