Prosper market anticipates Fed rate cut

In Prosper's second monthly lending market survey, CEO Chris Larsen says that the Prosper marketplace appears to anticipate Federal cuts in the intrest rate. Specifically he says a drop in the rates borrowers are paying on loans is close "to what was widely anticipated to be a quarter-point instead of a half-point reduction by the Fed." Here is the full text of Larsen's October announcement:

"When the Fed cuts interest rates people often expect mortgage rates to drop. However, this is rarely the case given that mortgage markets typically anticipate rather than react to moves by the Fed. On the flip side of the coin, the variable credit card and savings rate markets react sometime after the Fed moves. In fact, some variable credit cards have a 90-day window to make adjustments reflecting the rate cut. So the question is: did the Prosper marketplace anticipate or react to the Fed rate cut?

Many might assume that the Prosper marketplace would act less like the mortgage markets and more like the credit card and savings rate markets given that the latter compete with Prosper. Nevertheless, the month over month drop in average borrower rates indicates that the Prosper marketplace may have anticipated the Fed cut.

For example, in September the average borrower rates for all prime and near prime loans funded in the Prosper marketplace were 12.29% and 18.22%, respectively; down 0.37% and 0.28%, respectively, from August.

What is interesting about these percentage drops is how close they are to what was widely anticipated to be a quarter-point instead of a half-point reduction by the Fed. However, what remains to be seen is whether the market will continue to push rates down further in line with the Fed’s surprise move."

Last month Larsen said, lenders are exhibiting rational behavior and "being far more cautious about chasing higher rates offered by subprime borrowers."

Prosper CEO: lenders avoid subprime and 'flight to safety'

In Prosper's first lending market survey, CEO Chris Larsen says lenders are exhibiting rational behavior and "being far more cautious about chasing higher rates offered by subprime borrowers." This "flight to safety" is represented by a marked change in the type of loans that are currently being funded on Prosper.

Prosper has just introduced this first monthly market survey which provides "key statistics including: membership and loan volume statistics; marketplace returns; borrower rates; mix of prime, near prime and sub-prime loans; and noteworthy marketplace statistics and trends" and analysis from Prosper's CEO Chris Larsen. Here is the full text of Larsen's announcement about the current market situation for Prosper:

"The market turmoil stemming from the ongoing credit crunch, subprime mortgage meltdown and housing value slump naturally begs questions about what impact this market environment is having on the Prosper marketplace. In a nutshell, we would categorize the impact as broadly constructive for Prosper lenders and prime and near prime borrowers.

As consumers are being hit with the evaporation of introductory credit card rate offers and home equity loan options, Prosper is becoming an even more attractive financing alternative, particularly for more creditworthy borrowers.

At the same time, lenders on Prosper are exhibiting rational behavior by steering their bids toward borrowers in the higher credit categories and being far more cautious about chasing higher rates offered by subprime borrowers. Evidence of this flight to safety is seen in Prosper’s mix of funded borrowers. For example, the subprime category accounted for only 9 percent of loans funded in August 2007, a marked decrease from August 2006 and the 2007 year-to-date average of 25 percent and 14 percent, respectively.

What remains to be seen is whether lenders on Prosper will start placing less weight on homeownership as a factor in their bidding strategies. It is possible that we may begin to see evidence of this trend given that in our most recent defaulted loan sale the debt buyer placed zero value on homeownership across all credit categories – a highly unusual shift away from placing value on what is typically considered Americans’ largest asset."

Here at PLR, we have also noticed the movement of lenders away from subprime or high risk borrowers. In addition, we just wrote an article about how homeowners may actually be a greater risk than non-homeowners given the current market situation. This article was written before the recent Prosper debt sale where homeowners were not given a premium. Here are the statistics that Prosper wants to highlight for their first market survey:

August 2007 Prosper People-to-People Lending Market Survey

Membership and Loan Volume Statistics
		August 2007		August 2006		2007 Year-to-Date		Since Inception
New Members		30,623		12,825		270,866		408,633
Funded Loans		$6.6 million		$3.9 million		$56.6 million		$85.0 million
Average Loan Size		$6,733		$5,080		$6,969		$6,037
Daily Average Number of Borrower Listings		2,575		1,173		2,202		1,366

Estimated Annual Return on Prosper Select Index
		August 2007
Prosper Select Index		10.31%
Prime Select Index		9.41%
Near Prime Select Index		10.73%
Sub Prime Select Index		14.95%

Average Borrower Rates on Prosper Select Loans
		August 2007		July 2007		August 2006		2007 Year-to-Date		Since Inception
Prime Select Loans		10.15%		10.29%		11.64%		10.03%		10.14%
Near Prime Select Loans		16.83%		17.08%		16.25%		15.90%		16.06%
Sub Prime Select Loans		25.88%		22.13%		28.72%		23.30%		23.89%

Mix of Funded Borrowers
		August 2007		August 2006		2007 Year-to-Date		Since Inception
Prime		32%		26%		30%		28%
Near Prime		59%		49%		57%		54%
Sub Prime		9%		25%		14%		18%

Noteworthy

Top Five Prosper Borrower States in August 2007

1) California

2) Georgia

3) Illinois

4) Ohio

5) Florida

(PLR review note: Here's why Pennsylvania, the second most populous state, is not on the top state list.)

It's very important to note how Prosper has defined the terms used above, especially the Prosper select index. Only borrowers with zero current delinquencies, three or fewer credit inquiries, and a debt-to-income ratio of 40 percent or less are counted in the calculations. Here are the full definitions:

2007 Year-to-Date: January 1, 2007 through August 31, 2007.

Since Inception: November 1, 2005 through August 31, 2007. Prosper’s by invitation only “friends and family” launch began on November 1, 2005 and Prosper launched to the general public on February 13, 2006.

Prosper Select Index: The Prosper Select Index return is the estimated average annual return on invested principal, based on actual delinquency performance to date. The Prosper Select Index includes AA - E credit grade loans for borrowers whose credit reports at the time of application indicated zero current delinquencies, three or fewer credit inquiries, and a debt-to-income ratio of 40 percent or less. The annual return period reflects loans originated in the twelve month period ending one month prior to the observation date of August 31, 2007. Prime Select includes AA and A credit grade loans (credit scores of 720+). Near Prime Select includes B, C, D credit grade loans (credit scores between 600 and 719). Sub Prime Select includes E credit grade loans (credit scores between 560 and 599).

Average Borrower Rates: Average Borrower Rates are the weighted average borrower rates on Prosper Select Index loans. Rates shown are interest rates, not annual percentage rates.

Mix of Funded Borrowers: Prime includes AA and A credit grade loans (credit scores of 720+). Near Prime includes B, C, D credit grade loans (credit scores between 600 and 719). Sub Prime includes E and HR credit grade loans (credit scores below 600).

Just a couple of weeks ago Prosper was taken to task in the forums and and Prosper blogs for announcing that returns on Prosper beat the S&P 500. Critics said the data which showed Prosper beating the S&P 500 was carefully picked and misleading. Others argue that lenders have the same ability to carefully pick their loans. I look forward to seeing how lenders respond to this report.

All things considered, I think that this monthly data report from Prosper will be valuable. It's good to hear Chris Larsen's analysis and it gives a regular public way for Prosper to report their growth and success.

Prosper lenders avoid high risk loans

Earlier this week I put together a list of all the top Prosper blogs. As I was reading, I came across an interesting post from January on Money Walks. The article, Blame the Lenders? Or the Borrowers?, showed that high risk and E-grade loans made up a full 80% of the listings at the time. Money Walks also discovered that lenders were allocating nearly 50% of funds to those risky credit grades. This surprised me and I decided to take a quick look at current open loans.

At the time of this writing there are 2554 open loans. 48% are high risk and 19% are E-grade. A full 67% of loan requests are from these risky credit grades - not quite as high as earlier this year but still very high.

So, are lenders funding these loans? Of the open loans I ran a quick search to see which ones have already been funded at least 75%. Only 8 of 1221 open high risk loans (<1%) are on their way to funding. Not much better for E-grade - 6 of 476 (also 1%). How about AA and A credit grades? 18 of 67 (27%) of open AA loans are at least 75% funded while 13 of 67 (19%) A loans meet the criteria. It appears that lenders have learned their lessons over the past months and are now avoiding high risk borrowers. The money is now flowing to those with good credit. Of course, many of these loans I looked at have just opened so the percentage is not representative of how many will be funded by the time the bidding closes. It does, however, allow us to compare the different credit grades.


The graph above shows the number of loans that are at least 75% funded compared to the number of open loans for that credit grade. Last week Matt explained why it makes good financial sense for some people to borrow from Prosper. Those with good credit and no home to borrow against can usually get a better rate through Prosper on an unsecure personal loan than they can through a traditional bank. It appears, however, that this demographic may be a very small minority on Prosper. Many of those seeking Prosper loans may be borrowers that can not obtain financing through other means. Many months ago, lenders on Prosper may have funded these loans but high default rates have caused changes to investing/lending habits.

It's also interesting to note the size of loans being funded to high risk borrowers. Of the 87 open listings that are at least 75% funded only 4 of them are over $20,000 - all to AA and A borrowers. The largest funded loan to a HR borrower is $10,000 (which one lender put up the full amount despite never bidding on anything but B or better in 58 previous loans - very odd.) Bottom line, if you want to be funded on Prosper today and especially if you want to borrow more than a couple thousand dollars, your chances are pretty slim if you are a high credit risk. It appears lenders have changed their investment patterns in accordance with good risk management tactics.

I realize that more complete statistical analysis can be done on closed loans and perhaps I will do that in a future post. It will be interesting to look at which credit grades have been favored by lenders over time.

Prosper: A hands-on education in risk management

For some new lenders on Prosper it is a hands-on education in Risk Management. There are several different ways to learn about managing risk. Most colleges have economic courses on risk management, and there have been lots of books written about the topic and how it relates to investing. My favorite book on the topic is a book called Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein. I thoroughly enjoyed reading this book, and highly recommend it.

There are too many important concepts to cover them all in one article, but the two most important items are diversification and risk adjusted return.

Let's say you have $1000 to lend. If you put all of that on one or two loans then you run the risk of that loan defaulting and losing all of your money.

Here are some lenders that did just that:

• canes09
• generous1
• CommonInterest

If these lenders had instead diversified, then like this lender the default would be a small part of the overall portfolio and would not have a significant impact on the overall performance.

This concept extends beyond Prosper and is the reason that financial planners often counsel investors to buy mutual funds or index funds which allow the risk to be spread across a large group of stocks rather than putting "all your eggs in one basket" by purchasing a small number of individual stocks.

The next concept is risk adjusted returns. This is where Prosper's Marketplace Performance Data will help us out. Adjusting for loans that are too recent to go late or default we get the following percentages (by number of loans):

• AA: less than 1% late or in default
• A: 3% late or in default
• B: 7% late or in default
• C: 10% late or in default
• D: 13% late or in default
• E: 28% late or in default
• HR: 45% late or in default
• NC: the performance wasn't good on these loans, so Prosper has discontinued allowing people with no credit to borrow

With new lenders, I think there is a great temptation to bid on HR loans. You see a 29% interest rate, and a nice story that explains how the money will be used, and think "Wow! why chase after a 12% A rated loan when there are all these HR loans at 29%?" The answer is that once you subtract the 45% to account for the HR defaults you end up with a return of -16%. At a 29% interest rate on an E loan you end up with a 1% return after accounting for defaults. If you hear someone in the Prosper forums talk about having lost money on Prosper there is always one of two things going on: either they didn't diversify their portfolio or their portfolio is heavily weighted with HR and E loans. I have yet to come across a diversified portfolio that avoided HR and E loans that isn't doing well.

Here are how the stats actually end up by credit grade:

• AA: Expected Rate 9.5% (Start with an average rate of 11% and subtract 1% for defaults and the 0.5% Service fee)
• A: Expected Rate 9.5% (Start with an average rate of 13% and subtract 3% for defaults and the 0.5% Service fee)
• B: Expected Rate 7.5% (Start with an average rate of 15% and subtract 7% for defaults and the 0.5% Service fee)
• C: Expected Rate 6.5% (Start with an average rate of 17% and subtract 10% for defaults and the 0.5% Service fee)
• D: Expected Rate 7.5% (Start with an average rate of 21% and subtract 13% for defaults and the 0.5% Service fee)
• E: Expected Rate -4.5% (Start with an average rate of 24% and subtract 28% for defaults and the 0.5% Service fee)
• HR: Expected Rate -21.5% (Start with an average rate of 24% and subtract 45% for defaults and the 0.5% Service fee)

Keep in mind that these stats are based on a historical average which may not predict future results. Also, this is based on only about 18 months of data on 3 year loans. Once more longer term data for a larger number of loans is available these types of statistical analysis will become more precise. What these statistics do suggest is that, surprisingly enough, borrowers with A and AA credit end up being the best long term risk adjusted investment, and can be expected to return about 9.5%. Compare this to other investments like CDs or bonds and this is a really great investment return.

As you can see in my portfolio, 8 of my 15 loans are in the AA category and none are in the E/HR category. The B-D category still has a reasonable 6.5-7.5% expected return so, while not as good as A or AA, I still fund some of those loans if I find one that I think is a better than average loan for that credit group.

If you start lending after having a understanding of these two concepts I think you will do very well. If not, I think you will learn these concepts along the way.

Here is a good example of a lender who learned along the way. He goes by the name of BigGulp and is active in the Prosper Forums. What you will notice by looking at his loan details is that of the first 50 loans he funded, only one was to borrower with a credit rating of A or higher. Several defaults and late loans later he learned his lesson. Now, looking at his most recent 7 loans, 5 of them were to A or higher credit ratings. And, in the past 2 months none of his loans were to HR or E borrowers. So far he has earned about 1% on his portfolio after subtracting for defaults. If you were to take away the E and HR loans from his portfolio he would be at over 10%.

Analyzing Prosper data

Prosper has created a set of 3rd party tools that allow developers real time access to lending data on Prosper. This has allowed enthusiasts and academics to create all kinds of different ways of looking at the data. The most popular 3rd party site, LendingStats, allows you to view anyone's profile, get breakdowns of loans by state, credit grades, and group statistics. Other sites like Eric's Credit Community allow you to be notified when a lender places a bid so you can decide if you want to copy someone's movements, and lets you track "What if" profiles. Some websites have tried to quantify and graph exactly what the risk is associated with number of credit lines, number of inquiries, DTI, monthly income, and home ownership.

The fun part, for those of us who like databases, is that anyone can put all the data into a database and analyze it and graph it anyway they like. Right now only 18 months of data exist because Prosper has only been around for about 18 months. As time goes on, this data will become more detailed and much more accurate.

Theoretically, once the risk factors have been quantified for each item in a credit report, it should be possible, with a diversified portfolio, to calculate an approximate rate of return after accounting for expected defaults. Right now on the different websites you will see things like estimated ROI, Experian ROI, and EricCC ROI. Everyone uses different methods to estimate the expected return, and right now these can vary quite a bit. As more data becomes available these estimates should improve.

The current consensus based on analysis done to date is that on average HR loans return a negative rate of return after accounting for defaults. E's are slightly positive, and loans in the remaining credit grades average between 5-12% after defaults. Some people still go after the lower credit grades and try and cherry pick the better loans out of group with the hope that if they avoid too many defaults they will end up with a high rate of return.

I prefer to stick to higher credit grades with the knowledge that 5-12% is better than I can get in a CD or a savings account, and it is much more fun than buying a CD. It is a feel good investment knowing that there is a person on the other side of the loan that is being helped out by having access to needed money.