Prosper.com Loans: Not as Pretty Up Close

But those return rates are deceptive. In doing the numbers, I found that you can't compare 14% interest on a loan to annual interest on a CD or gains that you might receive in stock value…even supposing that none of your loans default.

Fascinating web site model and I tend to agree with your analysis. Actually the annual interest would be less than 8% but would compound to get you close to the 24% return you speak of. Thanks for sharing this...

It reminds me of the small town community bank where the townsfolk really do fund their neighbors mortgage. In a way prosper.com is getting back to the roots of loan products.

I am sure you are just trying to give Prosper every possible benefit of the doubt, but you are wrong to say….

Furthermore, out of 1,260 loans Prosper members have made to C-rated borrowers, only 7 have defaulted. Another way of measuring that risk: 94.4% of all "C" loan dollars are current with their payment schedule. So it would seem that even if you lend only to C borrowers (thus getting a much better rate than the supposedly golden AA borrowers), you can historically rely on your loans being good especially if you spread yourself out across multiple lenders.

The 1,260 loans that Prosper has made to C borrowers do not count as a history. Historically, loaning money to people with less then perfect credit makes you really good money when times are good, and causes you really heavy losses when times turn bad. The difference between good credit and bad credit is that when times turn tough, people with good credit usualy still pay. But when times are good, often times there does not seem to be that much of a differences in the default rates of people with good and bad credit.

In other words, your statement that can historically rely on Prosper C loans to be good is misleading because Prosper has not been around when times where bad. In fact, they have only been around for one year. Their history is misleading.

This is an important point to make because it is one that historically even the "professionals" tend to forget. I am sure you have been following the implosion of the Sub prime lenders. 30+ have gone broke so far and more heading in that direction.

All of those sub prime lenders were making money hand over fist for the last 7 years or so. But over the last couple of months the default rate for sup prime borrowers has gone way up. All of those "professional" were not prepared for the fact that people with bad credit might actually default.

Like you said, 8% is nothing to write home about. If I want to tie up my money for that rate of return I will buy some half way decent cooperate bonds.

I think I lead you astray by bringing up the Sub prime crisis. It is a valid example of what I was trying to communicate, but it is mixed in with so many other issues that it obscured the issue.

So let me restate my point apart from the current Sub prime crisis.

In good economic environment, bad credit out performs good credit in terms of yield. In bad economic environment good credit out performs bad credit in terms of yield. In other words, in good economic times you want to own Junk bonds. In bad economic times you want to own Treasuries.

This is because defaults go up more then expected in bad economic environments and down more then expected in good economic environments. This can changes the yield on poor credit quite dramatically. Good credit provides more stable returns (although they can fluctuate do to rate risk.)

You should note that the terms good economic environment and bad economic environment have nothing to do with the actual rate of economic growth. Rather, it has to do with the change in economic growth rate. In other words, if economic growth was humming along at 5% and it suddenly went down to 2.5% it would be bad for poor credit because defaults would be up by more then expected. Similarly, if the economy had been contracting by 5% and that rate of change changed to 2.5% then it would be good for bad credit because defaults would be down.

I don't see how low credit loans through Prospects can avoid being subject to same laws that have governed every other loan through out history. One year of operation in good times is not going to convince me.

Given the unsophisticated nature of the people loaning money through Prospects I think most people are not charging properly for the risk they are taking on.

By way of comparison, yield on 6 month Treasury bill in about 5%. And that does not include the tax advantages. I do not believe that 8% for low credit is properly pricing the risk.

You need to keep in mind that if the rate of defaults was predictable, then yield of poor credit would always be the same as the yield from good credit in aggregate. In other words, the higher interest rate that people with poor credit would pay would just cover the losses from default.

In practices, the rate of defaults is not predictable because it varies with the economic environment. Thus, intelligent investors demand a risk premium from poor credit borrowers.

Your Accounting is flawed. In order for the 8% you calculate to be correct, all of your money would have to have been committed the entire time. This is not the case. The loan repayment calculator states that you will be receiving $172/month. For example, if you look at 24 months out, it shows that the balance is ~$1900. You cannot expect those $1900 to be earning 14% of $5000, because $5000 is no longer invested.

If you took the $172 you receive every month and reinvest it in an identical loan you would get the 14% advertised.