Peer to Peer Lending – Prosper / Lending Club – Explaining the risk

A preliminary note on dealing with people in finance:

No sooner than 24 hours after I posted about how Peer to Peer lending is quite risky, I receive an email from Mickie Boone, who is the director of Public Relations of Lending Club. I do not believe I am breaching any confidentiality of email when she stated that:

Lending Club has always implemented tighter credit policies and invested heavily in collections, and as a result is now 3 times bigger than Prosper ($7.1M in Dec. for Lending Club against $2.2M for Prosper). Our historical default rate across ALL loans is around 3% and we produced an average of 9.68% net annualized returns.

She must be doing her homework by having good Google Alerts set to inform her of anybody writing about her employer or her competitors. Although the email was clearly marketing material, it did not feel like spam and was well crafted although it felt like she has sent something similar to many other writers on the internet. In fact, by me writing about this, she probably succeeded in increasing exposure to her employer, which is her job.

In her email, she also stated that she desired to speak with me, and to let her know when I was available to do so. After my horrific experience with exempt-offering limited partnerships (see “Worst Move” on He won’t play against the Kasparovs), one rule of mine that I religiously adhere to is to let the documentation speak, and to only let management’s words be colour in determining the credibility of the firm’s leadership.

When dealing with people from a financial perspective, you tend to take a liking to them. This is why I will never make a good financial adviser – they make their money through sales commissions, and in order to do that, you need to appear to be likable to gain clients that taking a liking to yourself. I am not a likable person when it comes to finance. I already felt like I knew Ms. Boone right after reading her email. The problem is that doing so clouds my financial judgment which is detrimental in making good financial decisions. The documentation should do most of the speaking.

Lending Club vs. Prosper:

Lending Club’s website is slightly easier to get information from than Prosper. In addition, Lending Club doesn’t make the mistake of having to register to get certain information (e.g. for Prosper’s secondary marketplace). Lending Club also has their entire loan portfolio available for a convenient 10 megabyte Excel download, something I don’t see on Prosper. They also give good metrics with respect to loan performance, while with Prosper, you have a dig a little deeper, but at least not have to log in to get some quantitative results.

Both sites openly share their SEC prospectus on their sites, or you can read them where you would normally read SEC filings. Both sites also have similar cost structures (to the money lender, 1% of interest and principal).

In particular, Lending Club touts the following chart…

The chart is annotated with the following description:

A $10,000 investment in Lending Club notes in June 2007 is worth more today than the same investment in any other major asset class**

** Based on Average Net Annualized Returns from June 2007 (inception) to October 2009. This comparison does not reflect differences in liquidity. Past performance is no guarantee of future results.

… this chart clearly showing their outperformance to the market, right? Not so – a junk-of-junk bond portfolio (which is essentially what Lending Club and Prosper deal with) should have a volatility that is at least that of a short duration high-yield bond index and most definitely not mirror that of the short term treasury graph.

Be very careful of straight-line performance graphs, and this is no exception. You’ll notice even the 1-3 year treasury bond index exhibits some variation in returns, while Lending Club’s graph is nearly as straight as an arrow.

Is Lending Club’s loan portfolio vastly superior than Prosper’s?

The answer to this question is no. The reason deals with the carrying value of the loan. It assumes that loans that are not in default have a carrying value of par. As there is no secondary market for the loans on Lending Club’s books, current loans must be carried at par value even when the credit risk would result in a significant downward valuation from par.

There are two ways to default on a loan – stop making interest payments, or by not paying the principal when it is due. Lending Club’s numbers properly reflect the default rate of borrowers not making interest payments, but does not reflect the future default rates of the failure to pay principal.

Prosper has data available for loans originated from November 1, 2005 to today. The loans have been standardized for three years. 91.1% of current loans (by dollar value) are current, which means 8.9% of loans are non-current. These reflect the failure to pay interest.

In terms of principal collection, 22.9% of loans have been charged off. This is netted by 0.5% of collection agency collections, leaving a net charge off of 22.4%.

Lending Club has 9.1% of loans that are non-current ($5,559,632 late/defaulted vs. $63,651,765 funded), which is very close to Prosper’s 8.9% non-current loan rate.

Here’s the big reporting problem – Lending Club has only been in operation for 2.5 years. If they are giving out three year loans, then none of their existing loan portfolio has reached maturity yet (minus pre-payments), which means that the principal payment default risk has not been represented in their performance statistics. Prosper’s data runs back 4.2 years.

My guess is that once Lending Club’s loans start reaching maturity that the default rate will start to skyrocket, comparable to Prosper’s net 22% charge-off rate of their entire loan portfolio.

If there is any way I could short Lending Club’s portfolio at their existing carrying value, I would place a fairly heavy bet on it. Unfortunately, there is no way to do this. If my hypothesis is correct, my prediction is that in 1.7 years that Lending Club’s blended loan portfolio will look closer to Prosper’s, which currently has a 38.4% default rate on historical loans (for matured loans, Prosper is at a rate of $42,260,196 in net charge-offs vs. $110,000,706 loaned).

To say that Lending Club has a “historical default rate of 3%” is true, but the key word is “historical” – this will rise very sharply and this is why you don’t see Prosper advertising default rates – because it is ridiculously high. In order to be compensated for this risk, investors should rightfully be demanding rates that would make credit card vendors bashful.

Notwithstanding this analysis, there is educational value for people to invest small (and I mean small) amounts of money just to demonstrate how difficult it is to make money even when allured with the promise of high rates of return. Instead of a return on capital, the return of capital becomes paramount in the loan business.

I invite the management of either Prosper or Lending Club to comment here, rather than email. My analysis could be wrong, and would appreciate any corrections.