(Jonathan at My Money Blog has a very in-depth two part review of Prosper.com. My Money Blog is one of my favorite sites, which is why it’s in my blog roll and feed reader. It’s worth familiarizing yourself with that article before continuing here with my rebuttals.)
1) “It’s not a short-term, safe investment” – Jonathan mentions an advertisement for Prosper (presumably from them) paints their returns favorable light to some online banks. I have not seen this advertisement, but if Prosper is the source, it’s an unfortunate misstep by their marketing department. It’s not comparable to bank interest. Since there is the possible loss of principle, it is best looked at as being similar to a mutual fund. Like a mutual fund, risk is managed by diversifying the investment in lots of small places. Prosper even recommends diversifying your loans to lenders. It’s worth noting that mutual funds aren’t short-term, safe investments either, but that doesn’t make them bad.
2) Other ways to get higher interest for extra risk – Jonathan mentions other ways to get 13-15% returns with extra risk. I’m personally making 24.32% gross, but when adjusted for risk, I’m making anywhere from 12-16%. (We’ll talk more about this calculation on Friday.) Some of the other ways didn’t seem like the best ideas either which may be why Jonathan doesn’t recommend them. Investing in PGH (a Canadian Oil Trust) or LUM (a REIT stock) is simply not very diversified. You are basically betting on one segment of the market. Accounting errors or investigations in a stock could make your invest worthless in seconds (remember Enron). The same thing could happen to Prosper, but even in bankruptcy protection, your investment would be safe from those accounting errors in Prosper. You simply aren’t relying on one corporate structure.
3) In looking at Prosper as an investment in general, Jonathan says the results are “Not so good…” He may be right, but it depends on the viewpoint. For instance, he says, “it seems that lenders as whole did a horrible job pricing the sub-sub-prime market. Sure, they charged them a fat 25% interest rate, but the default rate was so high that the net average return on an HR loan was -21% to -31%?!?! Ouch.”
Towards this point, lenders would have charged more, but most states’ usury laws make the highest possible rate 29%, with some states much lower. Thus lenders’ only other choice was to not lend to these people. That’s a valid point, but a lot of lenders didn’t know better. Prosper, for its part, does put up a warning window to lenders when they try to loan to someone with E or HR credit. Indeed some lenders still loaned them money, but a lot of people bought a Pet Rock as well. Not everyone is the sharpest knife in the drawer.
Some of these HR loans are no longer available. As of February 12, Prosper changed the definition of what it considered E and HR… “AA-D credit grades remain the same. E and HR credit grades have changed: E is now 560-599, and HR is now 520-559. NC (No credit) and credit scores lower than 520 are no longer able to create listings.” Looking at This blog post E used to be 540-599 and HR was 300 to 539. As you can see the average E score was about 570 (rounded) and is now 580 (rounded). The average HR score is now 540 (rounded), while it used to be 420 (rounded). That’s a huge change in HR and a bit of a change for E ratings. I’m still not lending to HR, but the \sub-sub-prime loans that Jonathan were worried about are no longer served by the Prosper marketplace.
4) “I’ve seen a lot of people recommend diversifying their credit pool to include everything from AA to a few HR borrowers. If people lent an equal amount of money to each of the seven grades, their aggregate return would have been a measly 2% – not exactly inspiring.” This 2% number is brought way, way down by the inclusion of the HR loans that no longer exist (see previous point). If you just use the AA-HR today your range is Experian ScoreX 900-520, which compares very closely with the AA to E (900-520) of the past. Doing that comparison gives you a 6% return. It’s still not great, but it’s better than you can currently get in a high-interest bank. Using this data, it’s easy to see that diversifying between A-D grades gives you a return of 9+%. If you are thinking of becoming a Prosper lender, it doesn’t take a lot study or discipline to get that 9+%. Simply avoiding the letters E and HR and you’ll be fine – on average. To Jonathan’s credit he mentions this, “On the positive side, the AA through C credit range seems to be the better bet, giving net returns around 10%.”