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.

Help wanted: Build competitor to Prosper

For the second time this month someone has placed an advertisement on a freelance website seeking developers to build a Prosper competitor. Last week we reported that someone had hired a developer through RentaCoder.com to create a "working, stripped-down version of prosper.com" by July 27th for $250. Yesterday someone posted a similar project on iFreelance. Here are the project specifications:

"We are looking to have a peer-to-peer lending site developed. It will have similar functionality to the existing sites in the market....For an example of a peer-to-peer lending site please see http://www.Prosper.com. We are looking to get started on this project immediately and are developing it on a very tight schedule."

Bidding on the project is open for a week and there are already four bids ranging from $3,000-$8,000.

Lending Club's Blog educates readers

Lending Club is challenging Prosper to become the leading peer to peer loan marketplace in the United States. They have been online since May 26th - just six weeks. I have not signed up as a lender or borrower yet, but I've been watching their blog pretty close. I've been very impressed with their communication with their community through the blog.


Of course they have the normal things you would expect on a corporate blog such as Lending Club announcements, but they also make a genuine effort to educate users on sound financial principles (mostly the perils of credit card debt). The posts are not overly technical or complicated. Most seem to be written for the average college age person. Someone who might be applying for their first credit card or taking out their first loan. They are clearly attempting to target the Facebook demographic. Here's a quick wrap up of the Lending Club Blog from the last six weeks along with some brief notes from me:

Education

Good Credit Part 1 - The importance of good credit - aimed at college students; housing, job, car
Good Credit Part 2 - FICO Review - what is credit; also see Components that make up a FICO score
Good Credit Part 3 - How to maintain good credit
Investment Mistake 1 - Procrastination
Investment Mistake 2 - Money Ignorance
Financial Independence - develop financial plan, start now
P2P Lending 101: The C's of Credit - character, capacity to pay, capital, collateral
Beware of the credit card access check - don't use the blank checks that credit cards send you without reading all the fine print
Know where your money goes - basic budgeting
Keeping tabs on your credit - one free copy of your credit report per year
Three financial ships - work, investment, charity (receiving, not giving)
Students: Don't be afraid of student loans - difference between 'bad' credit card debt and 'good' student loan debt
Primer on debt reduction - pay of highest interest rate debt first, consolidate debt
What banks don't want you to know - explains the practice of "universal default"; how banks can change your rates if you are late with a payment on another account
Credit Card debt is not simple - minimum payment on a $1,000 credit card debt can be a 22 year commitment
How much profit do credit card issuers generate - $16 for every $100 in outstanding credit balance
Is FICO score a reliable indicator of credit-worthiness - broaches topic of social credit scoring, how someone is more likely to pay their debt on time when they borrow from a community of people they know
Read the fine print - how credit card companies deliberately deceive card holders; the make a pledge "Lending Club does not operate with small print"
Double-cycle billing. Say what? - double cycle billing is used by 1/3 of credit card issuers and significantly increases interest
Grace Period - difference between effective annual rate (ERA) and APR and credit card grace periods
Jargon Watch: Defining DTI - percentage of a consumer’s monthly gross income that goes toward paying debts
Jargon Watch: Defining FICO - stands for Fair Isaac Corporation and is the standard credit scoring system used today; Lending Club's minimum FICO for borrowers is 640

Lending Club Promotion

Why a personal loan from Lending Club makes the most sense - interest rate, fixed payments/term, unsecure loan
Lending Club: an alternative to credit cards

Lending Club News

Close rate: 71% - a sharp increase from the original reports that only 1/3 of loans were closing
LendingMatch: Diversification and Matching - Lending Club's technology that helps lenders build their portfolio with respect to their risk/reward profile and their social connections through Facebook; also read this about LendingMatch
One week on Facebook - the report from their first week (4,000 users signed up in the first week; they are at just over 10,000 now)
Lending Club: How do we make money? How are we different than a bank? - financial comparisons between Lending Club’s operating model and bank’s models are difficult

From all early indications, Lending Club clearly has the best blog among peer to peer loan networks. By providing good, common sense financial advice they will attract an audience that will likely turn into borrowers and lenders.

Lending Club hits quarter million dollar milestone

Six weeks after opening its doors, Lending Club has brokered peer to peer loans worth a quarter million dollars. Lending Club is Prosper's only real competitor in the United States and is currently only open to Facebook members. This milestone comes just two weeks after passing the $100,000 mark. These mini-milestones have generated significant online buzz and have been reported in Mashable and TechCrunch. Lending Club is reporting the following statistics so far:

Lending Club Statistics
Facebook launch - May 24, 2007
First loan closed - June 6, 2007
Passed $100,000 in loan origination - June 20, 2007
Passed $250,000 in loan origination - July 5, 2007
Loans issued - 52 ($259,325)
Verified lenders - 411
Total members - 2,392
Facebook installs - 10,430
Facebook groups and networks - 20,936
Top Facebook group - Apple Students
Top borrowing State - Florida
Top lending State - California
Average Interest Rate - 10.28%

Prosper warns lenders of high risk credit grades

Prosperousland points out an interesting change in the bidding page for the riskiest credit grades. When you click to bid on E and HR credit grade loans you are now greeted with a large banner - Warning: Very low credit grade.

The disclaimer shows that E borrowers with 2 or fewer delinquent accounts have a default rate of 9.2% and E borrowers with 3 or more delinquent accounts have a default rate of 35.3%. High risk borrowers with 2 or fewer delinquent accounts have a default rate of 17.5% and high risk borrowers with 3 or more delinquent accounts have a default rate of 52.1%. This data is for loans with origination dates of Jun-Nov 2006 and as of Jan 2007.

There have been complaints in the forums that many lenders, especially new lenders, do not fully understand just how risky HR and E credit grades are. A lender who goes by the username thisguy has been the most vocal proponent of warning new lenders about the risk associated with E and HR borrowers. He has posted several messages such as this one, "If nothing else I still think there should be a 30 day ban from day 1 thru 30 of your lending life here where you are banned from bidding on HRs - then at least you will have had some time to build up your knowledge base, and see the 'reality' of the site." Other veteran leaders agree. In an open letter to Prosper in April Fred93, one of Prosper's largest lenders, accused Prosper of misleading lenders about potential returns and default rates.

This move by Prosper appears to be an attempt to respond to the criticism. It helps increase visibility of the likelihood of default on E and HR loans and will help new lenders fully understand the risk associated with lower credit grades.

While I think this is a great move for Prosper, it is also likely to make it harder for E and HR borrowers to get loans. As I mentioned in an earlier article, nearly 7 of 10 listings are from E and HR borrowers but very few of them get funded. Six months ago lenders aggressively funded low credit grade loans, but they have backed off due to the high default rate.

Analyzing the data using Prosper's Marketplace Performance, it appears that Prosper presented the most brutally honest, worse possible data. It also appears they included the rate adjustments in the default amount to come up with their percentages. If you move the range of dates forward or back the default rate gets slightly better or stays about the same.

An analysis of pre-payment risk on Prosper loans

There are many risks associated with lending money at Prosper. The primary risk is that loans will default or will have some late payments. The risk with a default is that the loan is sold off for pennies on the dollar, so most of the money invested is lost. The risk with late loans is that if payments are eventually made that bring the loan current a credit agency will take part of those payments as a collections fee. Of course, if payments are not made to bring the loan current, it will eventually end up in default. There are other more remote risks such as the risk that Prosper.com will go out of business. There is another risk, however, that is often overlooked: the risk of loan pre-payment.

Pre-payment occurs when a borrower pays more than is due on the loan, causing the loan to be paid off earlier than originally scheduled. Sometimes this is done by doubling up on payments, and sometimes it is done by making a lump sum payment for the balance due on the loan.

You may be thinking why is this a risk? After all, when a loan is repaid in this manner you are receiving all of your principal back plus interest for the time the loan was active. This is true, and it is certainly better than having the loan go into default. However, it is worse for the lender than if regular payments had been made according to the 3-year loan schedule.

When the loan is pre-paid, and the lender re-invests the money it is possible that it will be done in worse market conditions (i.e. interest rates may have gone down). Also, the interest earned from the good loans in your portfolio offsets the money lost from bad loans that end up defaulting. So, if your good loans pre-pay then you are making less money on each good loan, which decreases overall earnings. In addition, it takes time to bid and re-invest the money, so the money may sit idle for a month or more after a repayment at no interest until it is reinvested.

There are a variety of reasons why a borrower might choose to pre-pay a loan.

• If their credit score improved they can refinance at a lower rate.
• If the money was for a short term need such as flipping a house or buying inventory they might re-pay once they have reaped the profits from their investment.
• They might accelerate payments to get out of debt quicker.
• They might choose to consolidate their debt to reduce the number of payments they are making to creditors.

Banks understand the risks associated with pre-payments, and it is the reason that some banks charge pre-payment penalties on loans that are paid off significantly ahead of schedule. I don't have any great advice for avoiding this risk, but as with all investment risk I think it helps to be aware of all risks associated with an investment when deciding to invest. Also, unlike defaults I don't fault the borrowers for this additional risk; if I was in the borrower's shoes I would also pre-pay a loan if doing so could save me money on interest payments.

NPR features Prosper

Under the theme of financial independence for the 4th of July, NPR has aired a feature about Prosper. Marketplace's Amy Scott interviewed Prosper CEO Chris Larson, a couple of lenders and one borrower. You can listen to the radio spot here - A new way to get a loan. Prosper has been featured on NPR several times before including this interview with Chris Larsen.

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.

eHub interviews Lending Club CEO

Emily Chang from eHub conducted an interesting interview with Lending Club's CEO Renaud Laplanche. Here are a few noteworthy quotes:

Motivation to start Lending Club: When I started my first company in 1999, I charged the first few expenses on my credit card. Over the next few months, I had put $20,000 on my card, but was surprised that I was paying 18% interest despite my good credit score. I was too busy to shop around for lower rates and read the fine print. Instead, a few friends offered to lend him the money he needed, at a 10% interest rate. This experience set the founding principles of Lending Club...

Current company composition: We now have 21 people and will be adding another 20 in the next 6 months. The 3 main team members are myself (Renaud Laplanche), John Donovan and Joaquin Delgado. We have a diverse background of entrepreneurship, financial services and technology: before founding Lending Club, I founded TripleHop Technologies and sold it to Oracle in 2005. John Donovan developed and managed credit and debit products for Mastercard for 17 years, and Joaquin Delgado was my CTO at TripleHop and has a PhD in Computer Science, specializing in matching algorithms and user profiling. We also have team members who joined us from eBay, Oracle, Wells Fargo, Razorfish and Photobucket.

Current web traffic: We launched 4 weeks ago and all traffic is gated through Facebook at this point, but we’re already seeing more than 1,000 unique visitors per day.

Future of Lending Club: We launched exclusively on Facebook on May 24, 2007. In the next 6 months, we will be focusing on making the platform even easier to use and adding a few key features, and will also be expanding beyond Facebook. In the next 2 years, our goal is to make person-to-person lending mainstream: we want to make it so easy, simple and economically efficient that it is the first option borrowers think of, before even thinking of charging their credit cards or walking into a bank. On the lending side, we will continue to promote loan portfolios as a separate asset class that investors should consider when reviewing their asset allocation strategy...If we do this right, and we convey the value proposition clearly, in 10 years from now the mere idea that people once used to walk into a bank to get a loan or carried credit card balances will seem odd.

Thanks Emily for a great interview and the insight into Lending Club.

Rent A Coder: Prosper clone for $250

Someone from New Jersey with the username luxor has created a listing on Rent a Coder to build a clone of Prosper.com using PHP and MYSQL.


The bidding started on June 26th. Although the bid request was open until July 10th it looks like the requester has already selected someone to complete the project. A total of five people bid on the project and requested payment between $108-$3,500. Luxor selected Hiren Kotadiya from India to complete the project for $250. He will be expected to create a "working, stripped-down version of prosper.com" by July 27th for $250. If he is successful, I think that luxor is getting quite the deal. Is this going to be a Prosper competitor or is the buyer looking to create a different site with similar functionality?