What effect would a recession have on the Prosper marketplace?

In the financial news you can find a story almost every day about the weakness in real estate markets, rising foreclosure rates, and increases in the number of bankruptcy filings. Some economists worry about the effects spreading across the broader economy and triggering a recession. The bearish outlook suggests that lenders will tighten up their borrowing criteria, consumer spending will decrease, and unemployment will start to increase. FX Street lists 6 historical indicators that suggest we may be heading for a recession (all of which have now occurred):

1. When GDP growth was below 3% annualized for 5 consecutive quarters.
2. When the Fed tightened monetary policy (8 of the last 10 times).
3. When the yield curve was inverted (6 of the last 7 times).
4. When the Conference Board Leading Indicators were 0.5% or more below a year earlier (9 of the last 10 times).
5. When new building permits were 25% or more below a year earlier (7 of the last 9 times).
6. When payroll employment growth dropped to 1.4% over a year earlier.

Other economists are more optimistic and suggest that the sub-prime fallout won't spread, and we will continue to see the economy improve and move ahead.

The truth is that economists have never been good at predicting short term moves in the economy, but history does show cycles of booms and busts (or expansions and recessions). During a recession you will see a significant increase in the number of defaults among the lower credit grades. The following is a graph of historical default rates for speculative and investment grade loans.



From the above graph you can see that during the 1990-1991 recession there was a significant spike in default rates. In addition, most other asset classes don't do very well in a recession. In 1990 the S&P returned -3.11%, the Russell 2000 was at -19.48%, the US housing market showed a decline, and the junk bond market took a hit as default rates rose. In fact it is because of the 1990-91 recession that rates on junk bonds are so much higher than rates on better classes of bonds. When a recession hits it is likely that it will be accompanied by higher default rates on all types of debt including Prosper loans. If past recessions are a guide, the increase in default rates will be much more profound among sub-prime and lower credit grades.

So, what is the best way to protect against this potential risk?

First, make sure that you have the appropriate time frame outlook for your investments. At Prosper, your minimum time horizon is 3 years since all loans originate based on a three year term. I would suggest that your time horizon should be longer than that. If you have 20+ year time horizon then your returns are going to approach the market average. The long term average for the stock market is about 10%. For the bond market it is about 5%. We don't have good numbers for Prosper's long term average over cycles that include bull and bear markets, but I would guess that the long term performance for a portfolio of above prime loans would fall somewhere between the 5% bond market return and the 10% stock market return.

If you have a shorter time horizon, for example, if you absolutely needed the money in 3 years then you could end up taking a loss or smaller return on your investment. Think what would happen if you invested in the stock market before 9/11 and then took your money out 3 years later. Given enough time, however, the markets recover from downward cycles and investments return to their long-term historical rates of return (in economic terms this is called regression to the mean). The same is true for Prosper; with a short time horizon you could end up with less than the long-term expected rate of return if your investment horizon overlaps with an economic recession. With a longer time horizon, the recessions will have a small overall effect on the portfolio as they are balanced out by better years.

To further protect your portfolio from economic downturns, you can consolidate your loans into better credit grades and spread your risk out across a variety of loans as I discussed in my risk management article. If, for example, you loan primarily to homeowners or real estate investors than your portfolio will be more exposed to a real estate downturn than if you have a wider variety of loans. Focusing on the higher credit grades help, since historically it is the sub-prime loans that are least able to weather an economic downturn.

Lastly, don't put all of your investment money into any one asset class. You should start with an emergency fund in something like a money market or savings account that can be easily accessed if needed for an emergency. Then any remaining money can be diversified among several different asset classes - stocks, bonds, real estate, foreign markets, and Prosper. The allocation percentages should be based on your risk tolerance and investment timeframe. The longer term (10+ year) money can have a higher percentage in stocks, the mid-term (5-10 year) money can have a higher percentage in Prosper, and the shorter term (<5 year) money should be mostly in cash accounts or bond funds.