Lending Club made news earlier this month when they announced they were increasing interest rates again. But what they also shared was that this was partly due to an increase in delinquencies in particular at the higher risk end of the credit spectrum.
Grades E, F and G at Lending Club are at the highest interest rates ever with the top rate for a G5 rated loan now at 30.99%. The interest rates on these higher risk loans have been steadily increasing for many years. I have a screenshot I took back in October 2010 when a G5 loan had an interest rate of 21.14%. Today, a loan with that interest rate would be rated D5 at Lending Club
So, does this mean that the G5-rated borrower of today is more risky than the G5 of 2010? Certainly the expected loss for the 2016 borrower is far more than this same person in 2010. But while interesting I don’t think this says much about the possibility of a recession in the near future. It simply means that Lending Club is targeting a higher risk borrower.
Having said that, the reality is that there has been higher than expected delinquencies in the higher risk portions of Lending Club’s portfolio. Here is a paragraph from their 8-K released last Friday:
Consistent with observations earlier this year, we have continued to observe higher delinquencies in populations characterized by high indebtedness, an increased propensity to accumulate debt, and lower credit scores. Although the trend can now be observed across grades, it is less notable in lower risk grades and more notable in higher risk grades, particularly grades E, F and G, which account for approximately 12% of platform volume. Higher delinquencies are more evident in 2015 and early 2016 vintages, which coincides with an uptick in consumer indebtedness in the U.S.
What we also need to keep in mind is that Lending Club runs a pure marketplace. This means that they need to price loans that investors will find attractive. This fact is often overlooked but it is one that has been a driving force in the multiple increases in interest rates we have seen this year not just at Lending Club but at Prosper as well.
The other piece of news that caught my eye was this piece from American Banker last week on the increase in loan loss reserves at many of the large banks. Big card issuers like JPMorgan, Citi and PNC have been moving down the credit spectrum a little which has led to increases in expected delinquencies. So, this seems to be consistent with what Lending Club is saying, that those higher risk customers are experiencing higher delinquencies than they have in the recent past.
So, while I could speculate what this all means I decided to reach out to two people who follow the loan performance trends in this industry very closely. First, we will hear from the CEO of PeerIQ, Ram Ahluwalia:
Forecasting recession is very difficult. That said, the data is generally positive and recession probabilities appear low.
- Leading indicators such as the financial markets are not pricing in a recession. Financial markets have famously predicted 9 out of the last 3 recessions. They are not pricing in a recession at this time. Credit spreads are tight and equity markets are richly valued. Also, headline inflation expectations are increasing. Access to credit continues to expand. These are not trends consistent with recession.
- Coincident indicators are uneven – unemployment, industrial production, and capacity utilization have improved in recent reports. There is some weakness seen in recent reports from the Chicago Fed National Activity Index and manufacturing data.
- Increased delinquency rates are occurring across multiple credit asset classes at riskier credit asset classes – auto, student, credit card and also installment loans. The rise in delinquencies is primary driven by a mix shift to towards originating riskier loans. This is consistent with expansion of credit underwriting amidst increased competition for borrowers.
- On the prime portion of the credit spectrum, if you look at the delinquency data at the master trust portfolios of high credit quality master trust securitizations from JPMorgan, Citi and Bank of America we see a decrease in the path of delinquencies.
I would not draw the conclusion that increased loss-rates are sign of impending recession over the next 6 months.
Perry Rahbar is the CEO of dv01 and here is what he had to say when I asked him what the Lending Club and bank data means.
With regards to Lending Club, I think they’re still learning and iterating with their underwriting/pricing. To be honest, I’m a bit confused by Lending Club because the lower grades in the standard program continue to drive a negative PR effect for them when it’s become less and less a focus of their business. Just look at the volumes, they’re pretty small. Additionally, they have a pretty robust near prime program that’s covering similar territory, is pretty big in size, and is performing a lot better. Last, this is all only a conversation because of the transparency Lending Club offers and the tools we all have, whether it’s us or Orchard, etc…, to be able to quickly digest the performance data and derive actionable insights from it.
As for JPMorgan and the increased credit reserves, post crisis, banks pulled back significantly from lower credit borrowers. In fact, this was a big reason so many marketplace lenders had an opportunity to enter the market because they often targeted borrowers that were no longer serviced by the system. Given the strong credit environment, banks have recently expanded their boxes again and I think the increased reserves is a sign of them being responsible from a risk management standpoint. I think they’re choosing to err on the side of caution this time around.
Conclusion
While investors never like to see an increase in delinquencies I think the reality is that the economy is still in remarkably good shape. Another recession will certainly happen at some point and that will lead to increases in delinquencies across all credit grades. It seems that the increases we are seeing now is more about lenders (both marketplace lenders and banks) moving down the credit spectrum than about any macro economic issues.
I have asked many guests of the Lend Academy Podcast over the last six months about what they are seeing as far as delinquencies in both consumer and small business lending. Without exception, everyone has said that the loan data is telling us that a recession is simply not on the cards in the near term. Even the latest data seems to continue to bear that hypothesis out.
