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Updated 03 Dec 2020
With an unparalleled number of loans originated by many different lending companies around the world, the Mintos marketplace provides a great way to build a very well-diversified investment portfolio of loans. While diversification is the most important component for reaching long-range financial goals whilst also minimising risk, the question remains – how to pick which loans to invest in? Should one look at the loan performance, or rather, at the financial strength of the lending company? Or perhaps both? Is loan performance important at all if the loans come with a buyback obligation from the lending company?
We get asked these questions and see investors eagerly discussing them in forums. Martins Valters, the COO/CFO and Co-Founder of Mintos, decided to take the time and jump into the discussion to provide our view on this subject.
In general, by investing in a loan on Mintos, investors are getting exposure to the underlying loan issued by the lending company to the borrower. Currently, this is implemented by transferring claim rights against a borrower arising from the loan agreement from the lending company to the investor based on an assignment agreement. In the future, loans on Mintos will be classified as a regulated financial instrument called Notes.
Irrespective of the investment structure, investors will receive their invested principal and interest as each borrower makes payments according to their loan agreements. The received principal part of the payment reduces the carrying value of investors’ investment in the loan, while the interest and late payment fee portion of the payment is treated as investors’ income. In other words, investors make money from their investments as borrowers are repaying loans.
The importance of loan performance
As a result, the borrowers’ repayment discipline is the most important aspect in driving the returns for investors. When we connect any lending company to the marketplace, first and foremost, we look at the loan performance. We examine if, based on the historic loan performance, we can be reasonably confident that loans originated by the respective lending company will provide acceptable risk-adjusted returns to investors on our marketplace.
For example, if a loan is € 2 000 and it is offered to investors at a 10% interest rate, then the expected loan payoff (i.e. total loan repayments) should be at least € 2 000 principal, plus the 10% annualised interest for the respective period. If it is less, such a loan can’t be placed on our marketplace. In reality, the loan payoff should be higher as lending companies have to also cover their operational costs – marketing, servicing borrowers, running recoveries, etc. – and also allow for a profit margin (you can read more about this in our blog post about the cost structure of short-term loans here).
Our due diligence process doesn’t end after a lending company joins Mintos. We receive loan performance information in real time via an API for the loans listed on the platform, and review each lending company’s overall performance on an ongoing basis. You can read more about our due diligence process in our blog post.
How do we assess loan performance at Mintos?
At Mintos, we conduct vintage analysis to evaluate the credit quality of a loan portfolio. This means that we group loans on the basis of an origination period or “vintage” (usually calendar month) and track their performance – how many loans are repaid, how many go into delays and how many default. This allows for a better understanding of the loan performance over time as it is not biased by the changes in the total portfolio size.
As part of the vintage analysis, we look at payoffs – the total received repayments of principal, interest and any other fees over the principal issued. In particular, we look at the payoff time and what is the total payoff as a percent of the principal issued. The payoff time shows how many months it takes to receive repayments equal to the disbursed loan principal. This measure should closely correlate to the effective term of the loan. A slow payoff and a low total payoff can indicate problems with the underwriting and/or with the collection process.
Below is an example of a payoff analysis for 8-10 month personal loans. As depicted in the graph, the vintage payoff is reaching 100% within 5-7 months and the final payoff levels at 120% after 9-11 months for all the vintages thus providing around a 20% annualised return. Based on the historic track record we would conclude that the loan performance is satisfactory and that such loans should provide adequate risk-adjusted returns to investors and generate enough of a total payoff for the lending company to cover their expenses and profit margin.
Many of the lending companies on the Mintos marketplace operate in multiple countries, in addition, some provide more than one loan product. We evaluate each new country and loan product separately. It means that the lending company can originate and service the best performing loans in one country, but if the loan performance in the new country is lagging behind or there is not sufficient track record we will not allow loans from the new country on our marketplace. The same goes for new loan products. There might also be a different approach to loans originated by the same lending company in the same country. For example, we might identify that there is a significant difference in performance between loans issued to new clients and loans issued to existing clients, i.e. repeating borrowers. That can be especially true for short-term loans where the performance of loans to repeating borrowers can be satisfactory, while that of loans to new clients is not. In that case, we would restrict the lending company and allow it to only place loans from repeating borrowers on the marketplace.
Unfortunately, sometimes borrowers will not be able to meet their payment deadlines. This could be due to the loss of their job, mismanagement of personal finances, or a plethora of other reasons. Borrower default is part of the lending business. Defaults can vary a lot among different loan types, different countries, and even among different borrower segments of the same loan type in the same country. However, there is no easy answer to the question “what is the right level of default”. The loan performance has to be viewed within the context of many other factors, including the interest that is charged to the borrowers. It could easily be the case that loans with higher default rates can yield higher returns at the end of the day compared to loans with lower default rates because in the former case the borrowers pay higher interest rates and that compensates for defaults across the portfolio.
That leads to the question: should investors look at the performance of loans on an individual loan basis or on a portfolio basis? In general, when looking at loan performance investors should consider their investments in loans as a portfolio, rather than separate individual investments. The simple reason for this is diversification. If an investor has invested € 1 000 in one loan and the estimated probability of default is 5%, then if that particular borrower defaults, the investor risks losing the entire amount. However, if instead, the investor invests € 1 000 in 100 loans, with € 10 in each with the same 5% probability of default, then there is a risk that on average 5 loans will default. The remaining 95 borrowers will continue to make regular payments and the received interest over time should more than compensate for the defaults. Even though the expected default is the same in both cases, the volatility of returns will be much higher when investing in just one loan. Diversification is one of the most important principles of investing, and you can read more about the ways you can diversify your investment portfolio on our marketplace in our blog post.
What about loans with a buyback obligation?
So, first and foremost investors should look at the loan performance. But what about loans with a buyback obligation? A common misconception is that for these loans investors are investing in lending companies, not loans, and that the loan performance is not important. However, that is not true.
To explain why loan performance still matters the most, let us dig deeper into how the buyback obligation works. The buyback obligation is provided by the lending company. If the borrower is late for 60 days or more, the lending company is contractually obliged to buy back the loan at the nominal value of the outstanding principal plus accrued interest. Here it is important to understand that the cash flows to cover the buyback obligation come from the interest rate spread generated by the lending company.
The interest rate spread is the difference between what is charged to the borrowers and what is passed on to investors. For example, let’s assume the lending company issues 100 loans at € 1 000 each and assigns them to investors. The lending company charges the borrower 30% annually and the expected default rate for these loans is 10%. On the Mintos marketplace, the lending company has two options on how to sell these loans to investors – with or without buyback obligation. If they sell the loans without buyback obligation (i.e. the default risk is carried by investors) and passes on to the investors a 20% interest rate, investors at the end of the year would have made an 8% net return – investors would experience € 10 000 capital loss but earn € 18 000 in interest on performing loans (20% * € 90 000) for a net of € 8 000 return over € 100 000 invested. In this case, all the cash flows come directly from the borrower payments.
Alternatively, the loans could be sold to investors with buyback obligation, but instead of a 20% interest rate, the loans are sold at an 8% interest rate. In this case, the cash flows to investors would consist of two parts. The first part is the payments received from borrowers: € 90 000 principal and 8% of € 90 000 or € 7 200 in interest. The second part of the cash flows to investors are the payments received from the lending company for the buybacks – principal € 10 000 (10% of € 100 000) plus accrued interest € 800 (8% * € 10 000) for the defaulted loans. The net result is the same as in the case of the loan without buyback obligation – investors earn an 8% net return and the lending company makes € 9 000 to cover their costs and profit margin.
Although the money for the buyback obligation does indeed come from the lending company, it is important to note that this is money the lending company earns through the extra spread. In case of loans sold without buyback obligation, the lending company earns 10% interest (30% total minus 20% passed to investors), while in the case of loans sold with buyback obligation the lending company earns 22% interest (30% total – 8% passed to investors). With the additional 12%, the lending company earns an extra € 10 800 (12% * € 90 000) – that allows the lending company to cover the buyback obligation and pay to investors the € 10 000 plus accrued interest of € 800 for loans that are late for 60 days or more.
When considering if the lending company can place loans with buyback obligation on the marketplace, it is very important for us to see that the buyback obligation is provided from the extra spread. If we don’t see on the loan portfolio level that the buyback can be covered from the extra spread, we don’t allow the lending company to place the loan with buyback obligation.
As a result, even for loans with buyback obligation, it’s still the loan performance that matters the most. If the loans are performing according to expectations, the lending company generates enough extra spread to cover the buyback obligation. On the other hand, if the loan performance would deteriorate and the actual default rate turns out to be higher than expected, the lending company might experience difficulties buying back the loans. Should the lending company default on its buyback obligation, investors might not receive their money back. The ability of the buyback provider – which can be the lending company or a third party – to honor the buyback obligation is assessed in the Buyback strength subscore of investment opportunities on Mintos. You can read more about Mintos Risk Scores on our website.
The role of the lending company
If it’s the loan performance that matters the most when investing in loans on Mintos then what is the role of the lending company and why should investors pay attention to their performance?
The lending company plays a fundamental role in originating and underwriting loans. If the underwriting standards are low-quality, the loans originated by the particular lending company will underperform and that will directly impact investor returns. Such factors as the lending company’s and management’s experience, risk management and control, and the collateral risk assessment process are key when reviewing the lending company’s origination and underwriting. The health and performance of the loan portfolio is reflected in the Loan portfolio performance subscore of investment opportunities on Mintos.
Moreover, the lending company plays a key role in servicing the loans and collecting borrower payments. The quality, stability and experience of the lending company as a servicer directly affects the loan performance. When there is a stable lending company as a servicer, investors can be sure that the borrower payments will be collected and distributed in an orderly manner and the only thing that matters is loan performance. However, in case the lending company would go out of business and stop servicing the loans there would be interruptions in collecting payments from borrowers and passing them to investors. Therefore, we pay particular attention to the lending company as a servicer and analyse the management and staff experience, financial position of the lending company, policies and procedures, controls, and historical servicing performance to make sure that we can reasonably conclude that the lending company will be around to service the loans. Our findings are reflected in the Loan servicer efficiency subscore of investment opportunities on Mintos.
Finally, in the case of loans with buyback obligation, the lending company is usually also the provider of the buyback obligation. Here in particular we look at the financial standing of the lending company to assess if loans can be provided with buyback obligation, which is especially important at the beginning as it takes time for the extra interest rate spread to build up. As mentioned above, the ability of each lending company to honor the buyback obligation is assessed in the Buyback strength subscore.
It is important to note that loan performance has a very direct impact on the overall sustainability of the lending company. If the loan performance is good this will have a direct positive impact on the lending company and result in better financial results and financial standing. This, in turn, will make the lending company a more stable loan servicer. On the flip side, a severe decline in the loan performance might significantly impact financial standing of the lending company even bring down the lending company as such.
Bringing it all together
When investing in loans first and foremost it is the loan performance that matters. Loans that are performing according to expectations will provide the expected returns to investors. On the other hand, underperforming loans will have a negative effect on investor returns, even if the lending company provides a buyback obligation. Meanwhile, the lending company plays a key role not only as a loan originator and underwriter, but also as a servicer and provider of the buyback obligation especially in case the default rates are higher than expected. Investors can invest in well-performing loans but if the counterparty risk of the lending company is high investors might require higher expected returns to compensate for additional risk. On the flip side if the counterparty risk of the lending company is low investors might be content with lower expected returns. If you want to know more about the risks related to an investment opportunity on Mintos, you can check its Mintos Risk Score and subscores, and you can follow our Statistics page to see loan performance on an aggregate level.
In any case, the importance of diversification cannot be underestimated, be it across different borrowers, loan types, lending companies, countries, etc. You can read more about this in our article on diversification. The majority of investment professionals agree that diversification is the most important component for reaching long-range financial goals while minimising risk. Therefore, at Mintos we have our own saying: don’t put all your money into one loan, diversify!