Prosper.com
"Personal lending" startup Prosper.com must have recently hired a new PR firm, since it's been all over the place lately. I think I've heard or read three or four radio segments and articles about the company in the past week alone.
The idea is pretty simple: think of it as Ebay for lending. People who want to borrow money (up to $25,000) post a plea online, Prosper.com assigns them a risk rating (based on their credit score), and individual lenders can "bid" to fill some or all of the loan at a given interest rate. If enough lenders are interested, the loan gets made; and if the loan is oversubscribed, then the interest rate gets pushed down. Loans are all fixed interest rate unsecured three-year loans.
It's an idea with a lot of appeal, especially borrowers sick of paying 30% or more for credit card debt, and individuals looking for a better return than the 5% or so currently offered by CDs and other short term debt. Even the safest (lowest yielding) loans on Prosper.com are paying over 10% to the lenders, and the higher risk loans are offering well over 20% interest.
That's before fees and defaults, of course, and there's the rub. Prosper.com takes a 1% fee for all but the highest rated loans, and if the borrower defaults then the lender might not get anything. So the actual return has to be adjusted for fees and defaults.
Fortunately (and to their credit), Prosper.com makes a handy performance calculator tool available, which calculates the ROI for a basket of loans based on criteria you specify, including rating, origination date, and about a hundred other factors. So you can get some sense for the actual returns corrected for fees and default histories (though the calculation could be proven completely wrong if the economy changes and default rates go up or down significantly). And, according to the performance calculator, even after correcting for defaults and fees the returns still look attractive: over 9% for the highest rated loans.
But there's a couple of gotchas and oddities.
Gotcha #1
Looking at the default return calculator, it only includes loans originated between 6/1/06 and 10/6/07, and those where the borrower had no current delinquencies and no more than two recent credit inquiries at the time of the loan.
In other words, the "headline" return isn't the real return for all Prosper.com loans. Playing around with the tool somewhat, I found that including all loans in the performance calculation causes the return to plummet: even then highest rated borrowers only returned a little more than a money market fund, and the lower grades had substantially negative returns. In other words, even the high (20% and up) interest rates charged on those risky loans weren't enough to make up for the very high rate of default.
Worse, in the June-September 2007 quarter, only about half the loans originated at Prosper.com met the "no defaults and two or fewer credit inquiries" test. The rate of return published on the web page is seriously misleading, since it excludes the riskiest half of loans. Someone not paying attention could very easily miss that detail and wind up making much riskier loans than expected.
I presume that the default and credit inquiry information is available to lenders (I don't know for sure since I haven't created an account to see for myself), so clearly lending to people who have current defaults or more than a couple credit inquiries is extremely risky, whatever Prosper.com's rating might be, but this is also an avoidable mistake.
Gotcha #2
There's only a limited amount of data in the loan history, since Prosper.com didn't start making loans until 2006. On a three year loan, that means that not even the oldest loans have gone to maturity (though some have been paid off early), so the reported default rate will be lower than the actual default rate for the full life of the loan. In fact, the preset time frame in the ROI tool excludes the first six months of Propser.com's history--looking just at that initial six months shows an ROI a couple points lower.
In other words, if you want to know the actual historical return on Prosper.com's loans, the answer is "nobody knows because none of these loans has gone to maturity yet." It is a fair bet is that the actual return will be at least somewhat lower than reported by the performance calculator.
Oddity
It's also weird that the default-adjusted return for riskier loans is actually lower than for the less risky loans. Normally you would expect the riskier loans to return more, even after adjusting for the default risk, since lenders will demand more interest in exchange for the increased risk. But that's not the case.
This suggests to me that at least some of the lenders on Prosper.com aren't doing their homework, and get seduced by the very high interest rates offered on the riskiest loans. Because the interest rate is so high, at least some people aren't properly calculating the default-adjusted return.
Gotcha #3
If you really want to delve deeply into the expected return on a Prosper.com loan, there's no way to get enough historical data to make a meaningful calculation, and it isn't clear exactly how Prosper.com does the calculation.
For example, it's very important to know not just whether a loan defaults, but when. It makes a big difference if a loan defaults in the second month instead of the twentieth. In the latter case, the lender has already recovered over half the capital. It's also important to know what fraction of loans in default ultimately are repaid or written off.
It's also important to know when loans are repaid early, to get a handle on "prepayment risk." How could early payment of the loan be a risk? Simple: there's no guarantee that you can reinvest the money at the same interest rate, and the borrower gets to choose whether and when to repay early. If interest rates drop, many borrowers will refinance (which Prosper.com makes easy), and the lender is suddenly no longer getting the 10% interest he expected to get. On the other hand, if interest rates go up, the borrower has locked in a low rate, and the lender doesn't have the ability to make new loans at the higher interest rate.
In other words, borrowers get the ability to reset their interest rates by prepaying and refinancing, but lenders have no such option. This will always work to the lender's disadvantage.
When to Invest Through Prosper.com
Given all this, I don't think Prosper.com is likely to be a good investment for most people. Lending money is a complex business, and there are a lot of subtle details which can impact your return. Even for big, sophisticated banks lending money to individuals isn't a great business to be in: despite the absurd interest rates, credit card companies make most of their money on fees, not interest. There are some people who might find this model rewarding, however:
People willing to do their homework and be extremely smart and careful about the loans they make.
People who derive nonfinancial rewards from Prosper.com (for example, the satisfaction of helping someone in need, or the gamelike aspects of the site).
For the most part, however, the extra financial return you might earn through Prosper.com will not come anywhere close to paying for the time and effort to manage their loan portfolio.
And there's also the question of what happens if Prosper.com goes bust: the company has been backed by $40 million or so in VC money, and with that kind of investment the investors are probably looking for the company to have $50 to $100 million/year in revenue in fairly short order. That implies originating several billion dollars/year in loans, and right now they're a couple orders of magnitude shy of that number. It's not clear to me that there's anywhere close to the required level of demand, and if the VCs pull the plug, where does that leave the lenders? Only Prosper.com is allowed to service the loans, and it's not clear that any other financial institution would be interested in taking on that job.
So for now, I'd view lending through Prosper.com as a stodgier version of online poker: do it for the entertainment value, don't expect to actually make any money in the long run, and be mentally prepared to lose everything in the worst case scenario.