Last night I had the pleasure of attending a webinar where lots of technical jargon was used to discuss complex mathematical topics. The use of the word pleasure in that last sentence was not an accident. Allow me to explain…
When I say that I attended a webinar, I meant to say that I got to be part of the live studio audience. The audience consisted of SVB from The Digerati Life, Bobby from 2 Minute Finance, Peter from Social Lending, Fanny from Living Richly on a Budget and a few others. The location: Prosper’s office in San Francisco. I hadn’t been to the offices in more than 3 years since I used to write for Prosper’s Blog. Truth be told, I lost some money by misjudging risk with the way Prosper worked when it first came on the scene in February of 2006. However, all that is changed now. The people allowed to get loans are better risks and the returns are better.
On the topic of those better returns… we were there to learn about the difficulties in calculating the rate of return on peer-to-peer loans. It isn’t just a Prosper problem, but a Lending Club thing as well. That’s where all the technical jargon and complex mathematics comes into play. Let me give some examples that were discussed:
- Loan Vintage – This is analogous to wine. The credit market of 2008 was different than 2011… and it will be different than 2015. It is difficult to compare the three. It doesn’t get any easier when companies like Prosper and Lending Club change their lending criteria and other
- Loan Seasoning – Since a loan can’t default for a few months, a recently made loan with even a small payment is going to deliver top results. Anyone who has lent any serious money in P2P knows that there will be some people who won’t repay their loans and thus the actually rate of return on their portfolio will be negatively impacted. How should this be factored in?
- Idle Cash – Should cash that is sitting idle in your account be factored in your return?
- Secondary Market – You can sell off loans to other bidders. This creates its own set of complexity in measuring returns.
- Charge-offs – If a loan is delinquent (late), but not charged off (considered a total loss) yet, how should that be factored in? If a borrower calls up the P2P institution and works out a payment plan for less than original loan, how should that be handled?
(I should note that all the above is my best interpretation of the issues. Three years ago, I had a better handle on the math involved in judging a P2P loan, but the cobwebs in that area of my brain are thick.)
All these factors significantly impact the rate of return on a P2P portfolio. There are different philosophies as to is the most accurate method. There’s a tool by Nickel Steamroller (Update: no longer available), a tool by Lend Stats, as well as Prosper’s and Lending Club’s own assumptions. The interesting thing is that in general, a P2P investor doesn’t need to understand all these details to successfully lend on the platform. The P2P industry needs to have an industry standard. This way Joe Average Investor won’t just default to mutual fund rather than getting scared off by all the ugly math.
I have some of my own ideas and I’m constructing a rough straw-man in my head. However, that’s an article for next week. In the meantime, let me turn the floor over to you. What are your thoughts on an industry standard for P2P rate of return?