A financial innovation comes in many forms. They are generally invented, commercialized and adopted for purposes that both benefit the general populous and of course, generate some form of profit or return on investment for the innovator. Although not always initially developed for genuinely altruistic purposes, these innovations often evolve into newer, more broadly adopted systems and exchanges. With this evolution, there are often unintended consequences, for better or worse.

Update: You may want to consider LendingClub which really seems to be taking off while Prosper is no longer prospering...



Prosper.com is a model of financial innovation. The Prosper peer-to-peer lending marketplace makes consumer lending both more affordable to borrowers compared to virtually any competing legal option, while enabling investors to partake in an entirely new asset class, which has the potential to provide net returns exceeding the risk-free rate of return in the marketplace. While Prosper claims to also have some socially rewarding aspect to it, the true market driver for this new exchange was precipitated by the gains attainable to all parties.

At its most basic level, Prosper enables the existences of new exchanges never considered before, whereby pools of borrowers who are paying exorbitant fees to credit agencies are able to simultaneously consolidate their credit payments to one manageable monthly payment while reducing their average interest rate substantially in almost all cases. It allows lenders to invest their funds in an asset class that has virtually no correlation to any other major asset class in the investing world today. One could opine that if the U.S. economy were to sour, defaults on loans initiated through Prosper.com would be expected to increase. Therefore, there is likely a weakly positive correlation, but certainly less so than that of say, the correlation of other asset classes such as U.S. equities, commodities, international markets, real estate and bonds, especially given the flattening of the earth during this current global economic boom. Finally, the market maker, Prosper, benefits by collecting a nominal fee from both the borrowers and lenders to cover overhead and eventually, deliver accelerating profits.

Prosper.com Borrower Profile: A Classic Example

A relevant example of how this financial innovation would benefit all parties involved is as follows. A recent college graduate who put themselves through college and needed to rely on credit cards to help fund daily living expenses and the college lifestyle is now starting their professional career. Due to the predatory lending practices of credit card companies on college campuses (shamefully facilitated by the universities sharing in the spoils of these arranged relationships) and the general lack of education, resources, restraint; whatever the reason, on the part of college students, this particular graduate has now amassed say, $8,000 in credit card debt. Following a couple late payments and with little work history, the graduate is showing a C credit history and they’re paying 28% on their card. No other cards will accept a balance transfer with a lower fee.

What isn’t reflected in this person’s credit history or interest rate is the fact that they just landed a job at a Fortune 100 company for $70,000 per year and they carry very little additional debt or expenses since they transitioned from college life to professional life. They have no home mortgage and they’re still driving the same old car from college. The beauty of the Prosper.com community is that through competitive bidding and lenders’ ability to vet the loan details, the graduate ultimately ends up transitioning to an $8,000 Prosper.com loan payable over 3 years at an interest rate of 14%. They have just cut their interest rate in half. Lenders have just locked into a 3 year investment return well above any asset class available to routine investors and with an acceptable level of risk. The odds of this recent graduate defaulting and incurring a black mark on their credit history given their healthy income and debt burden are extremely low. Finally, the Prosper.com entity has benefited by capturing the transaction fees from funding the loan and the monthly lender side fees collected. While not all loan listings are this convenient, by reviewing individual listings and finding the ones that appear to carry an inordinately high interest rate given the risk, there are clear benefits to both borrowers and lenders that did not exist prior to the appearance of Prosper.com.







What Drives Financial Innovation?

Generally, financial innovation occurs to fill a gap or meet a need in a particular market. The intent may be to reduce risk, reduce cost or to provide some sort of economic benefit to people. Ironically, an unintended consequence is that these same financial innovations are often used for speculation. For instance, stock options can serve as an ideal vehicle to hedge risk or say, lock in a profit at a specified range so that the underlying stock can be liquidated at the end of a predetermined timeframe in order to realize a lower capital gains tax rate as opposed to a higher short term tax as ordinary income. Of course, as evidenced by today’s options market transactions, they are used in great part for speculation by retail investors. The majority of stock options actually expire worthless rather than being exercised. This is not to say their risks outweigh the benefit, but simply to highlight that no good deed goes undone and all financial innovations carry with them the spectre of speculation.

Do people speculate in the Prosper.com lending system? Of course they do. Upon review of several profiles and complaints from members claiming the site is a scam or a hoax, they complain about how they were enamored with the prospects of taking on 22-25% interest rates by lending to E and HR credit grade borrowers. Those were great rates, they thought. What they didn’t consider though, was the notion that the default rates would far exceed any benefit in having a high interest rate (any percent return on zero is still zero!). Many of these initial entrants to the lending market ended up with negative returns on their investment.

Market segmentation is often a key barrier that is overcome by a financial innovation. In the case of peer lending, it’s rare and uncomfortable to lend money to a personal contact, friend or family member. It would be even more so if you were to add an interest rate provision. Aside from loan-sharking, which isn’t legal, there was no practical way for borrowers to avoid banks and credit card companies as a source of funds and no way for investors looking for a new asset class to safely lend money to willing borrowers. Prosper.com made this market possible by de-segmenting this peer lending population.

As evidenced by the initial description of the Prosper.com basic operating framework, the Prosper lending marketplace clearly demonstrates its inclusion as a financial innovation. It lowers credit payment rates by borrowers and provides for an additional asset class with respectable returns (net of defaults) to investors.

What Prevents Borrowers from Defaulting?

An initial question that comes to mind from any lender would be, “What prevents scam artists from initiating loans to just take the money and run? What prevents people that actually do need the money from just reneging on their loans? What is the deterrent to people taking my money?” In order for this system to work, a lot of upfront work had to be performed to ensure all the right checks and balances would be in place. In order for a borrower’s loan to be funded through the Prosper.com system, a thorough check of all relevant aspects of the loan occurs, very similar to the safeguards employed at any local bank providing a personal loan. First, the borrower must have their personal identity verified via social security number, telephone number and other means. In the event this verification process was breached, Prosper.com offers a 100% Identity Theft Guarantee whereby they will refund the full amount of any loan that has defaulted due to identity theft that they overlooked. In the event a loan becomes late, the borrower is reported to a collection agency where they will seek to get the borrower back on track with payments or collect the amount remaining. When a borrower defaults on a loan, this default is reported to two of the main credit reporting agencies, Experian and TransUnion, negatively impacting their credit. Therefore, as a lender, a key consideration is what the borrower’s current credit rating and history is. If they have defaulted on prior loans or are currently delinquent on other loans, there is a decent likelihood they would do so again. Someone with 10 years work history and no past credit problems with a AA credit rating is highly unlikely to default on the same loan.

Transactional Details – How Does Prosper.com Actually Work?

It is instructive to visit the Prosper.com system’s inner workings to demonstrate what has driven its popularity, press coverage and new loan dollar growth since its inception. Once accounts are set up by lenders (say #s 1-100) and borrowers (A, B, C, etc.), there is adequate liquidity in the system to make a market. Lender 1 has $1000 to invest and seeks out appropriate loan listings to invest his money. Borrowers A, B and C have all completed the requisite background checks, determined their desired amounts to borrow and posted their listings with profiles in the system. Lender 1 wants to diversify his holdings of course, so he reviews each listing that suits his interests. The system allows for a query by credit grade, going interest rate and many other parameters.



Let’s say that lender 1 is somewhat conservative and is willing to sacrifice a lower interest rate for a very high level of assurance that his loans will not default. He runs a screen for all AA and A loans with interest rates of at least 8% where bidding is close to ending. Obviously, AA and A loans won’t have current delinquencies and past public records for bankruptcy filings, but those criteria could be added as well. As a result of this query, 3 loans come up that all match his screen. He now reads the profile for each one. He finds that two of the three adequately pass muster based on the explanation of why the loan was needed, a review of what other prominent lenders are bidding, and what the interest rate is (one is 8.1% an dropping fast, so he figures it would close well below his internal discount rate).

In the event lender 1 had been outbid, he would receive an automated email letting him know that he was outbid and had say, 2 hours remaining to bid on the same loan again before it closed. He may look at where the rate’s going and say, “Hey, lending at 7.9% today is better than leaving the funds in liquid cash earning nothing in the account, so I’m going to go after this AA loan even though it’s below my normal lending range”.

Prosper.com Research and Resources

Entire websites dedicated solely to the analysis and commentary of Prosper.com have sprouted up all over the internet. Some of them provide research and analysis not available from the Prosper website itself. This provides for a valid, independent viewpoint of the disclosures and claims made by Prosper to prospective borrowers and lenders. Additionally, it serves as a reality check for prospective lenders that are trying to forecast the returns they could attain by investing through Prosper.com. This data is relayed through many mediums ranging from message board forums and blogs to data analytics sites with multiple parameters highlighted.

Incredibly, there are analytics sites and blogs that are able to draw data and aggregate in real time from the Prosper.com website even though they are not affiliated with Prosper in any way. What is their motivation? Presumably, they derive a substantial amount of advertising revenue from their site’s efforts. Prosper.com has recently enacted a particularly attractive affiliate program whereby $25 referral fees are paid to both existing members who refer new members and to the members themselves. That $25 effectively cuts in half the first loan default assuming $50 loan increments. By paying both new members and publishers advertising the program, Prosper is able to maximize the number of new entrants attracted by the program. Presumably, the $50 outflow for each new member is greatly outweighed by the fees Prosper will collect during the life of membership since fees are collected from lenders, borrowers, late fees, overdraw penalties, etc. There are several sources of revenue derived from each individual signup.






Chart 1 – Eric’s Credit Community – Profile for dpritch15








Source: http://www.ericscc.com/lenders/dpritch15


As indicated, this is the profile for dpritch15, which is the screen name of the author in the Prosper.com community. The author has cross checked his own account’s standings versus the display on the site and it is essentially identical, which confirms the validity of the data on the site. There is a great deal of relevant information displayed. For instance, a comparison of loans by credit grade, displaying the number and amount loaned indicates that the author has a preference for A, B and D loans. This is primarily due to the propensity of loans in those populations and based on the risk/return profiles.

Another notable data point is the weighted average interest rate, which stands at approximately 15%. EricsCC Estimated ROI relies on a formula which will estimate the total return on an annual basis, inclusive of defaults (this value will always be lower than the weighted average interest rate since all loans carry some degree of risk of default). A data point which is key, but transparent to the untrained eye, is the average loan age. This is because newer loans have a lower likelihood of defaulting (it stands to reason that over the 3 year loan horizon time frame, more loans will default than during the first month for instance). Hence, a Prosper community member touting their stellar performance with no defaults should not be making such claims if their average loan age is say, 40 days. The first set of loans will have just started paying at that point. When exceeding 100 days for average loan age, the loans in the portfolio have now been through several cycles and demonstrated a higher degree of consistency in their payments.


Chart 2 – Lending Stats.com







Source: http://www.lendingstats.com

LendingStats.com offers a slightly different tilt on the same theme, reporting several data sets, including individual lender performance. In this case, a notable feature is the bidding history, which indicates this lender has dramatically decreased lending outflows in the recent past. Note the zero next to “Active Bids”. This is a very useful tool. If this were any non-zero number, an interested party could click on that number and a screen would appear outlining every bid in progress by the user. This provides for a unique insight into the bidding strategies of the top Prosper.com lenders. For instance, some lenders exceed $1 million in loans outstanding and carry impressive estimated ROI calculations. If one wanted to try to mimic that performance and save some time in reviewing every listing individually, one could simply view all the active bids by the target lender. A copycat lender could then simply bid on active loans that the proven lender is already engaged in. This arbitrage technique has two results. It increases the performance of the novice lender. It also bids down the interest rate of the premium lender if multiple novice lenders are employing the same technique. Although this technique is not widely publicized and these data aggregation sites are not endorsed by or affiliated with Prosper.com, the proverbial genie is out of the bottle.

As stated previously, borrowers can generally attain a loan with a much lower interest rate than the 25-30% rates they’re paying on credit card balances. If they turned to payday loans, these rates could be double or even worse. The attached image demonstrated these lower interest rates secured through Prosper.com sorted by credit grade.

Chart 3 – Borrower Interest Rate by Credit Grade






Source: http://www.prosperanalytics.com/?m=0&t=2




Prosper.com Business Model: Growth and Strength



Prosper.com was founded by Chris Larsen who co-founded and served as CEO of E-Loan, which was ultimately acquired in 2005. As evidenced by Chart 4, the growth in amount of loans funded has rapidly increased since startup in November 2005, but has started to drop off late in 2007. A key indicator of success and legitimacy is the dramatic improvement in lates (yellow bars) and defaults (red bars) over time. On one hand, that measure is, or course, very strongly correlated WITH time, since it takes at least 1 month to become late and at least 3 months to be considered in default and loans tend to gradually default over time, as opposed to immediately during the first month. However, the trend suggests that even when normalized for duration, the performance has improved dramatically (i.e. the initial lending population resulting from 2005 loans resulted in a disproportionate level of lates and defaults).


Chart 4 – Propser.com Loan Growth and Performance Since Inception








Source: http://www.lendingstats.com/loansFunded




It is rumored that Prosper.com will ultimately register for an IPO, but there have been no official statements from the company or SEC filings indicating such anticipated action.


Another indicator of commercial success is imitation. Within the past several months, multiple competing sites with a virtually similar business model have entered the scene. In the U.S., CircleLending and Lending Club have started up, while China has its own peer lending site PPdai. One particular site, Loanio.com, has not actually initiated operations yet, but has been advertising heavily through the Google Adsense platform, asking visitors to its site to register with their email addresses. Presumably, this is some sort of inexpensive market analysis to validate whether the initial interest in the site will be substantial enough to absorb the burn rate during startup.


Ironically, the notion of peer lending and a successful model was first demonstrated by a truly altruistic effort named Kiva.org. Kiva was founded by Matt and Jessica Flannery to provide microloans to applicants throughout the world. In the world of microfinance, a simple loan of perhaps $25 to a villager in Sub-Saharan Africa could mean the difference between a life of poverty with limited opportunities and potential to the funding of some additional livestock that enable a budding entrepreneurial venture. Even the addition of a cell phone to a developing world fisherman could make all the difference in the world as evidenced by a recent study outlining how fisherman could call ahead as they finished their fishing for the day to see which towns were paying premium prices for particular species of fish each day, both reducing spoilage and waste while increasing their income. Microloans provide this type of opportunity. While Kiva.org was not meant to be a profiteering venture for investors seeking a new asset class, Prosper.com quickly satisfied that niche.

As evidenced by the data supplied by Prosper.com, independent analytics sites and this author’s personal portfolio performance, Prosper.com has surely meets the criteria defined for financial innovations in today’s marketplace.











Note: The data and charts are as of the time of this post on 08-Dec-2007. At this time, the Everyday Finance Estimated Return on Investment (Total long term return including any anticipated defaults) is 11.06%.