Great technical execution; Investment proposition still unproven
Written: Jan 09 '07 (Updated Jan 09 '07)
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Prosper.com offers investors the chance to bypass traditional banks, and invest their money directly in personal loans offered to individuals. Personal loans are basically uncollateralized (there is no asset explicitly backing the loan) and offered to the individual without any need for an explanation of the purpose of the funds. Prosper.com limits possible loan amounts to between $1,000 and $25,000, with lower or higher limits sometimes imposed by state law.
I am admittedly a small investor on prosper, having just recently bid $50 each on four loans, and having only two of them complete the closing process. However, due to my academic and career background, I may have some useful insights on the process. Please note that I address Prosper as a lender, and that a borrower�€™s perspective may be vastly different. But regardless of which party you would like to be, it makes sense to understand both perspectives.
The site was started by the person behind eLoan as an experiment to disintermediate banks by allowing lenders and borrowers to meet with lower fees.
The technical process to being a lender on Prosper
So you want to be a lender ?
To become a lender you must sign up for an account as a regular user first. This process is fairly standard. Then, to become a lender you submit your SSN and a couple of other details. Prosper then verifies that you do not have a criminal record etc, since you will have access to credit reports on perspective borrowers. The final step involves adding a bank account online, with a trial deposit verification. Then, you initiate a transfer and wait four business days for the funds to arrive at Prosper.
A little grueling, but nothing out of the ordinary for a finance relationship.
Funding loans . . .
Mirror mirror on the wall, which borrower will default on MY MONEY.
So you get to choose. You can invest manually by sifting through loan requests, or you can set up an automatic loan criteria that Prosper then funds. Here�€™s the categories you get in either case: credit grade (from low to high -- High Risk, E, D, C, B, A, AA), current credit lines and historical defaults and current defaults of the borrower, first historical loan, and income in relation to debt (including perspective loan). In addition, each borrower can choose to be a member of a group or not, as well as whether or not to write a statement as to what they will do with the money, their monthly budget etc.
Many of the statements by borrowers are filled with spelling errors, which I find provides a good sorting mechanism. If you prefer automated sorting mechanisms, you can sort by credit grade, percent funded, closing soon, etc.
How do the loans work ?
The loans have a default (and unchangeable) 36 month period, lenders pay monthly and may prepay at any time. You may loan as little as $50 (so a number of people fund any one loan). The money paid by borrowers is divided up and paid monthly to lenders. Prosper.com takes a .5% fee on all payments, not too high.
If a loan goes into default for three months, a collection agency will take over and try to recover the debt for you minus a fee. If that doesn�€™t work, Prosper.com will sell off the loan in large bundles to institutional investors to recoup at least a small percent of the principle. KEEP IN MIND THAT THERE IS NO GUARANTEE THAT YOU WILL BE REPAID FOR THESE LOANS.
So far, everything has worked as promised and I have no complaints. Prosper.com offers you historical default rates and warns you when you lend to high risk people, which all in all seems like a fairly responsible business practice.
Theoretical Issues
Is this better than a moneymarket ?
Prosper�€™s default rates are higher than averages as listed by Experian. This statistic is likely the case because there is adverse selection for borrowers. If they are not going to a retail bank, it is often because they would not qualify for a loan or would be charged a higher interest rate due to their risk profile. In either case, there is good reason to be wary of these loans. In fact, the only people who would benefit lenders on Prosper are those that own a house and have medium risk factors, because they would still be offered a high rate on a personal loan from a retail bank but are in actuality much less dangerous. Therefore, splitting the difference and charging the 15% is a good deal for everyone.
Bad Stats
Prosper has unusually high default rates in weird areas. They offer complete statistics on their loan portfolio and defaults; so, to be fair, they aren�€™t exactly hiding the problem. For example, loans under $5,000 to people with the highest credit (AA) have a default rate about three to four times higher than Experian�€™s track record with AA people. This is likely due to fraud, and is not seen at higher loan amounts.
Also, after adjusting for defaults, all credit grades below B are returning less than a money market account. This outcome is disturbing. According to the CAPM finance theory, you should be paid to take risk. This theory is easy to prove intuitively. Say I offer you two options, invest $1,000 today and I give you $1,100 in a year or I give you a 50% chance of getting $2,200 and a 50% chance of getting $0 in a year. Both have the same expected value, but most sane investors would choose the first so as to avoid the potential for a total loss. So, while prosper gives lower returns to those taking higher risk, they should theoretically offer higher returns for higher risk.
Group associations have no real life bearing
The Nobel prize winner who started Grameen bank used groups of people borrowing in a linked manner to decrease defaults. Basically, if one member of the group defaults, everyone is denied access to further credit. These are people who live in the same village, so the social pressure is real. In return, the Grameen Bank gets 97% repayment on loans primarily to poor women without assets or credit histories. Fairly remarkable.
Prosper stumbles trying to apply this same idea. Prosper has virtual groups based on sundry affiliations (careers etc). However, due to the lack of real, daily social pressure, they seem unlikely to encourage payment. Additionally, very few group leaders rigorously screen their applicants to add value to the process; in fact, some automatically accept members.
Subprime credit is faltering
Defaults and late payments on Subprime loans in the US doubled from 4% to 8%. Many people overstretched themselves on loans to buy housing speculatively or above their means and are now eating humble pie. The results for the industry are horrible, with many large US banks selling off their subprime lending divisions for almost nothing. With the majority of Prosper�€™s borrowers being subprime, one wonders how this bodes for the site. If large banks can�€™t make it work, why can less experienced people do so?
Conclusions
Prosper is an interesting idea, certainly worth testing; but, as of now, I cannot vouch for its utility.
Recommended:
Yes
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Madrabbit3
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