Five Years On, Prosper Still Trying to Serve Risky Borrowers

When the peer-to-peer lending site Prosper.com launched in 2006, it cast itself as the place for borrowers to go if they had been turned away by a bank. It has struggled since then to live up to that image.

Over the past five years, the website's parent company, Prosper Marketplace Inc., has reined in, rethought and revamped its open-door policy on a number of occasions. Just a few months ago, Prosper decided to once again drop its high-risk category of borrowers, only to bring it back one month later.

Turns out, the investors who fund loans on the site wanted the option of taking on a little extra risk, which hasn't always been the case.

"There is a lender demand for them. It made sense to bring it back," Prosper Marketplace Chief Executive Chris Larsen said in an interview Tuesday.

As the peer-to-peer lending space has matured, Prosper has tried to figure out exactly where it stands and what it wants to be. Its evolution says as much about the growing pains of the social lending industry as it does the current credit environment.

Not long after it came online, Prosper found that lenders were reluctant to take a chance on the riskiest borrowers and that it was too expensive for the company to maintain listings for loans that never got funded. So it instituted a minimum credit score requirement (previously consumers didn't even need a credit score to list) and tightened its requirements for riskier borrowers.

In July 2009, after a nine-month quiet period imposed by the Securities and Exchange Commission during which the company stopped facilitating new loans while it sought registration approval, Prosper revised its underwriting policies again. It raised the minimum credit score borrowers needed to list and incorporated a new proprietary rating system based on previous performance of loans.

At the start of this year, Prosper further narrowed borrower eligibility on its site by eliminating the category for the lowest tier of its credit spectrum. But citing lender demand, Prosper brought those loans back in February — and they have been on the rise ever since.

Experts cited a number of factors behind the demand for riskier loans. For one, fewer traditional lenders are willing to make loans to this segment, leaving more high-risk borrowers in need of funds.

"You used to have plenty of providers willing to lend money to anyone," said Gwenn Bezard, research director at Aite Group LLC. "A lot of companies have moved up-market and have retreated from the subprime market, so it has created a very large niche to be filled."

Secondly, with benchmark interest rates hovering near zero, there are not many places investors can go for high yields.

But Mark Schwanhausser, a senior analyst at Javelin Strategy and Research in Pleasanton, Calif., said Prosper may be overestimating demand.

"Prosper is basically saying it feels there's a hunger for another flavor of ice cream," Schwanhausser said. "My overarching concern is that P-to-P lenders still have a long way to go before ice cream will become part of the average investor's idea of a well-rounded, nutritional portfolio."

Larsen conceded that "listings have been growing faster than liquidity," and that his current focus is on bringing more investors to the site, particularly institutional investors with deep pockets.

But that is becoming easier to do, Larsen said, as he is able to show that loans to riskier consumers have actually been holding up much better than Prosper had forecast.

"In this environment, you're seeing your riskier segments are sort of your best-performing segments, probably consistent with the economy improving and less competition these days," Larsen said. "It's a good time to be a lender."

Prosper has changed course to be more appealing to investors in other ways as well. Late last year it abandoned its reverse-auction model, in which requested loans are funded by the lenders who bid the best interest rates. Today, Prosper sets interest rates itself, similar to how a rival, Lending Club Corp., operates.

Prosper said it decided to set rates directly to speed up the matching process.

"The additional step that we started with, where you get to set the credit risk, was too complex and sort of asking too much of the average retail investor," Larsen said. "What we learned is to completely take that option off the shoulders of the lender. They can choose where the money goes, but they can accept a set rate and a set risk. … It also makes things much more efficient."

Prosper categorizes the credit level of borrowers based on a number of factors, including their credit score and the performance of previous loans to borrowers with similar characteristics. Loans that are assigned an estimated annualized default rate of 15% or higher are considered high-risk.

But Larsen said he believes Prosper's credit models are conservative.

For example, for the 467 high-risk loans originated on Prosper's platform from July 2009 to May 2010, the actual loss rate was 11.9%, while the average return was 16.5%.

Lending Club says it is also seeing investor demand for loans pick up, but claims it has taken a slightly different posture on borrower eligibility.

"In general, their platform is catering to a totally different audience than ours is. Their loan is serving a different borrower population," said Scott Sanborn, Lending Club's chief marketing officer. Only the top 10% of applicants are able to list on the site, he said.

"Investors are always looking for yield, and especially in this low-rate environment, we're seeing that," Sanborn said.

"But on the flip side," he said, "people are a little uncertain about what the future holds, so they are looking for short duration. The investment product across our platform is a relatively high-yield, short-duration product."

Because the two companies use different credit scores as benchmarks, it is tough to do an apples-to-apples comparison of borrowers on each site.

Nonetheless, the makeup of the two sets of borrowers may not be all that different.

Lending Club uses Fair Isaac Corp.'s FICO score (which ranges from 300 to 850), and Prosper uses Experian PLC's Experian Scorex Plus score (which ranges from 300-900). Lending Club requires borrowers have a minimum FICO score of 660 to apply; Prosper requires a minimum Experian Scorex Plus score of 640.

Prosper claims the annual average return on its loans is 10.4%. Lending Club touts a 9.64% return.

There is one glaring disparity between the companies, however: In April, the most recent month for which data is available for both companies, $17.5 million of loans were funded on Lending Club's site, while just $5 million was funded on Prosper.com.