A Kandinsky-esque picture: the evolution of Risk to Reward on Lending Club

We think a lot of about risk versus return. Recently, we looked in to the evolution of risk to return on Lending Club. Since alternative lending notes are highly illiquid and are ongoing, this question can provoke a complicated response. A simple method to view the information is to plot the average weighted interest rate, which correlates to “reward”, against the cumulative default rate, which can be viewed as the “risk” one is taking. The resulting graph reminds us a bit of Kandinsky, a Russian artist known for abstract artwork.

The data includes the cumulative Lending Club publicly available portfolio across all grades and on both the whole and fractional loan market. is current as of April 1st, 2017, and gathered from available Lending Club data.

Interest versus Default Rate by Year

This first image shows Lending Club’s unsecured consumer credit loans over time. As loans age, defaults within the vintage are expected to increase. This means that while each vintage’s “x” position is fixed, its “y” position will increase as time passes, until all loans are paid or charged off. Vintages from 2007 to 2011 have completed, while vintages from 2012 to 2017 still have loans that are paying. A line connects one vintage to the next.

We can see that the default rate increased for the first six years of the platform’s life, as Lending Club sequentially adjusted interest rates. The data shows that the default rates for 2016 have already surpassed the default rates for loans issued in 2015. This may be caused by several things, including macro-economic conditions, a degradation in origination standards, and a shift in the grade mix towards riskier loans.

Interest versus Default Rate by Quarter

For the next two graphs, we ‘normalized’ the default rate by assuming a fixed hazard curve and projecting lifetime defaults based on a loan’s current age. Keep in mind that while these assumptions are good for general comparison, any projection is only an estimation of future results.

The size of each dot represents the number of loans issued that month, with a larger dot representing more loans being issued.

In the early days of Lending Club, both interest rates and default rates tended to be about the same. From 2011 to 2013, Lending Club’s interest rates and respective default rates show a clear pattern of rising interest rates. This pattern reversed in the third quarter of 2014, as the average interest rate fell for the next ten quarters.

Differences between the Fractional and Whole Loan Marketplaces

We were interested to see what if there was a difference in the risk-to-reward ratio between the fractional and whole loan marketplaces. The resulting graph is below. The dots connected with the grey line represents the fractional loan market, while the dots connected by the black line represents the whole loan marketplace.

This chart does suggest that there is a difference in the risk/reward tradeoff between the whole and fractional marketplaces, with the whole loan marketplace tending to hold lower interest rate loans. One reason for this may be that, while Lending Club notes within grades are distributed randomly between the whole and fractional market, a higher percentage of ‘safer’ notes are funneled to the whole loan marketplace. This may indicate a reduced appetite for risk amongst institutional investors, who may be using alternative lending notes as corollary for the bond market, versus retail investors, who may be more yield reaching.