The numbers behind Zopa’s interest rate cuts

Interest rates for Zopa lenders are a little lower of late. Here’s why...

Last week saw leading consumer lending platform Zopa drop interest rates across all lender portfolios – Access, Classic and Plus – by 0.2 per cent. It was the second time in as many months that the platform had dropped rates by that margin, and each time representatives cited increased competition within the broader consumer credit space as the key driver.

As a Zopa lender, the rationale makes sense. Consumer lenders both old and new are busily adjusting to the Bank of England’s recent decision to cut interest rates to an all-time low of 0.25 per cent. And while Zopa may claim not to be as connected to shifts in the base rate as the banks, the company has nonetheless conceded to at least a level of correlation. Ergo, Zopa has been forced to lower gross interest rates in order to ensure that it remains an attractive option for creditworthy borrowers. Lower gross interest rates correspond to lower investor returns; it doesn’t take a “lending genius” (in the immortal words of Lord Adair Turner) to work that out.

But what investors may well find themselves wondering is: I’m now earning a lower rate of return – how can I be sure that gross interest rates have adjusted accordingly? How can I be sure that this isn’t simply a case of Zopa widening its margins?

Fear not. We’re here to help.

The chart below – courtesy of AltFi Data Analytics – demonstrates the evolution of average gross interest rates** across all Zopa risk bands in 2016.

What we see is that average gross interest rates either fell or were flat for all of Zopa’s risk bands in September. This fits with the fall in lender rates.

However, rather surprisingly, the average gross interest rate across all bands rose by 31bps. How can this be?

Answer: the average gross interest rate chart is weighted by origination, and the composition of Zopa’s origination from August to September changed significantly. A* loans accounted for 25 per cent of originations in September, down from 33 per cent in August. Meanwhile, volume as a percentage of monthly origination grew in every other risk band – with D loans exhibiting the greatest growth, from 7 per cent of monthly origination in August to 10 per cent in September.

So interest rates are indeed falling across all Zopa risk bands, which in turn feeds through to the platform’s targeted portfolio returns. However, for the month of September, the loans underlying those portfolios were, on average, riskier.

It’s worth noting at this stage that investors in Zopa Access and Classic have exposure only to risk bands A* through to C, while Plus investors get access to the full gamut (A* to E). Zopa’s Giles Andrews has previously stated that D and E risk loans should not be thought of as “sub-prime”, saying that they remain “high quality” loans. And of course they are originated at rates which offer significant compensation for the risk being taken on by investors, or, in practical terms, leave significant room for a higher rate of default across the platform.

The inaugural securitisation of Zopa loans – MOCA 2016-1 – secured an AA rating from Fitch in September. As part of its due diligence report, Fitch concluded that Zopa had been fuelling its growth with riskier loans in recent months, stating that: "the proportion of riskier lending increased at the same time that Zopa's volume was increasing dramatically." Business Insider was particularly enamoured with this finding.

The chart below (thanks again go to AltFi Data Analytics) shows Zopa’s monthly origination volumes by risk band. A clear trend has been emerging ever since July (roughly the time that it became obvious that the base rate was going to fall): Zopa’s A* loan volumes have been falling, while origination volumes for all other risk bands are trending upwards.

Now, the sample size is limited, with just a few month’s data to hand, but what we might be seeing is evidence of the increased competition within the prime consumer credit space that has been highlighted by Zopa on several occasions. The platform’s chief product officer Andrew Lawson, for example, wrote to lenders last week to inform them of the platform’s latest rate cut, saying: “at least 6 mainstream prime lenders further lowering their headline rates”. In such conditions, the chart above would suggest that Zopa is either struggling to lay hands on as many A* borrowers, or has become stricter in defining what an A* borrower looks like, with the former scenario seeming the more likely.

If the current trajectory were to hold true, at some stage we’d see a convergence between Zopa’s monthly originations by risk band, such that the platform would be originating as many or fewer A* loans as any other loan type.

But hold your horses. We’ve been here before. This is not the first time that Zopa’s monthly A* originations have looked likely to overlap with its riskier loan bands. The chart below shows that the two groups have come closer to one another than they currently are on a number of occasions since 2010. But they’ve never touched. In fact, they’ve always been separated by a significant gap of at least a few million pounds’ worth of origination. Who knows, the maintenance of that gap could even be a Zopa-enforced policy (remember that this is a platform that prides itself on a prudent approach to risk).

Bottom line: Zopa is telling investors that returns are falling because gross interest rates are having to be lowered in the context of a more competitive consumer credit space. That looks to be true.

Zopa is also telling investors that it’s against the company’s principles to lower criteria in order “to attract riskier borrowers”. It’s certainly true that Zopa has not loosened its credit criteria in order to accept riskier borrowers within existing risk bands. But what is also true is that investor portfolios have contained a greater weighting of riskier loans over the past few months, despite the fact that targeted portfolio returns were on average 0.2 per cent lower in September. In other words, the platform has been originating a greater volume of higher yielding loans in recent months than it has done previously.

But lower target portfolio returns aside, this is nothing new; origination volumes by risk band have fluctuated throughout the platform’s history. It’s also important to remember that a greater volume of higher yielding loans in lender portfolios does not necessarily translate to greater risk for lenders – so long as the pricing is accurate. And, as the chart below shows, Zopa’s track record of delivering strong net returns would suggest that its pricing has been consistently appropriate.

Zopa’s target investor returns have been lowered as a direct result of increased competition within the broader consumer credit space. The question, then, is not necessarily about whether the platform will continue to deliver strong net returns to investors – all signs would suggest that it will.

The real question is this: given the prevailing market conditions, will the gap between Zopa’s A* loan volumes and its higher-yielding risk band originations be maintained? Or will the mix of loan grades to which lenders are exposed on the platform start to change?

**While reading this analysis, it’s important to remember that “average gross interest rate”, as represented by AltFi Data Analytics, is an investor metric. It’s essentially a representation of investor yield, net of fees. But it does not represent the true cost of finance for borrowers, in that it does not incorporate up-front or ongoing borrower fees. It’s a useful metric for understanding the level of risk being taken by a given platform, and whether or not investors are being commensurately rewarded for parting with their money – but it absolutely shouldn’t be seen as a representation of the cost of funding for borrowers.