This blog post is part 3 of a “Beyond the default rate” series, which investigates what the default rate actually means, how it affects you and why you should know more than simply the number you see on some report.
If you haven’t yet read the previous posts in the series, please do that before reading this one. This post will be building upon the foundation we set in previously.
Two reasons to calculate default rates
There are essentially two separate reasons why you would want to calculate default rates and both of them have a different methodology and different results for doing the calculation.
The difference will be what you consider as D in the formula.
Current default rate
Most of the time on Bondora’s website or newsletters, you’ll see the current default rate of the portfolio or some segment within the portfolio. This means that the D in there equals to default less recovery.
This is useful to calculate when you want to see how well a portfolio or a certain segment of it is performing. The main usefulness will come out of it if you do it regularly though. Then it’ll give you a lot better indication of how the segment or portfolio is doing (see the graphs in my post here for an example of how the country-based results have changed over time).
If you do not thoroughly understand the statistics, calculations and default rate, you’re better off not using this method to make any forecasts for the performance of a certain segment of the portfolio. This is simply best used to watch the performance and changes over time to see whenever a certain segment might turn into a more interesting one or when it might make sense to reduce your investments into some riskier one.
The second reason is to calculate a default rate of a certain segment to figure out what the initial “loss” for this group is and whether it is profitable to invest into this group.
For this reason you should use the initial default numbers for D (depending on your method, either the amount or count of defaulted loans). This result can be used for a forecast of what would likely happen if you were to start investing into this segment.
By initial number I mean the amount or the count of loans that defaulted, irregardless of whether they have now started reperforming or have recovered entirely.
If your calculation says that for this segment the initial default rate is 10% and the current default rate has been rather stable over the last 6 months, then you can probably assume with some confidence that your investments with proper diversification, will yield a similar result in that segment.
The LP portion of the calculation
While the current and initial default rate calculations require a different type of data for the D and will likely give somewhat different results, the LP portion is essentially same for both.
One of the most common mistakes people want to do in the calculations (especially newcomers to the topic) is that they want to exclude the repaid portion of the portfolio to get an “accurate” rate for defaults.
You should exclude for both the LP and D portion of the sample, the data that we discussed in the second post of the series.
You may also (if you know how to do it) want to exclude cancellations by borrowers and Bondora (with the newly added additional security process) as this will artificially make the results look a bit more positive than they would otherwise. Although in most of the calculations my bet would be that they won’t be that relevant and you’d more than likely be wasting your time trying to exclude these to see a small 1% difference in the default rate (I might be wrong here of course, so if you have done the calculations, feel free to post in the comments).
What you should never exclude, are the repaid loans that were issued within the period you selected as your sample and have been repaid by the borrower.
If you exclude those, you’re simply doing some random calculation that is going to make you feel bad because the default rate will likely seem to be a lot higher than it actually is (depending on how long you have been investing) and the result has nothing to do with what’s actually going on in the portfolio.
As you can see, there are several different ways to approach the default rate calculation and even more the reason to not take any results posted in the forums on face value. Especially since there are the correct ways to calculate it, which give you rates that are good for different purposes, and then there’s several ways to do calculations that actually give you incorrect info and may lead to wrong investment decisions that end up costing you either money or reducing the amount of good investment opportunities, because you think due to a faulty calculation that some segment is riskier than it actually is.
In the next post we’ll cover some more of these typical mistakes and will also look into the situations when or how you should consider using EAD1 or EAD2 in your calculations.