I was in San Francisco last week visiting Lending Club and Prosper. So I took the opportunity to sit down with the risk management team at Lending Club to delve into the underwriting changes they introduced late last year.
As Anil from Random Thoughts pointed out recently at first glance it seems that Lending Club has moved to a riskier credit profile. Given that Lending Club now allows borrowers with a bankruptcy or a current delinquency it is easy to see how one would get that impression.
But Lending Club said the changes have resulted in a better ranking of risk that should lead to a more conservative credit profile overall. How is that possible given the supposedly more lax underwriting criteria? They went through a whole presentation with me to explain these changes in detail.
A Brief Summary of the Underwriting Changes
Before I get into the detailed explanation let’s first look at some of the changes that were made. Many of the changes were detailed in the Random Thoughts post and you can always read the latest underwriting requirements in the Lending Club prospectus. Here are the five main changes:
- Maximum number of credit inquiries is now 6 for all borrowers (before it was maximum of 3 inquiries for FICO scores of less than 740 and up to 8 inquiries for scores of 740 or more).
- Current delinquency now allowed.
- Revolving credit balance maximum of $150,000 restriction removed.
- Major derogatory record (meaning a bankruptcy) now allowed.
- Maximum credit utilization of 98% restriction removed.
Swapping in and Swapping Out
According to Lending Club the latest underwriting changes did two things. It removed the highest risk borrowers that were previously being approved and it added back in the best borrowers from previously declined populations. This was obviously not a change that was taken lightly – a huge amount of analysis has gone into this decision.
The problem with the old underwriting model is that if a borrower failed just one of the major credit criteria then it didn’t matter how pristine the rest of their credit report was they would be declined. The example was given of a senior member of Lending Club’s executive team who was declined for a loan. This person has a high credit score, a good six-figure salary, no delinquencies and a long history of excellent credit. But he had a HELOC on his house of more than $150,000 and that number is included in the revolving credit amount. So he was over the $150,000 revolving credit balance limit and was therefore rejected for a loan. Under the new model his loan is approved and rated an A1.
Now if there is one strike against a borrower other factors are taken into consideration. This is the key point here. Rather than just deny everyone based on one data point they are now considering hundreds of factors in the underwriting decision. This includes all the credit data they pull from TransUnion, the information gained during the verification process as well as the self-reported information from the borrower loan application.
The point they stressed with all this is that if someone does have, say, a $250,000 revolving credit balance or they have five credit inquiries in the last six months the rest of their credit report has to be excellent. The bar is set higher for these people, which is how Lending Club is able to add these looser criteria while at the same time decreasing overall risk.
How Can Lending Club Be So Confident With Their New Model?
This is a question I posed to them. My thinking was that sometimes these red flags should provide a legitimate concern. How do they know that their model will perform better?
It turns out they had a very credible answer for this. Lending Club went back through and analyzed their declined borrower population. As or this writing Lending Club has declined over 822,000 loan applications representing over $10.7 billion in potential loans. That is quite a decent sized data set.
So, what they did was pull the credit data from many of these declined borrowers and they back tested their new underwriting model. In particular they looked for credit lines that were opened at around the same date as the original borrower application and looked for a successful payment history.
For borrowers that passed the new model they could see their credit score history as well as what kind of payment performance they had experienced with their various open credit lines. They could see who had trouble keeping their obligations and who paid on time every month. From this they could determine who they really should have approved. This back testing gave Lending Club a high degree of confidence in their new model.
But What About Bankruptcies?
Sure, I can understand some of this credit data providing a false indication of creditworthiness but what about a bankruptcy? That is a serious issue and one that infuriates many investors.
They made two points around bankruptcies. One, for someone to have a bankruptcy on their credit report and get back to a FICO score of 660 is not an easy thing to do. This means they most likely have had an excellent payment record since their bankruptcy. Two, declaring bankruptcy a second time is a much more difficult thing to do and so these people were more likely to be consistent payers. The analysis they did of the declined borrower history confirmed this.
So there you have it. The new underwriting model that should provide even better returns for investors going forward. While Lending Club tweaks their underwriting every quarter this seems to be the biggest change they have made in several years, probably since 2008. I came away satisfied that these latest changes were made in the best interests of investors. But if you have your doubts you can easily just filter out these changes and stick primarily with loans that meet the old underwriting criteria.
What do you think? As always I am interested in your comments.