There are two financial issues in America that have been developing simultaneously: many borrowers have been locked out from the ability to access capital, and investors can no longer rely on bonds and CDs for their investment income. Rates are at record lows and many would-be borrowers have said over and over how they are effectively unable to borrow from the banks at all any longer. The world of peer-to-peer lending may at least partially change that, and this may also be a huge opportunity for traditional fixed income investors to capture higher yields.
24/7 Wall St. was recently given a chance to interview Joe Toms, the new Chief Investment Officer of Prosper.com to hear about this growing sector. If you do not understand the peer-to-peer lending model, think about crowdsourcing loans for what would have traditionally been a personal bank loan. There is even a degree of microfinance involved, although in a larger and peer-based manner. Prosper is effectively the go-to name in peer-to-peer (P2P) lending, and the service eliminates the middleman to connect people who need money with those who have money to invest. In short, this allows Joe Public to be the banker to individuals. The aim is a win-win for investors and borrowers, hence “Prosper.”
There are many questions that borrowers and investors will want to know before they go in and participate in the peer-to-peer (P2P) lending market. Investors have started looking at peer-to-peer lending for its high yield and current income appeal, and P2P lending has grown more than 100% in the past year alone.
Prosper.com focuses on individual loans in the $2,000 to $25,000 range. Borrowers choose a loan amount, and they list what the purpose of the loan is. Investors then review loan listings and invest in listings that meet their criteria. The borrower then makes fixed monthly payments (collected by Prosper for the lenders) and investors receive a portion of those payments directly into their Prosper account. Individual lenders are able to invest as little as $25 in each loan listing they select and they get to consider credit scores, ratings and histories, as well as borrowers’ personal loan descriptions, endorsements (and participation) from friends and family, and community affiliations. Debt consolidation, home improvement and small business-related loans remain the leading loan categories on Prosper.com.
CIO Joe Toms noted that the consumer lending market is about $2.4 trillion in America per Federal Reserve data, but the average loan size is about $7,300 and about 90% of the market is controlled by six of the largest banks. Mr. Toms noted, “P2P can attack a market that is grossly inefficient. The Federal Reserve data shows that the average credit rate on the outstanding consumer credit has been more than 15.5% from 1985 to 2010 and the historic default rate has been closer to 4.7%.” Effectively, this has left a net interest spread of well over 10% and the market is now available for investors to participate in.
Prosper.com was launched with a “eBay of credit” business model, but Toms went on to discuss how the P2P model has evolved into a world of registered securities. The company now files each of its Prosper.com loans with the SEC and he said that Propser.com is now ranked in the top 10 or 12 as far as the number of individual company filings with the SEC.
One issue that is impacting the attractiveness of this market is that the easy income of Treasury bonds, CDs and other fixed income opportunities are just no longer available. You can hardly earn 2% income on a 10-Year Treasury Note, and that is before taxes. Prosper showed its latest credit metrics and investors seeking higher credit quality still have the opportunity of returns coming in above 6%. If you want to go lower down the credit quality chain, projected investment returns can get above 10% or even above 12%. Toms stressed that more stable returns have to be considered by those willing to broadly diversify to limit exposure against any single loan loss.
Prosper.com recently listed that it had 1,140,000 members and that it has funded a sum of $262,000,000 in personal loans. The group claims some 7,100 investors who act as the lenders. Hedge funds and family offices have started investing as lenders through Prosper.com and there are of course many lenders who are only involved for up to $5,000 or $7,000 total.
Our big question is who collects and processes payments … There is principal and interest to deal with, and what happens when borrowers begin to default? The company finds the borrowers, it then runs prospective borrowers through its own extensive credit screening, and it then allows investors to choose whether or not to lend (invest). Toms added, “Prosper acts as a toll-booth and charges the borrower an origination fee that is usually between 2% and 4%. It then also charges a 1% servicing fee per transaction on the monthly payments to the lenders.”
Another critical question is the one that investors need to consider: What happens when borrowers default? Again, Toms stressed the need for lenders to diversify their portfolio of loan participation. No investor should ever have their entire investment in one stock, and no bank should only loan to just a small handful of borrowers. Prosper collects the funds, but if a default occurs it ultimately passes the receivables on to debt collectors after a period of time. It is not up to the peer lenders (investors) to pursue collections on their own.
Another big area of concern would be the default rates (loss rates) and loan fraud. On this front, Toms noted that Prosper.com’s default rate on a dollar-weighted and platformwide basis of the seven loan grade classes has been approximately 5.2%. As you would expect, the lower the credit quality and the higher the effective borrowing yield, the higher the expected default or loss rate.
Prosper is in the process of going directly to businesses with a peer-to-peer lending model as well. The company recently announced that it has partnered with Lendio, an online service matching business owners with viable business loans. Think of an alternative where SBA loan borrowers seek capital to grow their operations through personal loans.
Joe Toms believes that the trends helping P2P lending are here for some time. He noted, “The trends making this relevant for investors are the ease of online technology, a secular environment shift, the lack of current yield out there for investors, and ultimately because the regulatory environment is one where banks are not lending.”
The total funding in September through Prosper.com came to $7.4 million, and that doubled in size over the past year and is still growing. The company offers 1-year, 3-year, and 5-year term options for borrowers. Somewhere close to 90% of the loans are in the 3-year category.
We of course could not help but to notice that Prosper.com has raised close to $75 million in venture capital, including a $17.2 million round recently. Prosper was co-founded by Chris Larsen, who was also the co-founder of E-LOAN. Investors include affiliates of Accel Partners, Draper Fisher Jurvetson, Crosslink Capital, CompuCredit, Capital One Co-founder Nigel Morris of QED Investors, and others. We could not help but ask if Prosper.com is then an IPO candidate, and Toms did confirm that an initial public offering is of course one possible goal. He emphasized that the goal is to get this market larger and to ultimately to make lending and borrowing more transparent.
P2P is a field we have been monitoring for some time, but more philosophically rather than financially. That may change soon since there are just very few opportunities out there for investors to earn 6% to 10% in returns. Here is a list of the Prosper.com tables that show expected investor yields, borrower rates, loss ratios and effective yield rates.
The biggest question for the future is what exactly happens if the economy rolls over again and sends defaults or losses higher. The highest rated credit on those tables still posted modest returns from the November 2005 to June 2009 period, but the lower credit rating P2P group did post some small actual returns.
JON C. OGG