A Different Kind of High-Yield Investment

Only 16% of the stock market is traded by flesh-and-blood human beings. So tallies Morgan Stanley, which has been keeping tabs for the past 10 years, in a recent Financial Times article.

Computerized high-frequency trades (HFTs) dominate the other 84%. These trades, known as “black box” trades, are governed by complex algorithms that analyze data and transact orders in massive quantities faster than you can blink.

We wonder where the tipping point is. On top of it all, the Fed and Treasury keep interest rates at historic lows and dollar printing at historic highs, punishing savers and rewarding spenders. The special interests come first and the little guy last.

We believe we have found a way to avoid those “search and destroy” HFT programs, along with a lot of big-government and big-banking waste. We’re talking about a free-market solution to earn income by letting an individual be their own bank.

This idea may be able to safely generate a 6-15% interest on your savings — allowing you a five-10-fold boost over annual savings and CD rates.

It’s so transparent that you can actually access the detailed financial history of those on the other side of your trades through precise filtering tools. You won’t have to worry if you’re going up against a machine.

It’s called peer-to-peer lending. Two services caught our attention: Lending Club and Prosper Marketplace. These two have basically identical business models, but we believe that the former has the better overall record, so we’ll focus more on Lending Club.

The concept itself is simple: Peer-to-peer lending creates the shortest possible distance between individual investors and individual borrowers, the source of capital and the use of capital. When you cut out the big banks, you create some savings that can then be passed on.

You can get started with the money found lying underneath your car seats — just 25 bucks, the value of one note. And there’s no limit to what you can invest, allowing as much upside as you choose. Lending Club also does all the “back-end bank” work for you. You won’t have to worry about seeking borrowers or loan origination, transaction or late fees. It’s all done automatically.

The return on a loan is calculated by the same equation: They start with total interest received, add late fees received, subtract service fees and the outstanding principal for defaults experienced and divide by total outstanding principal for the period. They make their own money by taking a 1% annual cut.

To best explain this opportunity, let’s run through an example of how it works.

Let’s say right now, I go to the Lending Club site, sign up and get right into it. I then click “Browse Notes” under “Accounts.”

The top row on this page indicates the essential qualities of the loans I’m looking at: rate, term, FICO score, amount, title/purpose, percent funded and amount/time left.

But this alone won’t do for the smart investor. I want to diversify investments across specific kinds of borrowers. That’s where the site’s user-friendly filters come in. I can easily narrow down my list to desired levels.

First thing’s first: Choose between 36-month loans or 60-month loans.

Next, I’m going to filter the potential borrowers by their risk levels.

Lending Club categorizes, grades and prices loans by rating them A-G. This leaves the choice of which applications to fund and how much to fund each borrower. I consider myself more on the conservative side, so when I check the loan grade, I choose B-rated (11.88% interest rate) loans because their interest rates are better than A-rated, but I’m not willing to take the risk of C-rated or below.

Now it’s time to get down to the nitty-gritty. I click “More Filters” and find 23 additional filters that I haven’t considered yet. I check “Max Debt-to-Income Ratio,” “Home Ownership,” “Loan Purpose,” “Verified Income,” “Min Length of Employment” and “Credit Score.” That’s good enough for me. I hit “Update Results.”

One hundred and sixty-four results. I skim the descriptions: credit card payoff, home improvement, wedding expenses, debt consolidation, small business… that last one looks interesting. He wants $9,000… let’s check out the important info:

  • Loan Submitted: 4/27/12 12:18 PM
  • Monthly Payment: $293.55 (36)
  • Gross Income: $6,250/month
  • Current Employer: DEPT OF HEALTH
  • Home Ownership: OWN
  • Location: Bronx, NY
  • Length of Employment: 10+ years
  • Debt-to-Income (DTI): 1.63%
  • Credit Score Range: 714-749
  • Accounts Now Delinquent: 0
  • Earliest Credit Line: 10/2001
  • Delinquent Amount: $0.00
  • Open Credit Lines: 13
  • Delinquencies (last 2 yrs): 1
  • Total Credit Lines: 17
  • Months Since Last Delinquency: 10
  • Revolving Credit Balance: $2,431.00
  • Public Records on File: 0
  • Revolving Line Utilization: 9.70%
  • Months Since Last Record: n/a
  • Inquiries in Last 6 Months: 1.

Under loan description, I discover that he wants to fund a home care project that enables home health aides to take care of sick people, with a concentration on HIV clients

Since his employer is the Department of Health, that project makes sense. I like his reliable track record with respect to monthly payments, gross income, length of employment, debt-to-income and credit score range. A concern might be his credit lines, but if he’s replacing them with a better interest rate through Lending Club and it’s all going toward starting a small business, I find it acceptable. If I want to put my mind at ease, I could ask one of the 14 predetermined questions to pry a little further.

Now that I’ve found the borrower I’d like to invest in, it’s time to fund his loan.

I can invest as little as a $25 note, or if I really like this particular opportunity, I can invest in the remaining $8,975 on the loan.

Once the loan originates, Lending Club does all the rest for me: track the loan, show statements of the borrower’s payments and, most interesting to me, send monthly checks with my interest income.

If all goes as planned, I’ll earn north of 10% annual income after the loan.

As of this writing, Lending Club has originated approximately $620 million in loans. It averages more than $1 million in loan originations per day.

Investors with 800 or more notes have all experienced positive returns to date. Specifically, 93% had returns between 6% and 18%, with an average net annualized return of 9.64%. Defaults amount to less than 3%.

Of course, there’s a catch: Lenders are taking all the risk because there is no collateral against the trades. But this can be appreciated in its context.

First of all, the risk enables some exciting opportunities for those wanting to switch up their investing strategies. Both services have a secondary market platform in cooperation with Folio Investing, which offers portfolios of securities that you can buy, sell or customize in a single transaction.

Through this secondary platform, investors may buy and sell Lending Club and/or Prosper notes anytime before they reach maturity, as opposed to waiting out a three- or five-year loan on their primary market. It provides an escape route for those who are looking for something more short term, and it also increases transparency.

Second, each attempts to focus on highly creditworthy borrowers in order to reduce risk of default, declining approximately 90% of all the loan applications it receives.

Third, each has a contract with a collection service willing to provide anything from automatic reminders to debt-collection plans to legal measures for delinquents, if need be.

The business depends on a solid and proven track record, so these services are constantly tightening their credit policy, constituting a fixed-income asset class.

For now, they’re a supplement, rather than a replacement, for our banking system. However, we like where this is going because it could eventually claim serious market share. According to the CEO in an interview:

We’re focusing on personal loans today, and that’s only one part of the services you can get from a bank. We are not referring credit cards, debit cards, checking accounts, auto loans. But we do have plans for many of these products as long as [we fulfill] our mission of bringing responsible lending to prime and responsible borrowers, and then on the investor side present a risk/return equation that fits our investors’ appetite.

Here is our advice, should you choose to experiment with these services:

  • Always diversify into many different notes, and use filters as we demonstrated in our mock trial. These are the two golden rules. Lending Club recommends investing at least $20,000 across 800 notes for maximum diversification. We think that’s great advice.
  • If you can, place your notes in an IRA or Roth IRA to increase tax efficiency. Lending Club does not send 1099s for most transactions, because of their small size.
  • As far as the secondary market is concerned, there is a range of strategies to use. Vulture investing for the brave could reap immense gains if the timing is right.
  • Never let the cash you earn sit idle. Reinvest in additional notes whenever you can.


Addison Wiggin,
for The Daily Reckoning

The Daily Reckoning