Wednesday, June 20, 2007

5 Problems With Prosper



Would you loan to this listing?

So a friend of mine was very involved with Prosper, and has wanted me to get involved. Here are 5 reasons why I will not be.

1) Higher Default Rate Than Average - borrowers tend to come to Prosper when they can't get funded elsewhere. Additionally, there are other moral hazard problems, for instance some borrowers take the money lended to them as charity, with no intention of paying it back. The result is borrowers on Prosper have a higher default rate than the average person with a similar credit rating.

2) Taxes- Loan interest is not taxed at the long-term capital gains rate, and is instead taxed at your marginal rate. This can make a huge difference in your after-tax return. Additionally, Prosper delays in declaring loans in defaults, which hurts your ability to offset those losses on your income.

3) Poor Customer Service- Prosper has taken some steps to address problems, but if you read the message boards, their are certain problems, like group leaders who are gaming the system, which remain unresolved.

4) More Serious Lenders than Borrowers- A year or two ago, lenders would lend to anyone, based on their story. Having gotten burned on that approach, lenders are increasingly wising up and are pre-limiting their lending to borrowers meeting certain financial criteria. This creates a glut in lenders for the good listings with a resultant driving down of interest rates and returns.

5. State Credit Laws- Some states cap interest rates in an attempt to stop usury, but all they accomplish is that they make certain highly risky people, unloanable, since borrowers cannot charge an interest rate that properly reflects the risks involved.

3 comments:

Lazy Man and Money said...

- Is there proof to back up #1? Specifically, I'm thinking where is the proof of "borrowers tend to come to Prosper when they can't get funded elsewhere." I would go Prosper first if I needed money, because it looks a lot easier and their hours are better than any physical bank. Plus I know that if a bank is willing to give me a loan at 14%, it doesn't hurt to try for 13% or better on Prosper. This is what Tricia from Blogging Away Debt found out.
- Even if #1 is true, it's easy enough to compensate your lending practices to compensate.

- Towards #2: The taxes are true of most any investment I can think of outside of the stock, bonds, etc. markets. This means if you want to diversify yourself outside of those markets you are likely going to have to pay this extra tax. So you pay a bit for the diversity. That said, I'd rather pay 25% on gains of 12% than 15% of gains of 10%.

- Towards #3: I believe they've brought the customer service in house (and with 20M in additional funding announced today should only get better) rather than outsourcing it half-way around the world. From my understanding, no group leaders are "gaming the system", one set was helping to pay off the debts of people in their group. I would consider that a very good thing. I wish more group leaders were this generous.

- Towards #4: It's an open market system. If there's a glut of lenders fighting for good listings, some will lose out and decide over time that it's not worth their time. Hence they will leave the system and equilibrium between lenders and borrowers will be restored.

- Towards #5: Simply don't lend money to those that are highly risky people. If you can't charge a profitable interest rate, move on to the next loan. These people will learn the hard way that they need to improve their credit or can resort to really expensive payday loans. Prosper shouldn't be held to a standard to be all things to all people.

Alex said...

Thanks for the comment LMM
1) Compare experian's average default rate with Prosper's performance http://www.prosper.com/lend/performance.aspx, you have to do some extrapolating because there are a LOT of loans headed for default (more than several months late) that Prosper hasn't put in the default category. You can get a clearer picture if you search from 11/2005 to 11/2006

2) Your assuming that you make above average returns on Prosper. Most people do not. For instance the 30 day average for loaning to a "C" person is an interest rate of 17% (for $5K-$10K loans), yet only 88% of C's are paid in full or active and less than one month late. 4% of those loans are in acknowledged default, while most of the other 8% is headed for default though Prosper has avoided so categorizing it. If you make a conservative estimate that 8% of C's will default, you combine that with the expected 17% interest rate, you get an expected return of 9%, which taxed at your marginal rate (say 28%) means you have an ultra-risky investment which underperforms the market.

3. Never having lent on Prosper, I am relying on my friend who has been active has told me this is a problem, and it also appears as a theme in the discussion boards.

4. Yes, if there were too many lenders in any market that would drive down interest rates until lenders left, maybe some day interest rates would go back up to allow for reasonable returns again. Prosper isn't there yet.

5. True, I don't have to lend to those people, but its just another example of the lack of serious borrowers worthy of being invested in, at a rate that adequately compensates for the risks involved.

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