Is a Good Investment?

Almost three years ago I discovered peer to peer lending, in the form of the then widely hyped For a week or two I was enthusiastic on it as an investment, until I crunched enough numbers to decide it was not so US-Treasury-Small 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?

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