Lending Club Introduces IRA Product

Lending Club CEO and Founder Renaud Laplanche announced today that Lending Club has introduced the first IRA product that allows for peer to peer investments.

Laplanche told Prosper Lending Review today by e-mail, “now investors have more choice for their retirement accounts beyond traditional asset classes. Lending Club is delighted to provide this new alternative to investors. We look forward to offering more innovation and value for financial consumers in the future.”

Potential Lending Club IRA investors should remember that they need to enroll (the application goes by old-fashioned mail) and fund their account by 4/15/09 if you want to enroll for the 2008 tax year. EntrustCAMA, part of the Entrust Group, serves as the administer for these accounts.

Enrollment information is located online at https://www.lendingclub.com/sdIRA/registerIRA.action.

Lending Club has been nominated for the “Top 100 Innovators” by The Industry Standard. It was also recognized recently as one of the 20 “Breakthrough Ideas for 2009” by Harvard Business Review.

Jessica Ward is a freelance writer based in Seattle. She follows personal finance and family life. She also blogs at The Pennywise Family.

4 tips for Prosper lenders

Amy Hoak, who wrote 4 tips for Prosper borrowers for the Wall Street Journal, now has 4 tips for Prosper lenders. Here are Amy's four tips with my comments.

• Understand the model - Which one - Prosper, Lending Club, Zopa, or Virgin Money?
• Listen to the stories but don't ignore risk - I recommend Matt's article about risk management for a better understanding of this advice.
• Diversify risk - Few follow this advice. We found most Prosper lenders do not diversify. In fact, a full 70% have less than 20 loans.
• Start small - You often hear veteran lenders wish they started smaller. For example, Rateladder who runs several p2p lending sites and is the editor of the official Prosper blog said, "I have been lending since July 2006. I, like many, made some early mistakes in my lending strategy. Even though I was bidding on the better credit grades I didn’t pay close enough attention to other extended credit parameters… I continually adjust my bidding strategy and expect that my ROI (as estimated by both sites mentioned above) will continue to show improvement in the future."

P2P Lending Review: Best of 2007

The P2P lending market has changed significantly in 2007. One year ago the only P2P lending story was Prosper. Time named Prosper the top website of 2006. BusinessWeek predicted that Prosper would be one of the Top Eight Tech Companies to Watch in 2007. A year later, Prosper continues to make headlines but several other p2p lending companies are making news as well. Here are a few highlights from 2007:


Prosper

• Named one of the 50 best websites of 2007 by Time
• Passed $100 million in loans (now at $108 million)
• Changed the way they interact with members - after several forum riots and other tense public clashes with some members Prosper deletes their forums without notice and re-opens another more moderated forum; started an official blog; starts a monthly lending market survey; starts webinars to educate new lenders and borrowers
• Registers with SEC to create $500 million secondary market for p2p loans
• Announces plans to spread to Japan
• Receives $20 million in venture capital for a total of $40 million raised
  

Lending Club

• Launches inside of Facebook and loans $100,000 during the first month (now at $4.5 million)
• Expands to users outside Facebook
• Becomes the first p2p lending platform to loan to borrowers nationwide without state-by-state lending caps
• Hosts popular YouTube video contest
• Receives $10 million in venture capital
• (Disclosure: I recently started blogging for Lending Club. Read my Lending Club posts here.)

Zopa

• Expands from the U.K. to the U.S.
• They announce a very new P2P lending model comparable to a certificate of deposit at a bank or a termshare certificate at a credit union. You also have the option to reduce the rate to help out borrowers. The loans are federally insured and currently earn 5.1%.

Circle Lending/Virgin Money

• Richard Branson purchases Circle Lending and rebrands it as Virgin Money USA
  

GlobeFunder

• Announces they will launch on October 2nd but then delays for "lending licenses and website development"
• This week they just launched a new webpage and appear to be open for institutional lenders and will allow borrowers to sign-up, but individual lenders must wait

Loanio

• Receives some minor attention in the media during the summer and, like GlobeFunder, announces they will launch in the fall but delays
• Currently advertising on homepage that they are "Coming January 2008"
  

In June we started Prosper Lending Review. It's been fun and we have learned a lot. According to visitors, these are our most popular articles in 2007.

15 Most Popular Articles of 2007

A Prosper scam: The story of Jessica Wolcott
Prosper: A hands-on education in risk management
How does Prosper compare to other investments?
Prosper Lending Review - the first month
When to bid on Prosper loans
Review: Top Prosper Blogs
What is Loanio?
Borrowing money to lend on Prosper: Wise or Foolish?
Credit Scores on Prosper - Part 1 of 2
Why would a borrower use Prosper instead of a traditional bank?
Equity sharing - Prosper for real estate
Loanio prepares for fall launch
Prosper Lending 101 - webinar review
Prosper CEO: Lenders avoid subprime and 'flight to safety'
Lending Club announces $5000 video contest

The most popular articles are not always the most useful articles. While A Prosper scam: The story of Jessica Wolcott may be interesting reading, it is not going to provide solid actionable investment advice like some of the following articles. If you are about to commit your hard earned money to p2p investments it makes sense to do as much research as you can. Of the 100+ post of the last year I recommend that following ten as required reading for all investors (I'll also note they they were all written by the other co-author of this blog, Matt):

10 Best PLR articles of 2007

How does Prosper compare to other investments?
Prosper: A hands-on education in risk management
Why would a borrower use Prosper instead of a bank?
Borrowing money to lend on Prosper: Wise or Foolish?
Most Prosper lenders do not diversify
Are all Prosper loans within a credit grade created equal?
An analysis of pre-payment risk on Prosper loans
Are non-homeowners a safer lending risk in a declining house market?
Credit Scores on Prosper - Part 1 of 2
When to bid on Prosper loans

We look forward to 2008 and the many changes it will bring to the p2p lending marketplace. Happy New Year!

Are non-homeowners a safer lending risk in a declining house market?

With all the recent troubles in the housing market, some lenders are starting to ask whether homeowners are a higher risk than non-homeowners when lending on Prosper. In the housing market the biggest problem homeowners are facing is when ARM or adjustable rate mortgages reset at higher payments and higher interest rates after the initial one to seven-year fixed term. When combined with falling house prices, borrowers are sometimes unable to refinance their mortgage since they owe more on their house than it is worth. These borrowers are stuck with a house they cannot afford and cannot sell for the amount of their mortgage and are forced into foreclosure. Because of these deteriorating market conditions, some lenders have started asking borrowers whether they are in a fixed mortgage or whether they have adjustable rate mortgages (or ARMs). Others have taken to the forums to list the reasons they won't invest in loans related to real estate deals.

To get an idea of how the stats look in Prosper, I pulled one year of Prosper Marketplace data for loans from March 28, 2006 through March 28, 2007. Four months have passed since the end of the data range which gives all of the loans a chance at going late. Auto-fund loans were also excluded from this data. Here is a table that shows default rates for home owners vs default rates for non-homeowners for this one year time period.

Credit Grade	Homeowner Defaults	Non-Homeowner Defaults
AA	0.81%	0.58%
A	3.23%	1.29%
B	5.10%	3.46%
C	9.12%	6.58%
D	12.93%	7.52%
E	16.75%	20.79%
HR	29.49%	41.89%

What this data suggests is that homeowners in Prime or near-Prime credit grades have higher default rates than non-homeowners. In the sub-prime markets homeowners are actually a better risk than non-homeowners. This data came as a surprise to me. With all the news about problems in the sub-prime mortgage industry I had assumed that sub-prime homeowners would be at an increased risk for default.

Personally I don't pay too much attention to home ownership as a criteria when deciding whether or not to fund a loan. Without being able to see the terms of the mortgage or the borrower's equity position, it is difficult to gage what effect the mortgage will have on the ability to repay the Prosper loan. Some borrowers will include this information in the description of the loan or in answers to questions. However, there is no verification of the information in those sections, so I do not trust that it is accurate. It would be too easy for the borrowers to write what they thought the lenders want to hear - especially in answers to leading questions.

In the higher credit grades the higher default rate might be partially compensated for by the difference in the amount of money recovered in debt sales for defaulted loans. When these sales have occurred, loans for homeowners at higher credit grades have been sold for as much as 25 or 30 cents on the dollar compared to pennies on the dollar for non-homeowners. Also, with this data being from the very early stages of the house market decline it may be too soon to tell what the overall effect will be on the Prosper marketplace.

Borrowing money to lend on Prosper: Wise or Foolish?

Frequently you will see listings on Prosper where someone plans to take out a loan for the purpose of reinvesting the money back into Prosper at a higher interest rate. The idea is that you borrow money at a low interest rate and then reinvest it at a higher rate to make money on the carry, or price differential.

The concept is simple, and it is how banks earn much of their money. If they can pay less than 1% on money deposited in a checking account and then lend out the money at 8% then they are making money on the difference. This is also the idea behind the Yen carry trade, a popular investment technique where money is borrowed in Japan at very low interest rates and then reinvested in developing markets that have much higher interest rates. The risk, of course, is that currency fluctuations could wipe out any gains that you make.

At Prosper there is also a significant risk to this borrow-to-lend strategy. Before we look at the risk though, lets look at a wildly optimistic scenario:

Suppose you were a AA borrower with perfect credit. You take out a $10,000 loan at 8% (this is a below average interest rate for a AA loan of this size, but we are being optimistic). Then, lets assume you get really lucky and avoid defaults and late loans while lending at an average of 19% interest. Now you are probably thinking, wow I just made 11% on the carry. A cool $1100 of free money! Lets take a closer look to see if that is the case.

When you initially take out the loan you have to pay 1% in loan closing fees ($100 in this case). Then, if you are lending at 19%, you are in the B-HR credit grades on your loans so you will have to pay a 1% servicing fee on those loans (there goes another $100). Also, you have to wait for the money to transfer out and back in to Prosper. Then, once you bid on loans you have to wait for them to close. During this time, which will probably be about 30 days, you are not earning any interest on your money. That reduces the rate of return for the first year from 19% to 17.4% (11 months at 19% and one month at 0%).

So, instead of making 11% you are now at 7.4% in earned interest (we subtracted 1% for the loan closing fee, 1% for lender loan servicing fees, and 1.6% for idle money). Well, that's not too bad you think, it is still $740 in free money, right? Not so fast...

There is one more thing to consider: taxes. Prosper is not a tax friendly investment. Interest paid on money borrowed from Prosper is not tax deductible. To make things worse, money earned on Prosper is taxable as ordinary income. Lets assume you are in a 25% federal bracket and 7% state bracket. The federal government sees that you earned $1740 on Prosper (they are looking at just the lender side). In this case, your taxes eat up $556.80 of your earnings. Now you are down to $183.20 in first year earnings, and remember this is the optimistic scenario.

Now, lets look at a more likely scenario using the same methods and example as above. Only this time we will assume that you have a 12% default rate (this is a better than average default rate for loans at a 19% interest rate). Now, instead of earning money you post a loss of a few hundred to as much as $1000 in your first year of investing depending on when the defaults occur.

The worst case scenario is that you don't diversify, overweight in HR loans, or are particularly unlucky on your default rates. Under this scenario it would be easy to see losses well in excess of $1000 during your first year.

Looking at the numbers, the potential gain is small, and the risks are too great to make Prosper a viable place for making money on the spread in interest rates by borrowing to re-lend the money. It is possible to earn a reasonable rate of return at Prosper, but borrowing at 8% to re-lend makes it unlikely to be a successful investment.

What really makes me cringe is when I see postings from people with poor credit scores who are trying to borrow at 12% or 14% to re-invest the money back into Prosper. They are almost sure to lose money on their investment.

I have loaned money to one person who was trying the borrow-to-lend reinvestment strategy on Prosper. I loaned him money at 8%, which he reinvested in loans that have an average interest rate of 16.28%. He re-invested the full amount of the loan ($3000), and a nearly a year has passed since he made the investment. He now has 4 late loans, and according to LendingStats his estimated ROI adjusted for late loans will be 7.30%. That means he will be lucky if he breaks even on his investment.

Most Prosper lenders do not diversify their portfolio

Diversifying your Propser loans allows you to lower the overall impact on your portfolio if one or more of your loans go into default. With 20 loans of equal amount you would have 5% invested in each loan. That means if one of your loans defaults you loose 5% of your investment. Lets assume you have an all AA portfolio and you are at 9.5% interest on your loans. One default would reduce your return to around 4.5%, and a second default could put you at a negative return. Increasing the number of loans to 50 so that you have 2% invested in each loan achieves better diversification. Under this scenario, after one default you would still be at around a 7.5% return, and close to 5.5% in the event of a second default. So, diversification is really helpful at reducing the overall risk on your portfolio. So, how many prosper lenders diversify their portfolio? Lets look at some stats:

	Number of Lenders	Percentage of Lenders
Less than 20 loans	15769	70%
Between 20 and 50 loans	3895	17%
More than 50 loans	2863	13%

Looking at this table, less than 15% of Prosper lenders have well diversified portfolios and 70% have little or no diversification. So, why is it that Prosper lenders are not very good at diversification? Looking at some additional stats will help us answer that question.

At Prosper you are required to invest a minimum of $50 when making a bid on a Prosper loan. This means to have 20 loans you need to invest at least $1000, and to have 50 loans you need to invest a minimum of $2500. When we analyze the number of lenders by amount invested we get that 41% of lenders have less than $1000 invested. So, short of investing more money into Prosper, there is nothing that these small lenders can do to diversify their portfolio.

On the Petri Dish suggestion forums several lenders have requested that Prosper lower the bid requirements for lenders to allow them to better diversify small portfolios. Judging by the number of small lenders with no chance for diversifying their portfolios I think this would be a good idea and a welcome improvement. Zopa, a peer-to-peer lending site in Europe, allows lenders to have as little as 5 Euros invested in each loan. I think lowering the minimum bid to $10 or even $25 would be a welcome improvement.

Are all Prosper loans within a credit grade created equal?

The easiest way to categorize risk is by credit grade. At Prosper you can search and filter loans by credit grade. Many lenders, including me, pay particular attention to higher credit grades while excluding the lowest credit grades completely.

Today we ask the question: Are all loans within a credit grade created equal?

Let's start with some statistics. The following are the average lender rates by credit grade. Note, this is not the actual interest earned by the lender, just the rate the borrower agrees to pay the lender at the time the loan is made.

Credit Grade	Interest
AA	10.59
A	12.65
B	14.91
C	17.60
D	20.78
E	24.05
HR	24.03

Here are the same statistics for all loans that are current:

Credit Grade	Interest
AA	9.43%
A	11.41%
B	13.83%
C	16.50%
D	19.53%
E	22.98%
HR	23.06%

Now, lets take a look at the numbers for the loans that have defaulted:

Credit Grade	Interest	Percent Above Average Loans	Percent Above Current Loans
AA	not enough data	n/a	n/a
A	12.85%	0.2%	1.44%
B	16.62%	1.71%	2.79%
C	20.24%	2.64%	3.74%
D	22.65%	1.87%	3.12%
E	25.77%	1.72%	2.79%
HR	25.93%	1.9%	2.87%

So, what do these numbers tell us? Well, if we look at loans in the B through HR categories, the loans that defaulted had a 1.7% through 2.6% higher interest on average than other loans in that credit grade. What this means is that prior to defaulting lenders considered these loans a higher risk and didn't bid down the interest rate as low as they did for other loans.

The difference is even more pronounced when you look at the difference in interest rates between loans that are current versus loans that have defaulted. Lenders put as much as a 3.74% risk premium on loans that ended up defaulting - clearly lenders were seeing something they didn't like in the listings compared to other listings of the same credit grade.

There are two things that we should learn from this data. The first is that it is probably not a good strategy to look for the highest rates in each credit grade. If you consistently seek out the highest interest rates in each credit grade then you are going to have a higher rate of defaults then if you were sticking to loans that are closer to average or below average for those credit grades.

The second lesson that we can learn from this data is that there are other important pieces of information when looking at a loan. It is important to look at the whole picture including number of delinquencies, debt to income levels, income, public records, and revolving credit balance. Basically you want to ask yourself questions like:

• Does this person have enough resources to pay back this loan?
• Does their past credit history show they can be trusted with credit?
• Does their purpose for the loan make sense to me?

What you will find is that some lenders will stick to the higher credit grades to lower their risk, but then they seek out the loans within that credit grade that pay the highest interest rate to the exclusion of all other criteria. Some lenders, for example, might set a standing order that would bid on loans only if they are at a higher than average % for that credit grade. Then they wonder why they are having a higher than average default rate in their portfolio. The answer is that lenders have allowed them to close at higher interest rates because they correctly assessed that they were higher risk loans in spite of their good credit grade.

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.

When to bid on Prosper loans

On eBay, there are tools that allow you to set a bid time, and swoop in and bid in the last second to win an auction. Getting your bid in at the last second prevents others from outbidding you and stops them from seeing in advance what you are doing. I was recently watching a house sell on eBay, and the winning bidder placed their first and only bid in the last seconds of a 30-day listing to win the auction.

On Prosper, the bidding is not quite as intense because multiple people can win small bids, so for someone to outbid you they may have to outbid several other people first. It is, however, helpful to understand the how the bid process works so you can make an informed decision when placing a bid.

First, the borrower chooses whether to auto-fund the loan or to open it up for bidding for a certain period of time. Let's say the borrower chooses to auto-fund the loan at 29%. This means that as soon as the loan is fully funded the bidding will end and the borrower will pay 29% interest; the rate will not get bid down. Auto-fund loans are denoted with a yellow lightning bolt next to the rate on the listing. Borrowers choose this option to get access to the money sooner rather than waiting for the rate to get bid down over several days. For this reason some lenders are wary of auto-fund loans especially in the high-risk credit group. Lenders see this as an indication of a desperate borrower that can't wait the few extra days to save a lot of money, or a borrower that doesn't care about the interest rate (possibly because they don't plan on paying back the loan).

If you do want to bid on an auto-fund loan you will need to make the bid before it hits 100% or the listing will close.

Most loans are for a set time period. These loans will show a green progress bar indicating what % of the loan has been funded. The loan will remain at the starting interest rate until the loan hits 100% funded. At that point each person that bids at a lower rate will knock off someone with a higher bid rate. As this happens the interest rate on the loan will be reduced to the highest rate among the group of winning lenders.

Let's give an example:

Bob the borrower starts a loan of $1000 at 16% interest. A, B, C, D, and E are lenders.

• A bids $500 at 16%
• B bids $300 at 12%
• C bids $400 at 15%

Now the loan is fully funded. C's bid reduces A's winning bid amount from $500 to $300 since C was at a lower rate. But there is still time left on the auction, and more lenders arrive.

• D bids $100 at 15%
• E bids $500 at 14.98%

So, the winning bids on the loan end up as follows:

• B - $300
• C - $200
• E - $500

The questions are: What is the rate that the lenders make and why is C on the loan but not D when they bid the same amount?

First, the lenders make 15% in this example since that was the highest rate bid among the lenders that remained on the loan (all the lenders make this amount even though some bid a lower interest rate than this). C remained on the loan because he placed the bid sooner than D. Note E made a smart move by bidding slightly lower than 15%. Many lenders bid in regular whole or half numbers, so bidding odd increments like .47 or .98 will often keep you on a loan while lenders with nearly identical but slightly higher rates get outbid.

So the question becomes: Is it good to bid early since that will keep you in line before someone else who bids the same rate?

The answer is: Not really. If you bid an odd number like XX.47 the chances of a significant number of others bidding the exact same number are slim. The more important consideration becomes whether or not the loan will fund. Many loans on Prosper end up not funding because there are currently more borrowers seeking loans than there are lenders with funds available (a good situation for lenders). The risk is that you will have your money tied up for several days on a loan that ends up not funding (once you have committed a bid to a loan it can not be withdrawn, and that money is no longer available for bidding on other loans).

So, bidding on a loan after it has reached >75% funded, or bidding on the last day on a fully funded loan increases the chances of being on a loan that will close fully funded. If a loan closes before being fully funded then the loan is cancelled and the money is returned to your account.

After a fully funded loan closes it goes into a verification process that can take 3-10 days before the loan is completed. During this time a loan can be cancelled if it does not meet the verification criteria. The most common reason for a loan not meeting verification is for failure to verify income. Prosper does not verify the income until the loan closes. Since this is a personal loan only personal income counts. One thing that you often see is someone who makes $40,000 per year has a spouse that makes $35,000 per year, so they put $75,000 for their income amount. This will fail verification because you can only include your income in the loan since the loan is being made to a single individual. The same is true for self employed people who put their business income rather than their personal income on the loan. Often, as a lender, you can spot this in the listing and realize that the loan is likely to not pass verification. If you don't want money tied up for a week on a loan that will end up being cancelled then it is wise to pass on those loans.