Is Prosper.com dead? And what is a secondary market?

Anyone who borrows, lends, or regularly browses Prosper.com received an email from the site's management team about suspending lending activity for a while while they develop a secondary market. So what does that mean? Will we ever be able to lend or borrow again? And what on earth is a secondary market?

First of all, don't worry. Prosper.com is not dead nor will it be dead anytime soon. They're simply listening to users that write about the pros and cons of peer-to-peer lending (like me). Until recently, Prosper.com has been a very small fish in the big pond of lending. Now, they're growing to a slightly larger, more mature fish; they just need to pull the curtain for a few months while they renovate.

If you read any post on just about and blog that writes about Prosper, you'll notice that one downside for lenders is that any money that they invest is money with which they part until the loan is repaid. For example, if you lend $100 at 25% to someone, you will get approximately four dollars per month for 36 months. And if you all of the sudden you need emergency orthodontic surgery and absolutely had to have back that $100 that you lent, there would be no way for you to get it faster than waiting for the $4 monthly payments to add up.

But let's say you had a really good friend named Steve that noticed you were in a pinch. Steve sees that you lent out this money a few months ago but need it back today. Seeing that the lender still owes you about $120 over the next two and a half years, he offers to give you $100 today if you agree to give him the remainder of your $4 monthly deposits. You benefit by cashing out when you needed to and Steve benefits by taking control over a reasonably profitable investment ($20 in this case) .

But let's say that my other friend, Dave, also sees my predicament. He wants in on the investment, so he says that he'll give me $105 for the remainder of my payments. Sure, he'll make a little less profit than Steve, but he likes the idea of making $15 profit on his $105 investment. Steve isn't willing to pay more than that, so Dave ends up "winning" your loan.

Essentially, the offers of Steve and Dave to purchase of your stake in the loan represent a secondary market. A secondary market is a place where investors can bid on securities -- including bonds, stocks, and in this case, loans -- after initial public offerings have already been made. In the case of Prosper.com, the initial public offering was the original loan listing.

After you bid on a loan and give some money to another person as an investment, a number of things can affect the value of that investment. Let's say that statistics show that borrowers that make their first 10 payments on time are 50% less likely to default than people who have only made their first five payment on time. Therefore, anyone holding a loan to a borrower that has made 10 payments on-time could sell those loans for a higher premium on the secondary market. Or if you're an secondary market investor, you could buy up a bunch of loans that are currently late for pennies on the dollar. The original lenders are happy because they're able to get some money back, but you'll clean up if you can convince the delinquent borrowers to pay up.

The secondary market is a key part of our economy. Without it, stockbrokers on Wall Street would have pretty boring jobs. Without a secondary market, our investments in stocks and bonds would have very little liquidity. If we invested in stocks, we would only be able to cash out when the company agreed to buy that stock back from us. Or if we wanted to get our money out of a 30-year bond, we would have to wait the full 30 years.

Prosper.com wants to create a regulated, large-scale secondary market for their loans. To do this legally, they need to file with the Securities Exchange Commission, which takes time. But after the filing is complete, more people will be encouraged to lend because they won't have as much of a risk of having little liquidity. Basically, current lenders who run into financial troubles of their own will no longer risk not being able to get at least some of their money back. The secondary market will positively affect borrowers, too, who can expect to get lower rates on loans, as the risk to original lenders losing all their money is reduced; lenders whose borrowers are late will be able to sell the loans. And because their liquidity is increased, lenders will more likely invest more money.

Let's just hope that Freddie Mac doesn't start buying up loans made to High Risk borrowers, packaging them together, and selling stock in their "High Risk" fund. As our recent economic troubles showed us, that's just asking for trouble.

Will Prosper.com's development of a secondary market encourage you to start lending?