The second part of the Lending Club analysis involves what I already own. My goal for the portfolio is to own a duration laddered portfolio with a geometric weight on grades. That’s a serious mouthful so let me describe each part.
Since I am only investing in 36 month loans, the loans I expect to own have a duration of 36 months to one month. I would prefer to own an equal amount for each month on the duration ladder. That sounds simple enough but these loans pay down principal like any other loan which means it will take exact accounting to validate the purchase.
Weighting based on grades is more complex. The charge off rate increases as the grade gets lower. This is expected and validates the grade. I want to minimize my exposure to loans that will default (be charged off) and that means holding a larger amount in the higher grades. In looking at the 2012 – 2013 loans, the charge off rate versus grade approaches a line. There is an academic realm of consumer behavioral expectations that I would like to explore regarding credit, but this is designed to be about me.
If I were to accept a normal amount of risk, I would weight linearly along the grade scale. However, I am not willing to accept a normal amount of risk due to my age and retirement horizon. Thus, I have decided to use a geometric scale to establish a weighting pattern. The result is a weighting pattern where the highest grade has a target weight 19 times higher than the weight of the lowest grade.
So my routine becomes a simple pattern of downloading the loans for sale, filtering based on my criteria, sorting by the highest discount rate, and determining if the note would fit into my portfolio. Given the bandwidth I have access to, this should take less than five minutes each day.
As an aside, I am a little concerned about the amount of effort I will have to put into this, specifically on the accounting side. Each time a note posts a payment, I’ll need to markdown the principal that is paid. The purpose is to keep the amount available for each duration period accurate. At first I thought there would be only 36 loans — one for each duration period. Then I realized as principal is paid down, I can go into the secondary market and purchase smaller loans to back fill that period. Suddenly, the number of loans I would be owning became a number large and unknowable.
I think I should be able to keep track weekly and it should take less than an hour, but that will depend on whether there is seven loans with payments or seventeen. I really want to only do this weekly. It will match up with the weekly work I perform on the equity side of the portfolio. This will be an interesting experience as I continue learning about peer to peer lending.