Sunday, April 08, 2007

Prosper's $50m loan pool - high risk, high reward?

Prosper has reached a milestone of $50 million in P2P loans extended, however $10 million of these may end in default. Despite the high rate of Prosper defaults, much higher than traditional consumer credit defaults, lenders should not and may not mind if they are receiving appropriate returns.

P2P lending is emerging as a new credit category, not just in the visible ways of loan origination and delivery but also in the financial sense of how risk and reward are defined. P2P lenders are able to accept higher default rates since they are also theoretically realizing higher returns. Some portion of the 10% traditional spread in bank lending between borrowing and lending accrues to the lender.

It is clear that Prosper loans default at higher rates than traditional unsecured consumer credit loans. The chart below shows Prosper defaults in pink and Experian (as a proxy for the consumer credit market as a whole) defaults in blue. In every credit tier, Prosper loans have higher defaults. In the prime market of AA, A, B and C credit tiers, Prosper narrowly underperforms Experian. However as credit quality worsens, so do Prosper defaults with Prosper loans defaulting at double traditional rates in the E and HR (high risk) tiers.


Default data can be found at the Prosper website by scrolling to the bottom of the Performance page and selecting the Estimated ROI link. Lender ROI estimates are trickier, ranging from a blended portfolio ROI of -1% using the Prosper site data to 17% using the data from Eric's Credit Community.

The marketplace aspect of Prosper is working as sub-prime borrowers have seen the opportunity and are creating most of the volume on the site, 75% of listings and 60% of fundings. Although many loans receive funding that probably would not in traditional credit settings, the majority (75%+) of listings do not get funded.

Prosper is only about a year old and the P2P lending market needs to achieve much higher volumes before meaningful performance can be evaluated. The question is whether rates of return can be delivered which are appropriate given the higher risk from the higher defaults and if lenders can learn how to price default risk effectively in this new credit product.

13 comments:

dave said...

When looking at the default chart you posted, I don't think prosper is a bad as you make it look. Keep in mind that the experian default rates apply only to borrowers with debt to income ratios(dti) under 20%, because they say that over 20% is nearly impossible to predict. The prosper line includes those funded on prosper with dti's over 20%. This is why you are seeing so much higher default rates. If you took out those listings on prosper with dti's over 20%, I bet it would be a lot closer to the experian rate.

ProsperLenders.com said...

Yes to DTI's >20% being included in that chart, but DTI is rather loosly correlated with defaults, so far. The Experian projections are pretty flaky/optimistic for a variety of reasons, not least that the data they're based upon (bank card product data) is a loose fit (at best) for Prosper loans (as an asset class)...

Anonymous said...

take out the E and HR credit grade borrowers - you arrive at a neat result (and higher returns) - eliminating transaction costs in this online way can benefit lenders &borrowers, as well as prosper (prosperity for all? :) )

LaBlogga said...

Hello all, thank you for the comments. You're right, the Experian default stats are accurate for DTI < 20%. Re-running the analysis for DTI < 20% indicates substantially the same level of defaults, especially for sub-prime loans.

I agree, the Experian ratings may not be a good proxy for consumer credit defaults and Prosper defaults but they are given as a benchmark on the Prosper site and Prosper underperforms that benchmark.

Given that over 2/3 of funded loans are to E and HR credits, it does not make sense to leave them out of a default analysis. Plenty of lenders are interested in the returns they perceive in sub-prime credits. The lower transaction costs of the Internet should result in a greater surplus for both borrowers and lenders.

Anonymous said...

I think what is exceptional about Prosper is the transparency and data they provide in an easily accessible format. It is quite exceptional, and I think that the mere accessibility of the data will drive behavior changes and could alter the entire credit market over time.

Anonymous said...

I heard of Prosper yesterday, and am fascinated by the concept. I have done a little bit of due diligence, and one thing that worries me and that has never been factored into the risk is the risk that Prosper itself will have financial difficulty or will default. If it did, the so-called "lenders" who are participating in the loans could lose all their investment. I have not found much on the internet about Prosper's financial condition, nor for that matter, much disclosure about the legal relationship between the retail lender and Prosper.

LaBlogga said...

Hello anonymous and anonymous, thank you for the comments.

1) Yes, I think it is not only critical to Prosper's success but also extremely useful to be transparent by posting the default data. Also as you point out, the feedback loop created by the transparency (and user reputation) can itself drive behavior. I can see a future where individuals borrow solely based on repayment reputation, not on credit score.

2) Prosper has had 3 venture rounds from top-tier VC firms (Benchmark, Accel, etc.), the third round of $20 million in June 2007, and is doing well so far. If Prosper were to go under, I think their loan portfolios would be sold to/assumed by a loan servicer/bank. They must have some contingency in place for this possibility, I will find out about it. The longevity of Prosper was certainly a concern raised at the lender conference in February.

LaBlogga said...

Anonymous - I have heard back from Prosper that:

"If Prosper would go out of business, no new loans would be created, all Lender funds not actively associated with a loan would be returned to the individual Lenders immediately, and all existing loans will be serviced to completion by a third party loan servicing agent.

The third party loan servicing agent would take over the administrative responsibilities such as the transfer of monthly loan payments, providing timely payment notices, monthly Lender statements and required tax documentation, overseeing the collection of delinquent loans on behalf of the Lender, and reporting payment performance to credit bureaus."

apwall said...

Point of clarification. Glancing at the posted chart was at first very concerning. A default rate of 5% on "C" loans for example, would wipe out any benefits. That 5% number is the ammount your return is reduced. The actual default rate is significantly lower. May be obvious to others but not to myself.

apwall said...

I posted a little too quickly. If no payments were made at all, then a 5% default rate would essentially reduce your return by approximately 5% (taking C grade loans for example). However, prosper shows that the Net Default rate is 0.4% but the hit to ROI is 5%. Any thoughts on this? I probably shouldn't be sipping on Scotch and blogging.

LaBlogga said...

Hi Apwall, Thanks for the comments.

Looking at C tier loans, the 5% subtraction from the ROI for net defaults comes from conservatively summing all of the loans that are not current from the Delinquency Activity below: 1% 16-30 days late, 3% 1-3 months late and 1% over 4 months late.

Btw, blogging and scotch together sounds fine, just no LWI, lending while intoxicated :)

Anonymous said...

After just over one year as a lender on prosper, I'm pulling out. With 118 active loans, 28 are delinquent! These are all hand-picked loans and I'm well diversified from AA to HR. Yes, AA's can default, too!

LaBlogga said...

Hi anonymous, thanks for the comment and for sharing your Prosper experience with the community. Presumably AAs default at lower rates than HRs but you're right, any loan can default.