Is Prosper.com a Good Investment?

Almost three years ago I discovered peer to peer lending, in the form of the then widely hyped Prosper.com. For a week or two I was enthusiastic on it as an investment, until I crunched enough numbers to decide it was not so exciting after all. In the meantime, I had put $1000 in ten $100 loan slices.

Loans on Prosper are three years in duration, so next week this little experiment will finally wind down. Assuming that I get the last $15.46 that is owed me, I will have received a grand total of $1029.50 over three years. A zero percent return is pretty lousy, but at least I have the solace that quite a few other things that I could have invested in in January 2007 would have done a lot worse.

But, as it turns out, breaking even makes me an above average lender on Prosper. According to the delightfully data laden Eric’s Credit Community, which tracks and analyses Prosper loan data, the average lender on the site has an ROI of –2.29%. Again, it could have been worse.

I found Eric’s from a post by Mark Gimein at Slate’s The Big Money, cleverly entitled You Are Unlikely To Prosper. That post has made a minor splash in some circles by making the case, with the use of actual data, that investing in Prosper has not really worked out for enthusiastic early adopters like me.

Prosper is incensed by this slander, yesterday calling for The Big Money to retract the post. They considered it to be "disappointingly inaccurate" and continued their response with such outstandingly lame counterpoints as:

Mr. Gimein states that 39% of loans that have had a chance to come to maturity (originated prior to 12/31/2006) have defaulted. What he doesn’t say is that the annual yield on these loans was 16% and the annual loss experienced by lenders was actually 20%, resulting in an annual average return of negative 4%. Although this return is negative, put in the context of the largest recession in generations, and the performance of other asset classes during the same time period, this paints a very different and more accurate picture of how lenders have fared on Prosper.

Mr. Gimein continues to use his flawed methodology to state that 54% of loans with an interest rate of 18% or greater have defaulted, leaving the impression that lenders on these loans have lost over half of the funds that they lent, and that losses ran roughly three times the interest rate on loans. Again Mr. Gimein is equivocating annual interest earned with cumulative default rates over a three year period. Lenders on these loans lost 10% on an annual basis, and while not positive, it’s a far cry from the 54% loss that Mr. Giemein flawed analysis leads the reader to believe.

In other words, sure people who invested with us are poorer now, but not that much poorer. And given the recent performance of the overall economy and consumer credit in particular, this really ain’t so bad.

Okay, those are valid points. I guess.

But read carefully and you see that Prosper is not saying that Gimein got facts wrong, only that by citing those facts he left the reader with a more negative spin than Prosper would like. 39% of loans written before 12/31/06 really did default. The best Prosper can say is that that is not as bad as it sounds. Inconvenient things, numbers.

Gimein’s piece ends with what I consider to be the most interesting facet of all this, that despite the relatively easy availability of quantitative evidence that the Prosper model is, at best, questionable, the media continues to happily shill for it as the next great thing. Gimein cites a recent MSNBC interview with the Prosper CEO and an article in The Washington Post. (To be fair, the Post’s item is mostly about what a good deal it is for borrowers.)

To this I will add that there is plenty of optimism about Prosper in the blogosphere, apparently founded on something other than actual data. For example, and I cite it only as one example of many, just last month The Digerati Life told us that "peer to peer lending offers a fresh, alternative way to invest your funds" and stated that Prosper had an average annual return of 7.06%.

For obvious reasons, I will refrain from saying that you would have to be crazy to invest in Prosper. But in hindsight I find myself wondering why I ever thought this could make sense. The basic pitch of peer to peer lending is that it takes the middleman out of the consumer lending process. That is, that individuals making loans directly to consumers is, somehow, a more efficient and better model than the tired old bank way.

What could we have possibly been thinking? Granted, it is pretty clear that in the middle of the last decade those professional loan officers did not do a very good job. But they screwed up by being too permissive, not by missing out on opportunities to lend to our trustworthy and wholesome peers. That is a mistake that, had you known about it in advance, would have made you want to stay far far away from making consumer loans.

I think that banks are generally pretty good at loaning money, if only for the Darwinian reason that banks that are bad at it do not last very long. Yet the fundamental premise of peer to peer lending is that amateurs like us can do it at least as well as the professionals.

I can take seriously the argument that ordinary individuals can compete successfully with the pros in stock investing. (I still think it is wrong, but I can listen to it without eye rolling.) But competing with pros in writing consumer loans? Really?

Investing, Media, PF Blogs | Frank Curmudgeon | January 20, 2010 1:59 pm

18 Comments

By Susan Tiner, January 20, 2010 @ 3:45 pm

This makes me wonder what’s makes someone really good at writing consumer loans. Does it have more to do with actuarial science or judgment of character?
By Jim, January 20, 2010 @ 3:48 pm

Interesting. When I first heard of peer to peer lending I thought it sounded like a great deal. Theoretically it seemed it should work for both sides, the borrower and lenders gets a better rate than a bank will give them. But the more I saw about the actual default rates it didn’t really seem like you could come out ahead even with a high interest rate.

I guess the obvious flaw in the whole system is that the lenders have to trust their money with strangers who have crappy credit. And of course a recession certainly doesn’t help.

At least you came out even Frank.
By Neil, January 20, 2010 @ 4:06 pm

And what have we learned? People borrowing money at interest rates in the credit card range are bad credit risks. Somebody call the New York Times…they’re not going to believe this.

I don’t think this is anything wrong with the prosper model. I think the problem lies with the willingness of prosper lenders to underbid on people with crappy credit.

I looked into P2P lending at one point, because, yeah, 10-15% interest rate sounds wonderful. But I found the number of people looking for, essentially, consolidation loans astonishing. Or to borrow money for frivolous uses (vacations, new car, etc.)

I want to believe that people can change and that they can get use a consolidation loan as a way to get out of debt. But if I’m betting money, I’m going to bet that they’ll use the loan to pay down their credit card, and then use the extra credit available to get deeper into debt.
By Mike Piper, January 20, 2010 @ 4:18 pm

Affiliate programs are a big piece of the puzzle in terms of blog coverage. For example, if I link to Lending Club, and you open an account through my link, I make $25.

A “review” post of Lending Club is a quick, easy way for a blogger to make some money.
By Craig, January 20, 2010 @ 5:43 pm

Don’t I remember reading some research that more attractive people (or at least, people with more attractive pictures) were more likely to receive loans on Prosper, and also more likely to default? If I were going to loan on Prosper–and I’m not–I’d only loan to people as ugly as myself.
By Rick Francis, January 21, 2010 @ 10:41 am

Frank,

Do we really have enough data to declare peer to peer lending dead? Would you seriously consider an analysis of the stock market that only looked at the market’s first 3 years and declared it a failure?
How is peer to peer lending significantly different from a credit card lending? The banks don’t have loan officers reviewing credit card purchases- the rates and limits are based on the applicant’s credit score and the peer to peer sites have the same data.
If the rate of return accurately compensates the default risk then on average the loans will be profitable. While the market under estimated the default risk three years ago isn’t it likely there will be future periods where it over estimates the default risk and makes greater profits?
I found this article about the lending club’s default rates:
http://www.fivecentnickel.com/2009/06/10/lending-club-historical-repayment-rates/
From the data in that post none of the A loans defaulted, and the defaults increased as the credit rating decreased. If you had only invested in A loans you would have gotten ~7% return. Not spectacular but it certainly beat CD rates over the last few years, and it shows the predictive value of the credit score.

-Rick Francis
By Jim, January 21, 2010 @ 2:11 pm

Rick,

Vanguard intermediate treasury fund returned 7% annually over the past 3 years and the junk bond fund returned 3.5%. Prospers advantage for lenders seemed to be the promise of higher returns. Now that we’ve seen prosper fail to give higher returns why would an investor put money in Prosper over say buying junk bonds or ultra safe treasuries?

I don’t see Prosper having any advantage for an investor right now unless they raise rates. But If Prosper raises its interest rates then it becomes less compelling to the borrowers. Theres not much margin to give good rates for both lender and borrower and still give prosper profits off the top.
By Alexandra, January 21, 2010 @ 3:10 pm

I believe that peer lending still has it’s place in this world. But I would prefer to do it in a face-to-face manner with my enforcer right behind me so that they know if they default, they’ll get their knee-caps broken.

That’s my kind of loan gaurantee!
By Rick Francis, January 21, 2010 @ 5:04 pm

>Why would an investor put money in Prosper
>over say buying junk bonds or ultra safe
>treasuries?

Peer to peer lending should have a long term average rate of return in line with its risk. If it can’t it should die out in the long run. Thus Peer to peer must offer higher rates of return than ultra safe treasuries.

Right now I don’t think there is enough data to know exactly what the long term averages are going to be. However, I would be surprised if there wasn’t some bond fund that closely matched its risk/return profile.

Even if the risks/returns are exactly the same as some existing bond fund peer to peer lending should offer investors some amount of diversification.

-Rick Francis
By mwarden, January 21, 2010 @ 9:26 pm

You aren’t competing with banks. You can only lend out as much money as you actually have. The banks don’t have to worry about this pesky restriction.
By Investor Junkie, January 21, 2010 @ 10:15 pm

I think the issue comes down to Prosper did not properly calculating the risk to default. I am a Lending Club investor, abit small at the moment ($1k). I do believe they are a better option and wrote a review on my blog. I’ve been doing it for 6 months 30 loans, so far 10.42% return and no defaults.

http://investorjunkie.com/lending-club-review

I have no problem pulling punches against LC or any other P2P web site. The problem is many in the blogosphere are too influenced by the affiliate fees.

I don’t consider P2P dead. I will be posting updates more about Lending Club and my return in the future. I plan on putting up to $5k into Lending Club, but I consider throwaway money to try it out.

So while it’s an interesting alternative investment, I don’t consider it for everyone.

From a borrower I definitely think it’s the way to go if you cannot get better rates else where. I consider that factor too as CC rates are going up. People are looking for better rates.
By Dan, January 22, 2010 @ 12:19 pm

I stand to lose about $180 of my original $3000 investment in Prosper. I’ll find out in July 2010 exactly what my losses will be.

So what did I think I could do that banks couldn’t? Well… uh… there *is* that little game with 0% intro offers on the credit cards where the rates get jacked if you miss a payment. Most signature loans at a bank ran around 14% when I looked. So I figured that a prime borrower may be happier to lock in an 8-9% rate that couldn’t be screwed with. (I still believe that to be the case.) Trouble is, large enough loan amounts amortized over 3 years result in a rather huge monthly nut.

On the bottom end, however, I toyed around with the idea that banks over-priced the thin files. Turns out they knew what they were doing. (In this case, I thought those with a thin file actually had something to gain by adding to their credit history, and would avoid defaults as a result. I was wrong.)

Then, and I really did think there was some potential here — couldn’t we steal some business from the Pay Day Loan companies? Surely, paying off $1k at $35/mo for 36 months was much more reasonable than the business models the PDL folks use. I still believe this to be the case — but I also believe that people will act in their own economic best interest. The “HR” rating that Prosper gives isn’t just a credit grade, it’s a lifestyle. And those with crappy credit probably have more to gain by taking the money and the hit on their credit report (what’s one more unpaid collection?) than they do by paying it back at such high rates.
By Dan, January 22, 2010 @ 12:22 pm

Oh, I forgot to close with this:

So what were we thinking? In hindsight, it’s easy to call this a failure. But if existing business models are never challenged, we will never have any innovation or progress. And the pros have demonstrated with this economic crisis that they aren’t perfect.
By Kosmo @ The Casual Observer, January 22, 2010 @ 1:51 pm

“Then, and I really did think there was some potential here — couldn’t we steal some business from the Pay Day Loan companies?”

I’ve been hearing ads lately for a pay day loan consolidation company. Consolidate your multiple 500% APR loans into one nice, frienly 200% APR loan and everyone wins, I guess
By Kosmo @ The Casual Observer, January 22, 2010 @ 1:54 pm

One thing to note (and what I believe Prosper is driving at in their response) is that a default doesn’t always mean you lost the entire investment. If someone fails to make the final of the 36 payments, that’s still a default – but the lender is in considerably better shape than if the borrower made no payments at all.

I’m not saying that P2P isn’t risky, just that you can’t tell a geat deal by the raw default rate.
By Peter, March 16, 2010 @ 1:48 am

I just came across Prosper today and after looking at my money market and high interest checking returns, decided to look into it.

After reading a number of reviews, the one thing I haven’t heard anyone mention is Prosper’s failure to address the consequences faced by a defaulting borrower. As a potential lender, this is my very first question – that is, if i’m borrower, what is my motivation to pay this money back? Spend some time on the Prosper website and you won’t find this addressed, at least not directly and not from the lender’s perspective.

With no collateral, and a 0.48% collections rate, there is very little incentive for a borrower to pay the money back. The worst thing I can think of is that the person will be banned from the site and his or her credit score will be dinged.

For a person with great credit, this ding may not a be a big deal, as their credit will probably still be pretty good – and for a person with bad credit, well, they probably never cared too much about their credit score in the first place. So why pay?

Personally, I like the p2p concept and think it has strong potential. Eventually, the market will adjust for these things and prices will take this risk into consideration. To help this along though, Prosper could do itself a big favor by increasing the penalties for defaulting.

First of all, they obviously need to increase their collections rate – as it is pathetic.

But more importantly, they need to use social shame / embarrassment – one of the most powerful forces around. Prosper should require friends and family to “endorse” potential borrowers so that if they miss a payment, these people are contacted and told their relative / friend is a deadbeat that should be taken around a corner and shot.

Other possible references could be employers, social organizations, church groups – basically any person or group that you would be mortified to find out Prosper has contacted them and told them what a terrible person you are.

Additionally, I imagine most potential borrowers are “internet savvy” and probably have a profile on Facebook or LinkedIn or some other social / public facing site. Prosper could require borrowers to grant it limited access so that if a borrower missed a payment / defaulted, the borrower would be flamed on their public profile. How would you like a tweet, a wall post, or a message going out to your friends and professional connections saying:

“Mr. X is late on his loan payment by over 30 days. After making a commitment to repay his fellow community members on time, Mr. X decided to take advantage of their generosity by not living up to his word. If you read this post, please tell Mr. X to live up to his end of the mutually agreed upon bargain and whatever you do, do NOT lend money to MR. X!”

Lastly, shorter terms. From the reviews I’ve read, most borrowers make the first few payments and even do well for the first year, after that, it starts going downhill quick. Prosper requires a three year term; instead, it should allow a number of different term durations. Sure, a shorter term = less risk = lower return for the lender, but I’d rather have a lower return that I’m more likely to earn (and still beat the 1% I’m getting on my checking account) than to lose my principle as the effects of time make my borrower forget about the promise he/she made 3 years prior.

Does any one else have any ideas on how to improve the social lending model?
By Paul, May 26, 2010 @ 10:52 am

I’m a 2007 Prosper borrower rated “D” at the time paying 14% on a 3k consolidation loan. I think I only answered 2 questions from lenders, which somewhat surprised me. I’ve never missed a payment.

The way I see it, I’m the guy this stuff is made for, but when I looked at the site from an investor’s point of view, I don’t see how you could tell if I would be a good loan or not.

I do think the loan terms need to change. When the stats show the default rates rise rapidly after the first year a 1 yr term would be ideal for many higher risk borrowers.