Hedging High Risk P2P Portfolios

Thus far, Lending Club and Prosper 2.0 have produced some outstanding returns. When people use tools like Nickel Steamroller’s Return Forecaster they can see deterministically that taking on more risk will produce higher returns with a good degree of confidence.  Risk determines reward. But what would happen in a mass default situation?  What if a majority of borrowers suddenly had trouble repaying loans?

You don’t have to go far to see financially distressing scenarios can impact entire countries in short periods of time. In fact, just this last year Greece, Spain, Italy and to a degree France have all experienced varying degrees of financial instability. When people with debt have to consider what to “default on”, an unsecured loan will be the first to face non-repayment. Typically the order of default will go something like this.

  1. Unsecured Loan: Borrower walks away with little consequence (recovery rates on this are virtually negligible)
  2. Unsecured Credit Card Debt: Borrower foregoes access to future debt
  3. Mortgage: Borrower will rent
  4. Auto: Borrower gives up personal transportation, this is usually the last thing to go
Although there is currently no apples-to-apples way to compared credit card defaults to P2P loans, you can infer your own conclusion with the following chart which is based on S&P/Experian’s default indices. Credit cards give you the ability to take on additional debt in the future, while a loan does not.

During the height of the financial turmoil that occurred in 2008 A grade loans performed the best, producing ~+4.0% returns. F grade loans which are currently the best returning loans, returned (-3.85)% annualized for those issued in 2008.

If you are an investor that isolates lower grade notes, it would be wise to hedge your P2P portfolio with at least 5% A grade notes and 10% B. To my knowledge nothing like a credit default swap exists at this point for P2P lending so best things you can do lessen impact from a mass default scenario is incorporate higher grade loans into your investment strategy. Of course this will lower your ROI.  But, don’t expect a 5% drop or even close. A/B loans do incredibly well, and in the case of 2008 – the closest situation we’ve had to a mass default situation – they performed very well.

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  • Frankie C

    My initial gut feeling when I started with p2p was also to hedge my portfolio with low-risk loans. However, after reading more on the topic, I adopted a perspective widely spread amongst p2p investors: p2p is the riskiest 1-10% of my investment portfolio. P2p is hedged by the rest of the portfolio (stocks, mutual funds, bonds,…). Hedging within the high-risk segment of the portfolio is counter-productive. My high-risk segment will do its job better with higher risk loans. Low risk loans will just slow it down.

    What do you think of that perspective?

    • http://www.nickelsteamroller.com/ Michael

      I see your point.

      I do not view p2p lending as the riskiest position in my portfolio.  Positions in gold, silver, oil, and long term treasuries I feel have much more downside potential than p2p lending at this point in time.  If we go into a double dip recession I can predict with almost metaphysical certitude p2p will out perform all major indices significantly. I look at p2p lending as a way to lower portfolio volatility, while beating 10 year “risk free” treasury returns . Mixing in a small hedge of high quality loans will help even more – of course at the expense of reduced ROI. I have about 9% in B loans right now already, they are doing very well.  The reason for this blog post is because I think 2013 will be a significant down year in the equities market which may impact p2p lending to an extent. I could be totally wrong on this, I could be wrong on a lot. I just feel better with a small hedge in my p2p portfolio.

      • Russell Warden

        It’s better to hedge.  I’ve heard of money making unsecured ABS portfolios of credit card receivables blowing up when the economy takes a hit.  I know that P2P is tight and I love cruching the numbers, but the history is very short.  So it’s always good to keep that in mind.

  • Russell Warden

    It may lower one’s annual ROI — but the geometric return on investment will be much higher with a portfolio that doesn’t have as many fluctuations due to the macro-economy.  One year’s ROI is only part of the picture IMO

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  • Rawiswarden

    I’ve been thinking more and more about what kind of risks get embedded in a portfolio the riskier you go into Lending Club.  The data isn’t very lengthy yet, but I wonder if we could find a high R^2 with something like G Notes and Unemployment, S&P, GDP, or some other metric that would gauge economic risk.  Have you done this before?

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