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?

Prosper.com: Convincing My Wife, Part 2

...she ain't convinced yet.

In my continued efforts to convince my wife that Prosper.com is a good investment, I'll analyze another aspect of the website today. Today I'll study what makes the successful lenders successful, what makes the average lenders average, and what makes the biggest losers, well, the biggest losers. I'll be moving my analysis platform to a fabulous website that focuses solely on Prosper.com lender and loan data, EricsCC.com.

To get things moving along quickly, consider the following graph that shows all lenders' rates of return on a seemingly normal distribution curve (please click any graphic to enlarge it):
As you can see, the majority of lenders are making money, and a significant majority are also earning a higher rate of return than they would earn in a traditional savings account. However, of all the non-average lenders, there are more that are doing exceptionally poor than doing exceptionally well. This indicates that if you do not follow a reasonable, disciplined investment strategy, you are more likely to lose at a high rate vs gain at a high rate. I guess the same could be said about the stock market. Essentially, it's easier to make mistakes than it is to get lucky.

Do you ever watch that show called The Biggest Loser on NBC? Well meet the biggest loser on Prosper.com: scoobydoo. Here is a graphical representation of his investments:
As Antonio from the Merchant of Venice would say, His "ventures are in one bottom trusted." This guy has invested a lot of money into Prosper.com and has given several large loans to people with C-grade credit. If one or two of those loans defaults, his ship will have sunk.

Let's look at another big loser's profile. How about jasonpeery:
Here's another guy that has a poor, lazy investment strategy. He has invested over $50,000 in Prosper.com listings and has scores of late payments and defaults. This guy has made several individual loans over $1,000, including one that is in default for $11,000! Why in the hell would you EVER loan $11,000 to a person with high-risk credit? And without even asking them a question! I sure hope that jasonpeery is better at personal finance than he is at determining to whom he should lend his money. As Neil Boortz would say, I bet that this guy has a lot of rent-to-own furniture in his house. My guess is that this guy's grandmother died recently and left him a bunch of money. No one that worked for $11,000 and saved it would ever be that careless in giving it to a single high-risk stranger.

One thing to remember about Prosper.com's fee structure is that all individual loan fees are passed along to the borrower except for a 1% loan servicing fee which is paid by the lender. This means that, statistically speaking, there is no reason to invest more than $50 in ANY candidate. Period. If I lend $500 to one person or $50 to ten people, I will pay the same loan servicing fee. And though I may save a little time by investing more money in lower-risk candidates, it's just plain silly to not diversify to the max with sub-prime borrowers.

OK, so let's look at someone with an average return. Consider the portfolio of helpishere777:
Ahh, this is refreshing. This user is right in the middle. He is earning about 11% interest, which takes into account the probability of his late payments going into default. He has invested the same $50,000 that our last big loser had invested, but in a completely different way. Look at the nice even relationship between all of the blue and green lines. Do you know why they're all equal? Because he invested the same $50 into every single loan. He understands that in order to mitigate his risk, he needs to diversify -- especially if he can do it at no additional cost!

Now let's look at the best lender. I'm not going to evaluate the person earning the highest return on his money. Currently that person is DrakeCO, who is earning about 33.6% interest. However, the average length of his loans is less than one month and most of his loans have been large amounts (max of $1,500) to high risk borrowers. Because of the youth of his loans and the nature of his strategy, he is bound to fail. Instead, I'm going to look at someone earning about 20% return with a reasonably large average loan period (if it's not old, the borrowers don't have time to be late!) and a significant amount of money. It looks to me like the golden child of Prosper.com is brother_tam. Here is his portfolio:

brother_tam is obviously smart and probably a little lucky. He has invested a little more than $10,000 in Prosper.com, mostly in $50 increments. Of his 224 loans, he has given more than $50 only 13 times, probably just to spice up his account. As a lender that understands the need to diversify. He is aware that he can invest in lower-credit borrowers because of his discipline. But he doesn't invest in only low-credit borrowers. He has a nice normal distribution of his loans that has a mean slightly on the low-credit side.

To be a successful lender on Prosper.com, you need to stick with a disciplined strategy that is formulated around the values of diversification and a normally distributed loan strategy. When choosing which loans to bid on, consider your current portfolio and establish a quota. "Right now, 75% of my loans are to high-risk borrowers. I should invest in some low-risk borrowers."

Remember: there is no penalty for investing the minimum amount in a person. And with more than 2,300 active listings, you shouldn't run out of people to lend to.

If she's still not convinced, I'll have to write more tomorrow.

Prosper.com: Convincing My Wife, Part 1

My friend and frequent tepom.com commentator Steve Butcher has an active account with Prosper.com and is doing quite well with it. His current rate of return is about 16.9%. I'm interested in joining him and trying my hand at peer-to-peer lending, however, my wife takes a very conservative approach to lending and will definitely need some "talking-into" if I ever want to open an account.

I will write a small series of posts that will attempt to justify peer-to-peer investing and convince my wife at the end that it's a good idea. The end goal of my analysis will be to prove my hypothesis that Prosper.com provides an excellent lending opportunity by using their empirical loan data. If my hypothesis is proven, I will convince my wife to start investing and share with you all my plan of attack.

Day one analysis: The correlation between debt-to-income ratio and loan delinquency
Prosper.com evaluates borrowers' credit reports and assigns them an alphabetical risk rating, from AA (the best) to HR (high risk -- the worst), with A, B, C, D, and E in the middle. In today's analysis, I decided to evaluate the correlation between a borrower's debt-to-income ratio (DTI) and the delinquency rate for each credit classification. My analysis assumes that any amount that is not current (>15 days late) is considered delinquent. It should be noted that these numbers do not suggest a loan default, just the probability of delinquency. Here I evaluate both the number of default dollars and the number of default loans. In my opinion, the number of delinquent dollars are more important than the number of delinquent loans because we intend to diversify our money as much as possible. The more you diversify your money, the more important the number of deliquent dollars become. The less you diversify, the more important the number of delinquent loans become.

Though my analysis evaluates delinquencies as a whole, it should be noted that those with poorer credit that go into delinquency are much more likely to have their loans written off than those with better credit. Essentially, those that have better credit are better at getting themselves out of trouble.

Click a chart to enlarge:
Looking at all loans regardless of the borrower's DTI (the blue line), it comes as no surprise that as the borrower's credit rating declines, there is a higher probability of the loan becoming delinquent.

However, when three bands of DTI are considered, the equation changes. With a DTI of anywhere from zero to 50%, the curve doesn't shift or change significantly for any classification of borrower. However, with a DTI above 50%, the curve is flipped nearly upside down. This suggests that a dollar loaned to a person with great credit but a high DTI ratio is more likely to be late than a dollar loaned to a person with poor credit and a similarly high DTI.

Similarly, when looking at the number of delinquent loans, the curves are closely aligned for borrowers with DTI less than 50%. But once the DTI rises above 50%, the difference in likelihood of the loan's delinquency rises substantially, especially for borrowers with great credit.

To summarize, the number of loans that will become delinquent do not vary significantly as the borrower's DTI changes except when the borrower has great credit. A borrower with great credit and a high DTI is much more likely to become delinquent than a borrower with great credit and low DTI. A borrower with poor credit and a high DTI is just as likely as a borrower with poor credit and a low DTI to become delinquent on his or her loan. When you consider a dollar loaned, a dollar loaned to a person with great credit and high DTI is much, much more likely to be late as opposed to a dollar loaned to a person with great credit and a low DTI. The reverse is true for poor credit borrowers. A dollar loaned to a person with poor credit and a low DTI is more likely to be late than a dollar loaned to a poor credit borrower with a high DTI.

So what do we learn from this? When lending to people with great credit, be wary of those with a high DTI requesting a lot of money. Don't lend to them unless you can obtain a premium rate. When considering lending to a borrower with poor credit, be sure to diversify your money across different loans. If you're torn between two poor credit borrowers, if the only difference between their profiles is their DTI, consider lending your money to the one with the higher DTI, especially if their rate is higher!

More to come on other Prosper.com lending strategies.