Monday, June 18, 2007

Prosper lending - How to avoid bankruptcies

When lending money to someone on Prosper the worst case scenario is to have someone go bankrupt. At least with other types of defaults you will see a small amount of money returned when the loan is sold to debt collectors. This post is on how to spot and avoid loans where the borrower is planning a bankruptcy.

First the obvious case: when a borrower comes out and says that he needs the money to start a chapter 7 bankruptcy process then it is probably wise to avoid that loan. Here is a borrower that did just that. The scary thing is that if you don't read the listing where the borrower explains what the money will be used for, or set your loans to auto-fund based on a set of criteria then you could inadvertently end up funding a listing like that. Fortunately for Prosper lenders, this loan did not fund and no one lost any money on it.

One thing that might really surprise you (it did me) is that of the 9 loans that have defaulted due to bankruptcy only one of them was in the HR category while 2 were B's and one of them was an A. None of these loans made any payments, they just took the money and headed into the bankruptcy process.

So, what kind of patterns do we see in these loans that went bankrupt? Six out of the nine loans (a full 66.6%) were set to auto-fund at rates between 14.25-30.75%. All of these auto-fund rates were well above the average rate for the credit grade (the 14.25% was set on the A rated loan). If you are a borrower in process on a carefully planned bankruptcy then why not set the loan at a high auto-fund rate? That way you get the money sooner, and why care about a high interest rate when you don't plan on paying it back? Keep in mind that very few of the overall loans are auto-fund loans, and a much higher percentage of auto-fund loans turn into late or defaulted loans when compared to non auto-fund loans. So, while it can be really tempting to grab a few extra percentage points of interest, it turns out not to be worth the risk. Matt's advice: avoid all auto-fund loans (you can recognize them by looking for the yellow lighting bolt next to the interest rate).

Looking at the listing text for these loans, they mention a variety of reasons: divorce, medical bills, "an emergency that happened to my family", dental work, new businesses, and a new job. Two of them mentioned that they planned to "be out of debt soon". Interesting how taking an additional loan could help someone be out of debt soon, but the bankruptcy helps put that into context.

There have been some other listings that have raised my suspicion. For example, I have seen a couple of listings where people fresh out of college are trying to refinance their student loans. Now, you might ask, what is wrong with refinancing student debt? There are two reasons this is a red flag for me: First, thanks to the federal government, student debt usually has generous interest rates, and can be financed over a long period of time which allows for low monthly payments. Refinancing this through a Prosper loan would generally increase monthly payments by shortening the timeframe of the loan to 3 years, and it would likely end up at a higher interest rate.

So, why would someone do this? The answer is likely a carefully planned bankruptcy. Understanding a little about the bankruptcy process helps shed some light on how clever this is. In bankruptcy there is something called "non-dischargeable debt." This refers to debt that can not be eliminated through the bankruptcy process. This includes student loans, child support and alimony, taxes, divorce debts, court imposed restitution, court fees, and theft. In a carefully planned bankruptcy, people look to turn non-dischargeable debt into regular debt that can be eliminated in the bankruptcy process. So looking at the list gives us some things to be aware of.

Note that fortunately for Prosper lenders neither of the two student debt listings mentioned funded, so Prosper lenders did not lose any money on those two loans.


tom said...

So does this mean that only nine loans total have defaulted due to bankruptcy? That is actually much lower than I would have guessed.

Jimmy said...

Bankruptcy can free up money for child support. See the June 12 article "Filing for Bankruptcy Can Help Pay Child Support" at The Child Support Web

Matt said...

Yes, out of 11640 loans only nine have defaulted due to bankruptcy. A larger number have defaulted due to late payments. Loans that default due to late payments are sold to collection agencies, but with bankruptcies none of the money is recovered.

gelos said...

Does that 9 only include loans that have actually defaulted?

Two of my loans have a bankruptcy notice on them but neither are considered defaulted (by Prosper).

One is 4+ months late and the other isn't quite 1 month late.

I hope this is the case. I'd hate to think that I managed to pick 2 of those 9 loans.

It would also mean that there may be many more bankruptcies out there.

Matt said...

Yes, these are just loans that have actually defaulted. Prosper's 3rd party tools doesn't allow to search by notifications related to the loans, but it does allow you to search based on type of default.

DCS said...

Thank you for this analysis!

However, your statement that none of the defaulted bankrupt loans made any payments is incorrect. I have two defaults due to bankruptcy, and both made their first few payments. For example, the henryjr loan (included in your nine) made the first three payments before going bad.

Matt said...

That is interesting. Prosper must be purging the payment history for these loans once they enter bankruptcy. I wonder if that is a legal requirement for them for someone who has entered bankruptcy.