Thursday 2 November 2006

Is a Ponzi Scheme?

In today's post Tired But Happy commented that he had a couple of loans that are late, and he thinks that "the Prosper folks are making payments on one of the loans".

I sincerely hope that this isn't true, as using incoming funds to pay interest to existing shareholders at a high rate of return, so as to attract more new investors, is typical of a classic "Ponzi" type pyramid scheme. I've previously said I'd be careful about "investing" in unsecured loans via without doing a comprehensive evaluation of the risks.

Reading through the FAQs the following items stick out:

There are no guarantees that your loan will be repaid.


Prosper is not directly insured by the FDIC, but lenders' deposits are covered up to $100,000 by FDIC pass-through insurance provided by our banking partner, Wells Fargo Bank.

What exactly does this mean? How does "pass-through" insurance work? Just how safe is your money if went out of business?

I also find the published figures for default rates on existing loans unbelievably good. What happened to the normal risk:reward relationship? If the loans were really as low risk as these default rates suggest, the interest rates being bid for these loans would be lower.

Prosper's FAQ give an example of how the default rate would affect your returns if you spread your investment across several small loan amounts:

If you make 100 loans to B-rated borrowers at 8%, and B-rated borrowers have an expected default rate of 1.8%, then you might have 2 borrowers default, which would lower your return by 2%. After annual lending fees of 0.5%, this would give you an annual 5.5% return overall.

But, as Prosper says:

A credit grade is a measure of the likelihood that a borrower will repay his or her loan. We also provide the following table to lenders, which shows historical default rates by credit grade for borrowers with normal (<20%) debt to income ratios

However, a look at a small sample of currently listed "B-rated" borrowers shows that most have much higher than "normal" debt to income ratios, so the "stanard" default rate isn't applicable:

$4,500.00 @ 7% Debt to income: 39%
$20,000.00 @ 19% Debt to income: 23%
$25,000.00 @ 9% Debt to income: 31%
$15,000.00 @ 15% Debt to income: 458%
$10,000.00 @ 14.5% Debt to income: 33%
$13,300.00 @ 14.5% Debt to income: 12%
$25,000.00 @ 10.5% Debt to income: 41%
$10,000.00 @ 10.5% Debt to income: 48%
$2,500.00 @ 13% Debt to income: 34%
$14,000.00 @ 13.5% Debt to income: 18%
$20,000.00 @ 14% Debt to income: 65%
$25,000.00 @ 15% Debt to income: 38%
$17,900.00 @ 15% Debt to income: 38%
$3,000.00 @ 12% Debt to income: 24%
$22,500.00 @ 6% Debt to income: 32%
$3,900.00 @ 11% Debt to income: 12%
$15,000.00 @ 14.5% Debt to income: 64%
$10,000.00 @ 13% Debt to income: 20%
$4,500.00 @ 13.5% Debt to income: 106%

I leave it as an exercise for the reader to try to make a valid estimation of likely default rates for "non-standard" debt:income ratios.

Caveat Emptor.


mapgirl said...

I'd only worry if I could win a bid, which I haven't been able to do... BTW, Tired But Happy is a she. ;-)

Anonymous said...

You do have the promissary note when you lend out the money, so if Prosper went out of business presumably the borrower would still have to pay you back. If you had a lot of money in your Prosper account "unloaned", that could potentially be a problem, but who would keep money in there anyway - it doesn't earn interest.

Why do people wonder if Prosper would go out of business, but not a new mutual fund?

I wonder if people think about how Prosper would go out of business. They basically are a market maker like an eBay. It's a very efficient business to run as they don't need to hold any inventory and their main expenses are servers. They don't even need to improve their product as there are no competitors (until Zopa gets there). They look backed by some real investors and have $20M in funding. You'd almost have to try to fail to not be profitable - in my opinion.