We have noticed that many of you need additional guidance when it comes to loan originator Risk Scoring (no worries, that makes sense). Hence, we are back with yet another blog post to debunk the myths surrounding the Score and explain to you how it is calculated.
What to expect from this blog post?
First, we will guide you through the calculation of the Base Score. It consists of 4 core components that you see below:
Second, we will explain how the Base Score is adjusted, depending on the country in which a loan originator (LO) operates.
Third, we will elaborate on the final adjustments of the Score that is based on the security structure of the investments in the loans of a lender.
We want to be sure that, after reading this post, you will be ready to apply Risk Score to cherry-pick your next investments.
So, get ready to dive into the ocean of LO risk analysis!
Assessment of LO’s vs Individual Loans
Let’s start by addressing a very fundamental question that all the folks investing in the P2P lending market have probably asked themselves at least once: why should I care about the risk of the Loan Originator when I invest in individual loans? Why don’t you better analyze loans rather than giving some scores on LOs, wouldn’t it be right?
While that might be true for direct P2P loans on platforms like NEO Finance, in most cases it is not quite like that.
If you are an investor on platforms like Mintos and Peerberry, you are (hopefully) investing in loans with a buyback guarantee. Not the case? You are taking unnecessary risks - go change your approach and then come back to the blog. We will be waiting.
So what does that mean to you and why should you care about the buyback guarantee?
The point is that individual loan defaults (or long delays) are quite frequent in the lending business. If you have the loan secured with a buyback guarantee, however, whenever the loan will default (or go late for 60 days +), the LO will have an obligation to buy back that loan from you AND pay you the full principal plus interest. As a result of this, your funds’ safety is directly dependent on the LOs ability to cover the guaranteed funds and not so much on the end borrower. Therefore, only by carefully assessing the risk of a certain LO, will you be able to secure the safety of your funds.
Hopefully, it makes sense now.
As we’ve clarified this fundamental matter, now we can safely move forward to the components of our Base Score.
Base Score Calculation
The Base Score, as we call it, is calculated based on the financial information obtained from a company's financial statements, the information on the lender on a particular loan marketplace, as well as general public information on the LO and its operations.
The score is determined by assessing various metrics in 4 categories:
- Solvency and liquidity
- Product (portfolio) quality and resilience
- Governance and stability
Each category is scored depending on the strength of an LO in it. It is done by assessing various metrics relevant to a particular category to ensure an evaluation from all angles. For that, we use quantitative ratios, margins, hard rules, as well as qualitative variables.
Furthermore, each metric within the category is assigned a weight based on the importance of the metric, as well as each category is then weighted differently in the calculation of the Base Score. For example, the Solvency/Liquidity category has greater weight in determining the Base Score as most LOs default due to cash flow and liquidity problems. Within this category, there are a total of 7 metrics, of which, for example, the score of interest coverage ratio, liabilities/equity ratio, and net portfolio/interest-bearing liabilities are given more weight.
Each metric, each category, and hence each LO receives a score that ranges from 0 to 100 points, where 0 points stand for a terrible evaluation and ultra-high risk and 100 would be obtained by an LO with no visible risks.
After we have calculated the base score, we then move on to conduct an adjustment on the score based on the country in which the LO is operating.
As history has shown, even strong lending companies' business and, hence, their ability to repay their investors, can be affected by various country-specific factors such as local currency volatility, political unrest, and regulation. To account for just that and more, we have created a country multiple by which the Base Score of an LO is multiplied in the calculation of the final Risk Score.
The multiple is calculated based on 3 categories:
- Local currency volatility vs EUR
- Economic strength (e.g. unemployment, inflation, GDP changes)
- Internal structure and external risks (business environment, corruption, political risks, etc.)
Again, each metric within a category holds a different weight based on its importance, as well as each category is weighted differently to get to the final country multiple. As an example, currency volatility is given more weight than other categories. Within this category, there are 3 metrics of which, for example, the score of “currency strengthening/weakening against EUR” is given the most weight.
The Base Score adjustments, however, do not end here.
As with all investments, no matter how safe they are and no matter how carefully you pick them, defaults do tend to happen. Therefore, it is important to consider what (if any) security mechanisms the particular LO and the loan marketplace offer to investors to increase the likelihood of fund recoveries in case of financial difficulties for the LO.
Consequently, to arrive at the final Welfio Risk Score, the multiplication of the Base Score and the country multiple is further multiplied by the security structure multiple.
The security structure multiple is determined by carefully evaluating the legal arrangement that an LO has with the loan marketplace and with the investors. In the review, we look at the primary security mechanism - pledge vs assignment of loan receivables - and its details.
For LOs acting under a pledge, we look at whether the loan principal is underpledged (the value of the pledge is lower than the loan principal), overpledged (the value of the pledge exceeds that of the loan principal), or whether it has a matching pledge (the pledge value equals the loan principal value).
For LOs offering an assignment of loan receivables, we consider whether the LO has a "skin in the game" (in case of the LO's default, the collected debt amount is received by the investors and the LO proportionally to the share in the loan portfolio) or a "junior share" (in case of the LO's default, the collected debt amount is received by the investors first and then LO is paid only after the whole outstanding debt to investors is covered) and how large it is.
If there is no information on the security structure offered to the investors, the LO receives a painful penalty that significantly reduces the end Risk Score.
So here you have it - this is how a Risk Score of a lending company is calculated - quite a process, right?
That, however, is not all.
Red & Orange Flags
On the final note, we really want to emphasize the following - although we do our best to capitalize on the publicly available information and assess the LOs as accurately and diligently as possible, we cannot guarantee the safety of your investments.
To fight that and provide an extra layer of information for you, we introduced Red and Orange Flags.
The purpose of the Flags is to raise investors’ awareness about potential threats regardless of the result of the total Risk Score. Meaning, that there are some especially important factors that you should be aware of regardless of the Risk Score results.
Does this mean that you cannot trust our Risk Score? No, it just implies that in some cases specific Red & Orange Flags might be game-changers for an investment decision. Therefore, these factors are indicated separately so that our users would be more alert to potential threats.
For example - a Red Flag of not having financial statements according to IFRS reporting standards could be a significant factor not to make an investment in the company. Why? Well, there could be a high likelihood that the company has understated provisions, which could have a direct impact on the company’s profitability score. So, as we cannot validate the reporting numbers - there is a higher risk that financial statements do not show a true and fair view of the company’s result.
Consequently, you have to always look at our Risk Score and our Red & Orange Flags, which are conveniently placed in the Investing Guide and the LO Details view (that you can access by clicking on a particular LO in the Investing Guide view).
Hoping that all of this information has been helpful to you, we will leave you at this. Now go ahead and explore the Risk Score and see what interesting flags you can find that can make you change your mind about investing in the loans of particular lending companies.