Growth Street’s Largest Loans Turn Bad

There's been quite an exciting development at Growth Street. I use the word “exciting” to mean it's a story with a lot of bang, rather than good news. Certainly not for me, as it reveals a mistake by me. Probably my biggest since co-founding 4thWay.

But at least it's just my reputation and Growth Street's that have taken a hit – and not lenders' wallets.

What happened?

I wrote in summer that Growth Street has a dozen live loans that are confoundingly large. “Super large”, I called them in fact.

Large loans could sometimes cause shocks in an otherwise stable portfolio of loans, especially – but not only – when bad luck happens.

Yet Growth Street had built a good case for approving these loans. It piled on protections against the risks. And I considered them sufficient for lenders, with caveats.

What happened just a few months later is that two of these super-large loans have gone bad. This wouldn't be half as serious, except that it happens to be the two very largest loans Growth Street has approved that have gone bad.

The total value of the two loans combined is £3.1 million, which was over twice the size of the reserve fund at the time (worth £1.2 million) and equal to roughly 10% of the outstanding loans.

Growth Street currently expects to recover a large chunk of these bad debts. It remains to be seen whether it achieves that. But since the reserve fund pays out right away – and since recoveries can take many months or years – that's not much use at the point the loans turn into problems.

What's more, apparently none of the clever defences that Growth Street had put in place to prevent this from happening actually worked. More on that later. First, the good news.

Growth Street protected lenders with extreme actions

You can't say Growth Street isn't committed to its lenders, when you see how it responded to the immediate problem of £3 million in bad debt.

Growth Street had previously said that, in the event bad debts would overwhelm the reserve fund, it had two choices:

1. It might top up the reserve fund with its own money to protect lenders. The enlarged fund would then take the hit.
2. It might use up whatever's in the fund and then pool all loans across all lenders, so that all lenders share the cost of the higher bad debts fairly.

If Growth Street had taken the second option, the nuclear one, lenders would still have positive returns over about a year due to the interest they've been earning. So it wouldn't have been the end of the world. Indeed, anyone who'd already been lending for some months would have built up a nice cushion already.

However, these two loans were embarrassingly large. So that's why Growth Street decided on a third option: it used its own money to buy the bad debts from lenders. This way, the bad debts don't show up in its published statistics or in the results of its reserve fund. Any money it recovers from the borrowers will go back to Growth Street.

Did any of Growth Street's defences work?

Growth Street came through with the ultimate defence against losses: putting its money where its mouth was.

But it can't keep doing that. In the end, the Growth Street ecosystem needs to be able to protect itself. Losses need to be contained so that interest paid to lenders, along with fees paid regularly by borrowers into the reserve fund, keep lenders in the positive. And that's without massive emergency cash injections.

So what happened to the planned defences that were supposed to prevent this happening in the first place?

Growth Street had a series of quite interesting safeguards. This table recaps the main ones, as well as the actual results on those two super-large loans:

Growth Street's defences against large loans going bad	What happened?
Larger loans are only approved when the calculated risk of them going bad is considerably lower than the rest of Growth Street's loans.	That might be true, but in that case it was incredibly unlucky for the two largest loans to go bad at the same time.
Growth Street calculated the overall risk across entire loan book of the reserve fund running out of money was below 1%.	The reserve fund would have been completely overwhelmed by just these two loans twice over without the extraordinary action taken by Growth Street.
Large loans are unlikely to go bad until they have become small debts or have been paid off. Because the loan contracts and the borrowers' situations are such that Growth Street is allowed and able to “manage out” borrowers. It does this by getting borrowers to swiftly reduce their debts or to pay them off with a loan from somewhere else.	This didn't happen. The two loans were almost at the maximum amount borrowed when they went bad.
Due to a plethora of (actually quite good) tools and services that Growth Street used to keep track of borrowers, and additional disclosure requirements for larger borrowers, it was confident of spotting problems very early. It could therefore take steps long before a borrower becomes unable to repay.	While Growth Street had a little time to try (and fail) to reduce one of the debts, none of this seems to have helped Growth Street see early enough that these loans were heading for trouble.

In short, it looks like nothing worked as planned. None of the steps that were specifically to minimise the risks of approving large loans.

What went wrong with the loans?

We have little detail on one of the loans. It appears the borrower simply just became unable to pay in the ordinary course of its business.

With the other borrower, it was fraud that did it, combined with bad press about the fraud that forced Growth Street to take harsher action sooner than it wanted to. It's never good to see fraud, but it can happen. Growth Street has taken appropriate action to reduce other fraud risks in the past, so we'll keep an eye on future fraud cases and follow its record.

Does “super-large loan” sound familiar to you?

Long-time lenders and followers of 4thWay will have seen our research and articles on other peer-to-peer lending companies when they have taken on loans that are too large. These are Assetz Capital, RateSetter and Wellesley & Co (which is no longer doing P2P but still in the lending business).

All three of them suffered some issues as a result of their super-large loans – although all three survived and so did their lenders.

It's notable that all of these P2P lending companies were comfortable with their lending decisions. They had faith in their processes for approving loans. Indeed, until the problem occurred, at least one of the platforms had the gall to hail its massive loans as highly positive for lenders.

How RateSetter reacted in the same situation

Wellesley, Assetz and RateSetter survived their over-sized loans, and so did their lenders. They then learned fast and took huge steps to reduce or eliminate the risk of large loans causing widespread losses.

I think RateSetter is the best model in terms of how it reacted, so I want to take a look at that and compare it to Growth Street's steps after its super-large loans collapsed.

In 2017, RateSetter had a huge business loan of £8.5 million turn bad. The total lent to the borrower had reached £12 million at its peak. In comparison, RateSetter's reserve fund had cash in it of about £12 million.

The steps it took next were as follows:

1. RateSetter bought the entire bad debt itself

RateSetter's initial response was identical to Growth Street. Rather than raiding the bulk of the reserve fund to buy out a single massive bad debt, RateSetter itself bought the loan off lenders using its own money.

2. RateSetter acknowledged and admitted its mistakes publicly and in full

It's always reassuring to us at 4thWay when a P2P lending website has the confidence to admit its biggest mistakes, which RateSetter did very publicly in its announcements and communications with lenders and the press.

Not only is it about trust and a sign of self-confidence, but it shows that the platform is self-reflective enough not to pass the buck. This doesn't go without saying. Not at all. Many peer-to-peer lending websites don't have the courage to face up to and own up to their mistakes.

Even more than that: going public forces peer-to-peer lending websites to consider hard what to learn and what to change. They can't pretend to themselves that it won't happen again.

3. RateSetter introduced new procedures to eliminate the risk of super-large business loans

RateSetter said buying bad loans off lenders was a one-off. It was not going to do that again. So it had to come up with much better procedures for the future.

The most significant change by far was that it reduced the maximum amount an ordinary business borrower could borrow from the peak of £12 million down to a far more manageable £750,000.

(It later reduced this again to £500,000 and then ultimately restricted business lending even further in other ways over the following three years.)

With the actual cash in the reserve fund at the time being around £12 million, £750,000 is a much more tolerable limit, especially because such loans were rare. It would require a sudden crash in a hefty proportion of its relatively few large loans to ordinary businesses – all at the same time. Only then would they become troublesome.

“Troublesome” might even be too strong a word: £750,000 was just 0.1% of the total being lent at the time, and so it's easily covered by interest earned.

You can read more about RateSetter's super-large business loans in Fact Check: Was RateSetter Hit By £80m Of Struggling Loans?

What Growth Street is doing

Some time ago, when two of its small, experimental invoice finance loans surprised Growth Street by turning bad, it was one of the reasons that Growth Street stopped doing those kinds of loans altogether. At the time they were still far from being a danger, but nevertheless Growth Street took action to shut them down.

Now, two super-large loans surprised Growth Street by going bad, which is a considerably bigger deal for lenders. And yet Growth Street's steps this time are half-sized.

It's reducing the maximum loan size from £2 million to £1 million. This is a good start. Once they have the few loans over £1 million off their books, the risk of losing money overall improves considerably, due to both the reserve fund and the interest earned by lenders covering the difference.

But £1 million is still enough to consume most of Growth Street's reserve fund single-handedly, at least until any recoveries on that loan start to trickle in.

There are about one dozen loans remaining that are over £800,000. These are so large that that a handful of them could cause substantial issues by eating up the reserve fund and reducing interest to lenders. Potentially, these will even lead to temporary losses for lenders who lend for less than a couple of years. The risk is higher if it coincides with a recession, which is when bad debts rise generally.

(I think this is a good time to mention that most data for this update was in a data pack received by us from Growth Street that is dated 8/12/2019. It's probably changed a bit since then, especially since Growth Street is taking steps to rapidly shrink or offload the largest loans.)

Growth Street is making other changes, such as becoming more rules-based, which is usually a good thing. It can mean fewer errors of judgement.

I've had confirmation this week that their head of risk will discuss those changes with us in detail. All I know for now is that it's changing its process of monitoring borrowers that show any potential issues. And it's looking more closely at the interest rates it's charging borrowers. Part of the interest is paid out to lenders and another part goes into the reserve fund.

What I and 4thWay have learned – bigger caveats required

Growth Street's super-large loans caused sufficient simultaneous losses to wipe out both the reserve fund and nearly a year's interest. With some caveats, I had previously thought the risk of that to be relatively low. It's prudent for lenders now to assume the risk was higher than Growth Street calculated and higher than I thought.

Our research and opinion will be affected

In hindsight, the case studies of RateSetter, Wellesley and Assetz should have been a stronger warning. Now, Growth Street has made the streak 4/4. Certainly, the 4thWay team has now added this to our knowledge chest. And it means that we need to be as conservative or even as cynical with super-large loans as you have come to expect of 4thWay in all its other assessments.

That's why, from now on, 4thWay will always require solid, data-driven, results-based evidence before it gives a “pass” to super-large loans.

And until a great record in super-large loans is well established, 4thWay's specialists and researchers will be more cautious in how we describe the risks.

4thWay PLUS Ratings and 4thWay Risk Scores will change

My team and I have also taken the opportunity to update our calculation methodology for the 4thWay PLUS Ratings and 4thWay Risk Scores. We update these methods regularly over time as we get more data, facts and knowledge.

The 4thWay PLUS Ratings (a risk-and-reward measure of lending accounts) and 4thWay Risk Scores (a measure of risk only) are based on a tougher version of the same tests that international banks are required to use.

But those banks are very large, so even loans over £20 million can't easily cause a shock.

We have therefore updated our methodology to add penalties in our rating and risk-score calculations if a P2P lending account or IFISA fails an additional, conservative stress test on any super-large loans. That means we assume that far more of those loans go bad than is typical. It also means we assume the amount of bad debt that is subsequently recovered is lower than typical.

The penalties would mean a P2P lending account or IFISA that earns a 3/3 “Exceptional” 4thWay PLUS Rating or 2/3 “Excellent” 4thWay PLUS Rating under our standard calculation would be limited to a maximum 4thWay PLUS Rating of 1/3 “Fair”.

If the lending account would have earned 1/3 with the standard calculation, it will now not have a 4thWay PLUS Rating at all if penalised for super-large loans.

We've updated part of our official definition for a 1/3 PLUS Rating as follows:

While lenders are expected to make money most of the time, losses are possible for the average lender in a minor or major recession. Alternatively, but not in addition, losses might be possible as a result of some large loans in the portfolio, which do not have a proven record and could have an unusually big impact on results if they turn bad.

The 4thWay Risk Score will also rise if super-large loans are troublesome, because the additional potential losses from those loans will be reflected in the score's calculations.

Growth Street's new 4thWay PLUS Rating

Growth Street will need to establish that its £1 million cap is sufficient or it will need to reduce the cap further. Until then, it has been hit by our new penalty calculations.

Its 3/3 rating is now reduced to a 1/3 “Fair” 4thWay PLUS Rating.

Growth Street's new 4thWay Risk Score

The 4thWay Risk Score helps you understand the interest rate you might need to earn to offset the risk of losses from bad debts. You can also loosely use it as a guide to help you understand how many loans you might need to spread your money safely enough.

(In contrast, the PLUS Rating incorporates the interest rates currently on offer, so that it combines both the risk and reward. It therefore gives more of an all-round picture – but it doesn't give much indication of the spread of loans you might aim for.)

Growth Street previously had a 3/10 4thWay Risk Score, which is extremely low. (I.e. extremely good, because 10/10 means a high risk of sudden losses and 0/10 would mean no risk – which is impossible.)

In our re-evaluation this month, Growth Street was already going to have the 4thWay Risk Score tick up to 5/10, which is still on the low-risk side. That increase was going to happen without the super-large loans, based on our latest methodology and Growth Street's updated historical results.

With the super-large loans, it now ticks up to 6/10, which is in the balanced-risk space.

A 4thWay Risk Score of 6/10 means that if super-large loans go bad and our other estimates are correct, in a severe recession unrecoverable bad debts might be 10%-15% of the amount lent. Factoring in the Growth Street reserve fund, it would take two to three years of lending (either before, during or after the recession) for lenders to have positive returns.

What's the bottom line on Growth Street now?

Growth Street still has a strong case for being part of your lending portfolio. It's still professional. It learns fast. It offers a kind of lending that is different and worth putting money in. It stocks its reserve fund well.

The two largest loans wouldn't have completely wiped out lenders.

A £1 million cap is far better than £2 million.

And it did rescue lenders using its own cash. Growth Street likely still has cash left from a £17.5 million cash injection from its shareholders, so another bad-debt buy out is not completely out of the question.

But the caveats that go with lending through Growth Street have become bigger. The defences it was so sure of did not function and it either assessed the risk of large loans turning bad incorrectly or suffered rather bad luck.

Therefore, I suggest a new cap on Growth Street lending of about 15% of your total lending pot, or 5% of your total savings and investment pot, would now seem to be about right.

The massive Growth Street safeguard you make yourself

You can't forget that after you have already lent safely through Growth Street for a few months, your tolerance for losses has grown already, since you can absorb losses with interest you've already earned. After a year or so, your tolerance is pretty substantial. At this point, it won't be long before even super-large loans shouldn't concern you from the point of view of making an overall loss.

Lend – and re-lend – the repayments and interest you receive for several years, through good times and bad. This has a powerful effect at lowering the risks.

Visit Growth Street.

Read the Growth Street Review.

Pages linked to above:

Biiiiig Growth Street Update On Bad Debts, Reserve Fund And Super-Large Loans.

Fact Check: Was RateSetter Hit By £80m Of Struggling Loans?

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