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The End of LendingClub?
Jul 14, 2016, 12:05p - Investing

There are 2 parts to this story. The first is about LendingClub's (LC's) actions as a company, and the second is about my returns on the site.

Early on in LC's history (2007-2009), they advertised a 9% return for investors, right on the front page of their website. I was always skeptical of this from the beginning, because I didn't believe that they properly factored in the default rates of the loans. There is a fundamental difficulty with estimating returns on loans (3 year duration for LC's first generation of loans): returns are high in the beginning when loans haven't had much time to default, and drop over time. So if you have a portfolio of very young loans, you will likely overestimate your return. LC's loan volume has been growing so rapidly that the site-wide portfolio has always been very young. After the first batch of loans were 3 years old and I had a chance to analyze only those loans that had had a chance to go to completion, I found that the return was half of what they had been advertising, closer to 4.8%.

Strike #1 - LendingClub advertises inaccurate estimates of investor ROI, due to underestimation of defaults.

Still, a 5% return was not bad, and that was site-wide. I had some filters setup based on lending experiences on Prosper and LC, so I thought I might be able to do a bit better, around 6-8%. That seemed worth the work of spending 15 minutes every morning reinvesting principal on the site, which I did for several years, until 2014. Payments come in as interest + principal, so to really get the maximum return you need to keep reinvesting the principal. Contrast this with bonds, which make interest payments (the coupon) and pay back the principal at the end of the term. Uninvested principal due to regular payments and early repayment of loans is a necessary headache to be dealt with these kinds of investments.

As an aside: LC never made a good automated investing feature on its website - in fact, the UI and feature set is essentially unchanged since 2009. That on its own is a bit pathetic for a so-called "tech" company, but I think it represents a kind of inertia and lack of connection with its individual investors.

In addition to the complication of prepaid principal, the second complication with LC is how taxes are computed. All interest is counted as ordinary income, and all defaulted loans are counted as capital losses. From a holistic point-of-view, this is a bit backwards, as I would have expected the losses to be deducted from my interest earnings, and the leftovers to be taxed as ordinary income. Alas, this isn't the case. Note this isn't specific to LendingClub, but is an issue with a lot of loan-like investments, including bonds. What is specific to LendingClub is their whopping-high defaults, which have ended up being 40% of my interest earnings. If you are able to sell capital gains to recover the capital loss benefit, your effective tax rate is increased from 30% (fed + state) to 37% on this LC income. This caused my post-tax ROI to drop by 33%, from 6% to 4%! I'll give some more detailed numbers later, but this sucks.

The main issue here is that you can't compare LC ROI to another income investment's ROI, like a bond fund, because the tax consequences are so different. So LC looks great at first, than surreptitiously bites you when you go to pay taxes.

LC never clearly explains this tax situation when it is advertising its ROI, and the investor doesn't realize this until they start doing their taxes. I didn't full quantify the magnitude of the effect until after many years of investing, and many investors I suspect may not even notice.

Strike #2 - LendingClub again inaccurately estimates investor ROI, due to the tax consequence of high rates of default.

OK, 2 strikes. Still, I can manage the tax consequence and factor that in, and factor in more reasonable default rates. Perhaps I can still make a 6-8% return? Ahh, but the work of lending every morning is starting to wear on me.

Voila, as if they heard my issues, they start their own LC fund (called BBFQ). This removes the burden of me picking the loans each day, and the tax consequences should be better, or so I was told (this later turned out not to be true - the tax consequences ended up being just slightly worse). The downside is I don't get to use my special filters anymore, but the fund had averaged 8% or so over the past couple years, so maybe I don't need my special filters. Also, the fund invested in 5-yr loans in addition to 3-yr. I only ever invested in 3-yr loans. But 2/3 of the fund is supposed to be in 3-yr and only 1/3 in 5-yr. Maybe this is what I've been waiting for?

So I invest in the Fund at the end of 2014, pulling most of my money out of the website, and 2015 returns are alright (see below). Then, the founder and CEO is forced out in May of this year because he did not disclose an investment in an outside fund that LendingClub itself is considering investing in (conflict of interest), and because some loan applications were incorrectly dated to match an investor's criteria (fraud). WSJ has some good coverage, and I take a closer look at the Fund. Turns out, the Fund has not been investing to its target ratio of 66% 3-yr, 33% 5-yr loans. Instead, it has inverted, and has been investing 60% in 5-yr and 38% in 3-yr loans. I found this very suspicious, as 5 yr loans have higher interest rates, but greater risk, so it looks to me like LC is pumping up the returns in the Fund, just like they had inflated returns on the website. I call them to ask why this is happening, and they can't give me any definitive answers. Regardless of why, it is a violation of the stated portfolio strategy, so there is clearly a lack of internal control in the Fund.

Strike #3 - LendingClub is unable to maintain the portfolio targets they advertise for their Fund.

Then, on June 28, they send out an investor letter. June will be the first ever month of losses in the Fund, which I can handle. But they also report that additional investigations have found more acts of dishonesty in the company. First, the (now booted) founder borrowed money on the site in 2009, apparently to pump up their loan volume numbers for their VC investors. This sounds like a spoiled culture from the very beginning. Second, the Fund bought loans that no one else would buy on the site earlier this year, in violation of its stated investment strategy.

Strike #4 - The LendingClub Fund (and company) have a lack of internal control, which allows erratic and unethical behavior.

Now they have laid off 12% of their employees. There was 1 week when no new loans were listed on the site. Random stuff seems to be happening.

I expect more disclosures of ineptitude over the coming months as they audit all of their internal processes. But I suspect this might be a dishonest company at its heart. They may be able to change, but after 7 years of swallowing their issues, I think I've had enough.

Nonetheless, all of this risk would be worth it, if the returns were sufficiently high. Sadly, they are not.

Here are my pre-tax returns on LC's site (non-Fund), all on 3-yr loans:
2009: 7.1%
2010: 5.7%
2011: 5.3%
2012: 6.7%
2013: 6.5%
2014: 6.5%
2015: 4.1% (drop is because I stopped investing on the site and moved money into the Fund)

My pre-tax return on the Fund in 2015 was 5.7%, but my post-tax return is actually 3.6%. And 2016 is looking worse, with a pre-tax return of 3.2% and a post-tax return of 2.0%.

Altogether, over 7 years, my pre-tax annualized ROI on the LendingClub site was 6.1%, and over 1.5 years on the Fund was 5.1%. But my post-tax ROI on the site, properly accounting for capital losses, comes out at 3.9%.

All this work and nothing that amazing to show for it :( The post-tax return of 4% on a California long-term municipal bond fund is starting to look mighty appetizing. So much simpler, and without the tax headaches and company drama.

Of course, the bond fund has its own issues, esp. how bond yields will respond to upcoming interest rate increases, if in fact the Fed every decides to start those...

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