Thursday, January 12, 2012

Low Risk, High Return Lending Club Strategy (For Some States)

While I love the great state of Texas, I am disappointed in their regulation of citizens investing in Lending Club. There are many states that prevent their citizens from funding Lending Club Notes, and unfortunately I live in one of them. At the end of this post, I have a summary of a strategy I think will give huge returns for those in states who can fund notes, with really low risk.

Lending Club is offering a No Maintenance Fee for the life of loans over $20,000. The added bonus is that loans of that amount have the highest return, in general.

So for those who live in a state that allow them to fund notes, if you focus on funding notes in the $20,000+ range, not only do you get an average return of 10.29% (as opposed to 7.42% to 9.9% for lower amounts), but you get a 1% boost from not having the maintenance fee.

Now if you funded a $25 share of the loan to minimize risk exposure, the maintenance fee could be as high as 1.7%, because it is 1% of your payment, rounded up. Since $25 shares payments can be as low as $0.60 (possibly lower) that would be $0.01, rounded up to the nearest penny, which is about 1.7%.


To get the best returns with the least risk, fund notes in the Grade E and Grade F range. While these Notes have higher theoretical risk, there are ways to mitigate those risks we'll talk about later. Grade G Notes can go way too low of a return, while not getting much better high range than Grade F (as well as the average return is worse).

To continue to maximize your return, you can fund 60 month Notes (versus 36 month Notes). Lending Club gives a higher risk value to 60 month Notes, which translates into higher interest rates, 2.05% to 4.5% higher (see interest rate factors). True, the longer term Notes have more risk, but again there is a way to mitigate that risk.


So now we get to the risk mitigation, the FolioFN trading platform. This is where those who are in states that can fund Notes can help (and benefit from) those in states that do not allow us to fund Notes.

There seem to be two major camps of loan buyers. Michael at Nickel Steamroller focuses on highest Discount. This approach looks for the steepest Discounts or lowest Markup on Notes as opposed to highest Yield to Maturity. This approach appears to get you the most for your money.

The second approach is looking for the highest Yield to Maturity. This approach assumes that if the Note is held until it matures, and it does not default, you'll get the highest return. Of course, with Grade E and Grade F notes at 60 months, that seems like a bit of a stretch.

Yield to Maturity seems to be a very popular method of choosing Notes (hence the Nickel Steamroller post warning against it). It is the approach I use to maximize my return. I've heard many people wonder why people would buy a newly funded $25 Note for $26.50. The three reasons I can think of are (a) they are looking for the Note to be held to term and not default, (b) they are looking to sell the Note to an (a) at a slightly higher premium or (c) a combination of (a) and (b).


I am a (c). I buy mainly Grade F Notes with a smattering of Grade E and Grade G (yes, I know G is a lot riskier with lower return). I tend to also buy some mature Grade C and Grade D on occasion when I have under $20 available to buy Notes. I also buy mostly 60 month Notes. Both the Grade and the term of the Notes I buy is not really a conscious decision, but a byproduct of buying the highest Yield to Maturity Notes.

Strategy

So to maximize potential return, here is my recommendation for those who can Fund Notes:

Buying Criteria
  1. $20,000+ Loans
  2. $25 Notes
  3. Grade F Notes (22%+ Interest)
  4. 60 Month Term
Selling

Upon Funding, sell the Note at a 5% Markup. You'll get an immediate 5%, assuming it takes a month from the time you pledge the money for Funding to the time you get the money back from the sale. Annualized that would be more than 50% return. This cuts your risk because no Note will ever default because you sell them before their first payment.

For example, say you Fund 4 Grade F 22% 60 month $20,000 Loan Notes, spending $100 (4 x $25). You offer each Note at $26.25 (of the current top 60 Yield to Maturity Notes, 6 of the 14 $25 Notes are offered at over $26.25). Your funds (after FolioFN takes their 1%) are at $103.92. If that took 30 days, and then you reinvested the $100 in the same way, after 7 months you'd have $127.44. Then you start funding 5 Notes with the same criteria. In 5 more months, you'd have $152.09. For the year, you'd have over 50% return.

Caveats

This strategy is based on current market conditions. If too many people flood the market with high Yield to Maturity Notes, you'll have to reduce your Markup to get your Notes sold. I in no way guarantee that this strategy will work as described as the market place can change dramatically based on a number of conditions.

This is a win-win for those in states that can Fund Notes and those in states that cannot. It gives us in non-Funding states a nice stream of Notes to buy. It gives a nice low risk, high return for those in states that can Fund.

11 comments:

  1. Getting 5% on a newly issued loan would be rare. I've had good loans with 18 months of payments sit on Foliofn for a week at 4% and not sell. Just because people are listing notes at $26.50, doesn't mean those notes are selling.

    Lou

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  2. @llamoure, Thank you so much. I have no (zero) experience in funding Notes and selling them, only watching from the other side of the fence. Is getting 5% on newly issued F Grade Notes rare? From my side of the fence that seems to be the going rate. Almost a quarter of all the Notes I currently hold I payed over $26 for (4%+ markup). Over half I paid more than $25.

    I'd be interested in some data on how long it takes to sell $25 F Grade Notes at different premiums (1%, 2%, 3%, 4% and 5%).

    A couple of questions. What do you consider a "good loan"? And with 18 months of payments, I'm not surprised you didn't get 5% premium, you've already gotten most of the interest (especially on a 36 month note). Newly minted Notes have a high Yield to Maturity because all of the interest is front loaded. The payment remains the same during the life of the loan, but at the end it is mostly principal. At the beginning it is nearly all interest.

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  3. I try to sell all my notes right away (Lots of high D and E grade notes), and I'm happy to get away with 2-3% markup prior to the first payment. If I can get 2% in the 7 days they allow you to list it, it results in an annualized return of somewhere between 100% - 2000+% (depending on how quickly you can sell it in that week). 3% obviously only makes it a higher return, but I've found much less likely to sell. Maybe it's that I have mostly E grade notes and not F or G.

    Question for you as you look for loans. Do you only look for those that are Now Current/Never Late, or do you look at those who have had payment issues in the past? I was wondering what your success was with those that are steeply discounted due to previous glitches but current as of the date of purchase.

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  4. @ChrisB, Thank you for the info. So it sounds like a 3% markup on Grade E Notes is an upper limit. I didn't know how long it would take from funding to cash ready to invest again. Sounds like a week is not unreasonable (I assumed a month in the article above). I wouldn't bother with Grade G Notes, as they tend to have lower overall returns anyway.

    I only look for loans that have never had payment glitches. I am now using only the Never Late filter. I then select the Notes I want to buy (Highest Yield To Maturity, I don't already own a Note from that Loan, $25 slice of the Loan) then I see if there are any payment glitches before buying the Note.

    Would you mind trying a few Grade F Notes and letting us know how they turn out?

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  5. Mark,
    This is my experience selling new notes. I list my new notes with a 3% premium. I do not adjust the price as interest accrues. Most G notes sell in one to two weeks. I have never had a G note that does not sell before the first payment. F notes take a little longer usually selling by the third week. E and D notes are a crap shoot. I have many that did not sell before the first payment. This is even after accrued interest takes the premium down to around 1.5%. I only buy E and D notes that have passed my filter criteria so I am not all that concerned about holding them.

    I can tell you that there is a lot of competition in the G note arena. There are people that purchase 25+ of the same note and list them all and will adjust their price below whatever price someone else has the same note listed. So to sell your note you have to wait until all of their notes are sold or lower your price. These typically are the G-4 and G-5 notes.

    I believe that the E and D notes are harder for buyers to find. No matter what filters you use on folio the E and D notes are buried many pages in the listings.

    All in all this strategy works pretty well if you are into the work it takes to purchase and list all of these notes.

    My average since late May has been around 100 notes per month. Not all of these have been new notes but a large part has been.

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  6. @c.j. Thanks for the data. So from the time you commit the money to funding a Note to the time you have the money ready to commit to another funding, about 2-3 weeks?

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  7. @Mark,
    That would be a fair assessment of the time frame. I only commit money to notes that have already been approved. This cuts up to a week off of the process. In the past I would commit money to unapproved notes only to see them cancelled. This would tie up money for a week or so for no return. I also try to commit money at the end of the funding cycle either with one or two days left or if a note is 85% funded. This also cuts the time down. Time is money in this game and everything helps.

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  8. @c.j. I really appreciate your perspective. Thank you.

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  9. Mark,
    I am not sure if you noticed yet but Lending Club has changed the secondary platform. The newly issued notes are not in the now current section and not the never late section. This makes if very difficult to sort for newly issued notes due to all of the junk notes in this lower category. In fact I have not sold one newly issued note in the days since this change was made. This strategy may not work as well now due to this change. Just waned to make this update.

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  10. @c.j. Thanks for pointing that out. I didn't notice that either.

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  11. @c.j. In my latest post (February 16, 2012) I figured out of to view Issued Notes (near the bottom of the post). You now need to search for Issued separately from Current, but you can get best Yield to Maturity for each.

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