Penny Notes: A Detailed Look at an Innovative Strategy for Lending Club FOLIOfn Investors

Note: This is a guest post from New Jersey Guy, who currently only invests through FOLIOfn - the secondary market for Lending Club.  He implements several FOLIOfn strategies, some of which he outlined in his last posts (4 part series) on Peer & Social Lending.  This is a continuation of the post from Lend Academy about his penny note strategy.  Below New Jersey Guy gives a little more detail into this particular strategy.  Please keep in mind that this information is not investment advice,  just the opinion and perspective of one investor.  Thanks to New Jersey Guy for another fantastic guest post!

Who has a crystal ball?

Imagine that one-day you’re on the computer looking at new notes on either Lending Club or Prosper.  Low and behold, a super-great note appears on your screen.  It’s wrapped in gold lettering with the sound of cherubs reverberating through your speakers.  A halo slowly descends over your monitor.  It’s the perfect note!  However, you have something others don’t.  You have a crystal ball.  So you chant some magic gibberish and gaze deeply into the ball.  All of a sudden the crystal ball gives you new information.  It tells you that 14 months from now that the note will be 100-days past-due and on the verge of Default.  It also tells you that the note you’re willing to pay $25 for today will be selling in mass quantity on Folio for an average of $2.65 per note.

Would you still buy it?  Obviously, not!

So what do the subscription services fail to predict that the crystal ball did?  Life!  Economic downswings, job losses, divorces and even death are just some of the variables that cannot be calculated when crunching numbers.  The best your subscription can provide is an overall probability of failure.  For example, your service might tell you “That out of the 100 notes you bought this month, odds are 5 of them will fail before maturity”.  What it can’t tell is exactly which 5 of the notes are going to be the failures.  So how do you know?

You do posses some magic!

WHAT IF you were able to eliminate life’s variables from your decision making?  WHAT IF there was no divorces, disabilities or even death?  Would that help you in making loan decisions?  Naturally, it’s a silly assumption.  However, you do have a little magic at your disposal.

Most of you are already aware that I wrote the Guest Blog  “Foliofn Users at Lending Club Are Not Second Class Citizens”.  What I didn’t expect were the replies and questions concerning the strategy, which talked about purchasing “Penny Notes” off of FOLIOfn.

What is the “Penny Note” strategy?

Simple.  The Penny Note strategy is a very short-term strategy based on buying quality, seasoned notes with no more than 15 remaining payments.  I think Simon Cunningham (Lendingmemo.com) best explained it in his blog.  He described a loan as having “3 Seasons” with the first season (the first 10 months) as having the highest odds of default.  The Final Season, as he describes “(are) months 18 and up, (which) has the most stable returns since the majority of loans that default would have done so.”

The nice thing about buying Penny Notes is that you can have absolutely no knowledge of P2P lending and make this work. You don’t need to know terms like DTI, ROI, RBI, DOA or DNA.  You don’t have to know about the Big Bang theory, the Flophausen-Thong Aeronautical Algorithm Model or any of the other rocket science articles you may have read.  Unlike picking newly issued notes where you can have up to 35 different variables to look at, Penny Notes have only 2!  In less than 20 seconds, you’ll be able to determine whether or not a note is worth buying.  It’s that simple.  But first, let me explain my theory behind this, a theory I call “Profile Equalization”.

Let’s take two loans that issued on the same day 24-months ago.

The first was an A-Grade loan paying 6.5%.

The second was a C-Grade paying 14%.

After 2-years, both borrowers have made their payments on time and have perfect track records.  So, at this point, what is the difference between the two?  The interest paid, and not much else!  Odds are, both of these borrowers will continue to pay their loan on time, right to the end.  In other words, the profile differences that separated them 24-months ago have now “Equalized”.  Both are great payers.

In more detail, all the profile variables investors studied 24 months ago mean very little or absolutely nothing today.  It doesn’t matter what the reason for the loan was for.  It doesn’t matter if the borrower wrote a good description.  It doesn’t matter what they do for a living, how long they’ve been at their job, how much money they make, or whether or not they rent or own.  Best of all, it doesn’t make a difference if the borrower was an “A” grade borrower paying 6% interest, or a “G” grade borrower paying 24% interest.  All are now equal.  What is important here is that regardless of what life changes they experienced, they managed to successfully pay their loan, and will most likely continue to do so.

Just like you cannot get today’s news off of a 2-year-old newspaper, you will not derive any new information from a borrower’s 2-year old profile.  Odds are, most everything shown there has changed, but unfortunately, we are not privy to that information, as the profiles are never updated. So I rarely bother to even look at it.  However, like I stated before, there are still two current variables shown to help you make a buying decision.

A.)   The payment and collection log

B.)   The FICO score

The Payment and Collection Log

The payment and collection log is the first item you want to look at.  Obviously, you want a quality payer.  So a borrower who has a perfect track record (regardless of loan grade) deserves your strong consideration.  Unfortunately, not everybody is perfect.  So, you must also be slightly forgiving.  I totally eliminate any note that shows a consistently sloppy pay history.  That’s not what I consider quality.  As soon as I see slop, I click off.  That takes all of 2-seconds.  I still will consider notes that may have had a missed payment or even 3 Grace-Period payments over the term, as long as these problems aren’t too current.  “Too current” means the last problem is longer than 6 months ago.  When considering these notes, I’ll take a quick look at the collection log.  Was there real borrower contact and not just the usual emails?  Were there promises to pay?  I look for anything that might indicate the borrower took his loan seriously when problems arose.

The FICO Score

The FICO is the only other variable that changes on a monthly basis.  It is the second thing I look at if the payment log has passed my eyeball test.

An absolutely perfect note would be a 18% D-Grade borrower who has never missed a payment, has no collection notes, and his 640 starting FICO has risen to 730 over the past 2 years.  Don’t count on it!  As a matter of fact, most notes you look at will show a decline in FICO.  Very rarely will you see a FICO chart where the borrower has maintained basically the same score month-after-month, year-after-year.

What I look for is a FICO that has remained fairly stable over the course of the last 8 to 12 months.  And, it doesn’t make a difference if that score is 780 or 580.    Typically, low FICO scores will also have sloppy payment histories.  So those notes won’t even pass your payment log test to begin with.  However, I do have many notes where the borrowers maintain scores in the 500’s and still pay perfectly.

Your Red Flag here are FICO’s that seem to be taking an unexplained dive over the past 2 to 4 months.  Many times, I’ll see a FICO that lost 20 points 2 months ago, and another 15 points last month.  That’s a fairly good indication that something is amiss, and a note I’ll avoid regardless how good the payment history has been or how cheap the note is.

Additional buying tips.

Yield-to-Maturity (YTM) is very important here.  Grab the notes that offer the best yield regardless of the grade.  Remember, everything has pretty much equalized and that high-yield D-Grade isn’t any riskier than the A-Grade above it.  Personally, I like double-digit returns and I find them in B4 and lower grades.

Avoid buying notes at any type of a mark-up!  I’ll pass on a 15% note at a 1% mark-up, but would never pass on a 15% note at a 0% mark-up.  As a matter of fact, it’s important that you mix discounted notes in your portfolio, even if the discount was a mere .1%, and I’ll tell you why.  Lending Club charges you 1% (fee) of every payment made.  This will pretty much negate any interest you make on that last 1 or 2 payments of a loan’s life.  Buy purchasing notes at a discount, those extra few cents you make will help offset the Lending Club fees keeping your returns stable!  The more discounted notes you buy, the better off you are.  If you’re really astute, you can set yourself up as a discount buyer, only buying notes at a discount.  Not only will this offset Lending Club Fees, but also in the end, the extra gains you make will boost your IRR well past your posted rate of return.  (Remember!  The extra money you make by purchasing discounted notes is NOT interest, but rather Capital Gains.  It’s like getting a small bonus when the borrower pays his loan off)

Next, don’t be tempted into buying sub-par notes only because they are being offered at a larger discount. For example, you might find a decent note at a 7% discount only because it is currently in “Grace Period”.  If you purchase this note thinking it might go current, then you are “Speculating”.  Speculating is a whole different strategy and does not belong here.  Be forgiving, but don’t speculate.

Lastly, avoid notes where the borrower has made a large, single payment at one point.  In other words, if a note has 15 remaining payments, I want to see 21 lines of payments, not 6!  It’s not that I don’t appreciate borrowers who try to pay off early.  It’s just that a 6-month old note still falls into that higher-risk arena regardless of what his loan balance is.

No System is Perfect.

I wanted to keep this article short-n-sweet, but if I didn’t bring these points up, others would in the comment section.  Regardless of what strategies you may be using, all have their good points and bad points.  Here are the points for using the Penny Note Strategy.

Pros

1.)    You’ll be spending an average of $11 per note versus $25 for a new issue.  This allows for greater diversification using a smaller bankroll.

2.)    You will not be rushed into buying a note.  Lending Club buyers face numerous obstacles including declines, issue delays, competition from institutional buyers and a host of other factors that force them to make hasty decisions.  You’ll also avoid the so-called “Feeding Frenzy” where new notes come up on Lending Club and get gobbled up in mere seconds.

3.)     This is a “Passive” investment strategy.  You’ll spend less time babysitting your notes looking for trouble.  Chances are greater that the “Current” notes you buy today will continue to stay current until maturity.  They pretty much run on cruise control.

4.)    Your loss in the event of default is much less.  If you invested $11, the most you can lose is $11.  However, in the small event a note does go sour, you can sell it on Folio and recover part of your original $11 before it defaults.

5.)    Quicker first payment.  New issues on Lending Club will generally have to wait 30-days before the first payment.  Notes bought on Folio don’t have that waiting period.  Some notes you buy can actually begin to pay you within a couple of days of purchase.

6.)    You’ll turn your principle over faster.  Since you’re at the tail end of the loan, your principle returns will far outweigh your interest payments.  Quicker return of principle allows you to keep your money moving while still making a great return.  This is great if your just looking for a temporary way to store extra cash or if an exit strategy is in the near future.

7.)    You’ll have the ability to buy the balances of $50, $100 and even $250 notes, which will provide you with even larger monthly payments.  These are notes that you may not have had the ability to buy when they were fresh off the press.

8.)    You’ll have the ability to purchase riskier “D”, “E”, “F” and “G” notes with greater confidence and less risk.  Again, as time goes on, risk factors equalize.

9.)    If you are an ultra-conservative investor, there always seems to be an abundance of beautiful notes in the A2 thru B3 ranges.  Granted, the returns are much smaller, but these notes would fit in perfectly with Peter’s plan of making 5% to 6% on your money.  Again, if you are able to purchase these notes at a very slight discount, it will boost your IRR.

Cons

1.)    Fair Seller Markups.  Since Folio charges sellers 1% of the sale, many notes you find will be marked up higher than their par value.  (We don’t buy those)

2.)    Lack of selection.  Some days I’ll run out of money before I’m done buying.  Sometimes I go two days in a row and not have a decent note come up.

3.)    Slow dispersion of your cash.  If you’re entering this strategy with a few grand in your pocket, it’s going to take a while to get all your money fully funded.  Be patient.  In the end, it should be worth it.

4.)    Old Fashioned Detective Work.  You can’t use auto-buy programs to buy these notes.  You got to do it one at a time.

5.)    Competition.  You and I are not the only two looking for that great note.  I’ve had notes bought out from under me before I could finish my transaction.

6.)    Lower Yield-to-Maturity rates than at issue.  Typically, Penny Notes will yield 1% to 2% less than when the note was issued. This is to be expected.  There are 2 upsides to this, though.  The first is that the high risk usually associated with new notes has greatly decreased.  The second is you have the opportunity to invest in lower grade notes to keep your YTM high.

In conclusion, diversification in your portfolio is important.   Unfortunately, nearly all investors see diversification the same way.  Typically, they search for new loans by running the same filters day after day, month after month.  They spread their money out in $25 or $50 increments to avoid putting all their eggs into the same basket.   Pretty much, this is what we were taught the day we deposited our first dollar into P2P lending. Are you this investor?

You can diversify your portfolio even further by realizing there are other opportunities besides new notes.  The Penny Note Strategy is one of them.  The Penny note Strategy could be your only form of investing, but it should be an alternative plan to your current portfolio.