There’s a critical discussion of peer-to-peer lending in the blogosphere this week that’s definitely worth a read.
In a scathing article for The Big Money, Mark Gimein called Prosper Marketplace Inc.’s advertised returns misleading. Taking defaults into account, he wrote, the majority of investors who have loaned $188 million through Prosper’s online exchange have actually lost money.
Prosper demanded a retraction. The company doesn’t dispute any of the figures in Gimein’s story, but it says he uses them “out of context.”
For example, Gimein points to data on Prosper’s Web site showing a default rate of 39% on all loans that have reached the end of their three-year term. In an open letter to The Big Money posted on Prosper’s blog, the company said Gimein errs in discussing its loans “in the context only of cumulative … default rates rather than in terms of the average annual returns lenders have earned.” Prosper says the annual yield on loans that have reached the end of their three-year term was 16% and the annual loss suffered by lenders was 20%, resulting in an annual average return of negative 4%.
“Although this return is negative, put in the context of the largest recession in generations, and the performance of other asset classes during the same time period, this paints a very different and more accurate picture of how lenders have fared on Prosper.”
Gimein also cites numbers he says he crunched on another blogger’s Web site showing that more than half of Prosper loans with interest rates of 18% and up have defaulted. Proper says this gives “the impression that lenders on these loans have lost over half of the funds that they lent, and that losses ran roughly three times the interest rate on loans.” Rather, the company says, “lenders on these loans lost 10% on an annual basis, and while not positive, it’s a far cry from the 54% loss that Mr. Giemein’s flawed analysis leads the reader to believe.”
Because Gimein doesn’t provide any actual returns data, he leaves “the false impression that lenders have lost 39% to 54% on their Prosper lending,” the company says. Instead, “the median return across all Prosper lenders was negative 3.2%." It added that "39% of lenders have made money on their Prosper investment.”
Instead of undermining the case for its lending model, the company argues, “a low single digit loss for Prosper lenders in the context of the worst recession since the Great Depression shows great promise for peer-to-peer lending as an alternative asset class.”
It’s a valid point that Gimein’s analysis would have benefited from actual return data, but the returns Prosper provides aren’t exactly enticing. And they don’t detract from Gimein’s argument that Prosper’s advertising is misleading. The company’s home page touts three “portfolio plans,” which let you automatically bid on loans matching certain criteria, with “estimated” returns of between 6% and 14%.
And, as Gimein points out in his article, the “marketplace performance” charts on Prosper.com indicate that loans in the AA to E categories were profitable, at least between July 15 and Dec. 31. But he writes “there’s a sleight of hand that only those who are familiar with the history of Prosper’s borrower ratings and sift through the data carefully are likely to notice. Prosper re-opened its marketplace to new loans last July after a long hiatus to comply with new regulatory requirements, making the requirements for each category more stringent. Most older loans have now been reclassified as ‘HR’ [high risk] or are listed in the N/A column.”
Gimein says HR and N/A loans account for $136 million of the $188 million in loans that Prosper lenders have funded since the marketplace started. And he says close to $36 million of that has already been charged off.
“In other words, only by cutting out more than two thirds of its loans, does Prosper manage to eke out the positive results for AA to E-rated loans that prospective lenders see on Prosper.com,” he says.
In an email to BankThink, Prosper disputes Gimein's characterization of its reclassification of loans. "It is true that the change in the rating methodology resulted in a downward migration of letter grades," the company said. "However, this migration brought the letter grades in line with the loss expectations that Prosper was already providing to lenders [prior to bids being placed], and did not result in the dramatic shift in loss estimates provided to lenders that Mr. Gimein states."
The company added that there have been approximately $25 million of interest payments made on the defaulted securities on the HR and N/A securities that have been charged off.
Gimein concludes that Prosper, and peer-to-peer lending in general, have been plagued by the same problems as the broader lending industry: “loans to unqualified buyers, reliance on mathematical models that turn out to be a lot less useful than they seemed, failed hopes that high interest rates could make subprime loans profitable.” As a result, it’s “not a solution to the credit crisis, but a microcosm of it.”
Felix Salmon picks up the argument in his blog on Reuters’ Web site, saying Prosper’s problems are bigger than just the credit crunch and ensuing recession. He says the peer-to-peer lending industry also suffers from adverse selection. “Prosper’s borrowers with a given FICO score are inevitably going to be more likely to default on their debts than most other people with the same credit score,” he wrote.
Salmon, who said he still has “some hope” that peer-to-peer lending can disintermediate banks and get credit flowing again to individuals and small businesses, continued: “Peer-to-peer lending was meant to create a personal connection between borrower and lender, and therefore make borrowers more likely to repay their debts than people faced with large obligations to hated, faceless banks. But it seems that adverse selection effects overwhelmed the site’s attempts to be warm and fuzzy.”
Peer-to-peer lending may yet fulfill its promise. But those venturesome enough to lend through sites like Prosper would do well to look gift horses in the mouth. Salmon cites an email from Gimein, who wrote: “I’ve cut up Prosper numbers in a bunch of ways, and one thing I’ve noticed is that some of the worst returns come from folks with okay credit who are willing to pay very high interest rate: they’re willing to pay a lot because their finances are in worse shape than they seem.”