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The Mind-Blowing Economics Of Rebuildingsociety Lending
At 4thWay, we're fascinated by the unusual nature of Rebuildingsociety's loan book. No high-street bank dataset we've ever seen comes close to this kind of profile and nor do any other P2P lending companies.
The loan book defies belief. Borrower grading has historically sucked. Bad debts are exceptionally high and recoveries of said debt completely laughable.
Yet, somehow, the economics works for investors. (On average. But I'll come to that later.)
The instinct is to say that it can't work. But it's rather like the chess player who sees that the opponent has a common checkmating pattern of moves, only to find, after 40 minutes of back-breaking calculations, that there's an unusual kind of defensive move after all, which completely stops the attack in its tracks.
So this is a very different kind of lending to anything we are seeing elsewhere.
It's all due to a combination of what we call the default curve and very high interest rates. Let's look at how Rebuildingsociety's lenders seem threatened of being checkmated, and then what the counter is:
Borrower grading – not a smooth ride
Some P2P lending companies, such as Rebuildingsociety* create their own borrower grades, which helps them set interest rates. It is also intended to help lenders choose loans that suit their risk-reward requirements.
(It's important for lenders to know that any borrower grades you see when P2P lending are not taken from some standard place, such as a credit-reference agency, so the grades vary considerably.)
Of the 300 or so Rebuildingsociety loans that were issued between its first loan in 2013 and up to around one year ago, just four have been graded A+. This suggests that Rebuildingsociety has been extremely selective in giving this top grade. Yet two of those of four loans turned bad and most of the total lent to those borrowers has been written off.
Grades A and B have seen an almost identical number of loans turn bad. There aren't a great deal more than 100 of them, so there's limited statistical significance, yet in an effective grading system we should still most likely expect to see a difference emerging.
Grade C does have an increase in bad debts, however, and the step up from B is substantial. This shows that Rebuildingsociety has likely got at least some aspects of its grading system right at the very riskiest end. Here, a third of loans from the dataset have turned bad.
You expect to see borrowers spread a little bit more evenly across the four different borrower grades. But more than that, we would expect a much smoother, gradual increase in the risks across the grades. That's not what we're seeing.
Grading ability is something we usually look into as part of an assessment of so-called heterogeneity and monotonocity of the loan book. (Don't ask me to pronounce that out loud.) Basically, it means: Can the P2P lending company correctly categorise loans and grade them?
In more ordinary loan books than this one, it is a useful reference to seeing the skill of the people who are approving the loans, because it tells us whether they truly understand their borrowers.
Grading is probably improving
Recently, we've seen Rebuildingsociety give out considerably more C grades. I think this is a sign that it's improving and that it's understanding its borrowers better. It also hasn't given an A+ grade since July 2019, which is also reassuring. Rebuildingsociety has always been very big on data analysis, so it's good to see that this might be paying off.
Bad debts are extremely high
Around one-in-four Rebuildingsociety loans have turned bad at some point. For business lending, we generally expect around one in ten to be the limit.
Rebuildingsociety's loans are very different. Possibly, its grading system should start at C and end with E, to make it clearer to lenders where the business borrowers really stand on the risk scale.
We don't find it possible at this stage to establish whether any Rebuildingsociety efforts to reduce the proportion of loans that turn bad have had any impact. The pandemic has made that difficult and we also need more time to see whether new loans either mature successfully or turn bad.
Rebuildingsociety doesn't necessarily have to reduce bad debts, provided it's now grading the risks better for lenders.
Recovery of bad debt is atrocious
Legally speaking, Rebuildingsociety's lending is secured, although its loans don't behave that way. So far, around 8% of any debt amounts that have turned bad has been recovered. We would expect much better results to have filtered through by now.
Usually, we'd expect at least 20% to be recovered even with unsecured business loans. For lending that is well secured, we'd expect recoveries to be considerably higher.
Interest rates – Rebuildingsociety's first counter against checkmate!
Rebuildingsociety counters the very high risks with very high interest rates. Lenders are paid an average of 17% before bad debts, which is truly a phenomenally high average rate.
This is of course an annual interest, so you're paid 17% on your good loans (or the ones that haven't turned bad yet), every month and year, albeit on a declining balance, since the loans are gradually being repaid.
Each bad debt, on the other hand, only occurs once. It's not annualised, as in you don't suffer the bad debt one year and then the same bad debt for years to come. That's partly how 17% rates on an annual basis can offset one-in-four loans (25%) turning bad as a once off each.
The default curve – counterstrike 2!
Rebuildingsociety's secret weapon is probably the default curve. This means the points in time at which loans start to turn bad and the gradual increase in bad debts on an outstanding book of loans. The curve flattens out eventually as fewer loans turn bad towards the end of their lives.
For business lending, Rebuildingsociety has an unusually late curve. To give you a simple snapshot of part of the curve, most bad debts for Rebuildingsociety occur after borrowers have already made around 21 loan repayments, on average. That means that loans usually pay a very large amount of interest before turning bad – as you can imagine at these interest rates.
How it adds up
Around £4.6 million has been paid out to lenders in interest to date (excluding loans that are re-lending to the same borrowers to repay prior Rebuildingsociety loans). In contrast, “just” £3.1 million has either been written off or remains in recovery.
The bottom line is that lenders have made an average rate of something around 8% while earning £1.5 million after bad debts. That's a high return for small business loans. High interest rates appear to do their job over the entire loan book.
And that's with a big thanks to interest paid by borrowers who eventually become unable to repay. Those borrowers have paid well over £1 million in interest alongside their monthly loan payments – until they were no longer able to do so.
Not all Rebuildingsociety lenders avoid checkmate
The huge, huge caveat to all the above is that you can expect an extremely large array of results, differing wildly from that average, from different lenders, depending on the batch of loans they lend in.
This isn't offering anything like the smooth results you see elsewhere, where all lenders can expect positive returns, so there will be some big losses. With such a high amount of bad debt, as you can probably imagine, lenders lending in a few dozen loans are particularly asking for trouble, as random chance could see them achieve substantial losses. Even spreading across as many loans as you can over a year, it's not always going to be easy to stay in profit.
Some tips for lending through Rebuildingsociety
If you're going to take a chance on this very high risk lending, you clearly need to spread the risks. If you'd lent equal amounts in every single one of Rebuildingsociety's loans, you'll certainly have come out well. The more, the better.
But if you want to pick individual loans to outperform, it shouldn't come at the expense of diversification. More loans is going to be even more important here, so perhaps a clever strategy would be to ditch just the ones that seem most concerning for you, rather than be too restrictive when selecting loans.
Take all the time you need to drip your money into a large number of loans, as and when they turn up on the Rebuildingsociety platform. In the past year, there have been 59 new loans, so you're going to need to drip your money in for well over a year to try and build up the sort of diversification you need.
(Also, 31 borrowers have borrowed again through Rebuildingsociety to pay off their existing loans. Rebuildingsociety needs to build more of a record before we can see that those re-borrowings are high quality loans rather than kicking bad debts down the road.)
Psychology is also extremely important
This type of lending is clearly not for the faint of heart. Not at all.
There could be a lot of nail biting to go through to get an average return of 8% or so after bad debts. You need a tough psychology and ample confidence to stick with it.
You could have several years of massive outperformance and then be on the deeply unlucky side for the next few years. Most investors faced with that would say “Rebuildingsociety's gone downhill,” but, actually, it's just likely to be part and parcel of its offering for many people, with a much longer commitment needed by them to benefit from what will be a more volatile investment, rather like the stock market.
And, if it happens the other way, whereby you invest and get poor results in your first years, you're going to need to be even hardier and even more confident to stick with it, instead of selling up and crawling away.
You will checkmate yourselves with business loans if you sell your good, interest-paying loans early, while holding onto your loss-making bad debts. A common mistake. You need to keep earning interest on your good loans until the borrowers repay in full, in order to offset losses and maximise your returns.
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