Archive for the 'P2P Finance' Category

Prosper Adds Portfolio Plans

Prosper has added a way to create a portfolio of loans targeting a certain risk level. Flavors include Conservative  (target 8.55%), Balanced (9.20%), Moderate (10.40%) and Aggressive (11.56%).  They work by creating standing orders for certain loans based on specified criteria.  You can also create your own portfolio of standing orders to create a customized portfolio.  Obviously taking a page from the Zopa UK handbook, but a good addition overall that highlights the versatility of the platform.

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Zopa US – Worth the Wait?

I’m tardy in posting on Zopa US. In a nut shell, their system here works in the following way:

  1. You buy a CD from a credit union, which you have to join.
  2. I take an unsecured personal loan from the credit union, which I have to join.
  3. If you like me or my project you can contribute interest from your CD to reducing my interest payment.
  4. Zopa earns fees originating loans and servicing them.  Do they also earn a fee for each new credit union member?
  5. The credit union earns the spread between the CDs  and the rate on the unsecured personal loan.
  6. The credit union takes the risk of loss.
  7. Presumably the credit union offers both of us additional products making this potentially a lower cost member acquisition channel for them.
  8. To the extent that CD’s exceed underwritten loans, the credit unions have a new source of deposits.

I like the participation of the credit unions and the potentially viral nature of getting family and friends to subsidize a loan, but I think we’ll have to wait and see how Zopa and the credit unions extend the platform before we really know the potential of the model.

Prosper’s Regulatory Innovation, Considerations and Implications

In my earlier post on Prosper’s planned resale market, I identified four key aspects of the proposed approach outlined in the prospectus. In this post, I’ll dig into each and explore both the considerations and implications. Before doing that, a disclaimer. I’m not a lawyer, so approach my comments accordingly. Also this post as well as my previous posts on Prosper are not in any way investment recommendations.

Many individual issuers. At the cost of being redundant to my previous post, here is the description from the prospectus for how the process will work for creating debt on Prosper:

The Notes are promissory notes representing three-to-five year, unsecured, fully amortizing credit obligations of individual borrowers. If and when a borrower listing placed on the [Prosper auction] Platform is matched with a bid in, or multiple bids totaling, the amount of a requested borrower loan, Prosper makes the loan to the borrower and evidences the borrower’s obligation by separate Notes in the amount of each individual’s winning bid. Each Note is thereafter sold and assigned by Prosper to each respective winning bidder…Prosper has no obligation for payment of principal of or interest or other charges on the Notes.

Through this mechanism, any investor (institutional, accredited or retail) will be able to buy and sell the debt of a single person on an exchange within the existing regulatory framework.

Today when an investor buys debt it’s typically against the credit of an entire enterprise (say Ford) or a pool of loans that are diversified to diminish risk (think securitization). In the first case, an investor can make a judgment about how strong the company’s business is and the likelihood of default (usually with the help of credit ratings from Moody’s and S&P). In the second case, diversification reduces the impact of any single borrower defaulting. Even with the subprime meltdown something like 80% of residential mortgage backed securities remain classified as having a low probability of default (e.g. strong investment grade rating).

In both of these cases there is an intermediary – the investment bank – sitting between the issuer and the initial buyer of that debt. That is the primary market. After the debt has been purchased by the first investors it then trades in what is called the secondary market. So Prosper is proposing to facilitate both the primary and secondary markets using registered notes without securing the debt themselves. This is a very elegant approach.

Now for the implications. Think again of Ford. They help millions of customers to finance the purchase of their cars. The Prosper mechanism creates a way for an individual to issue registered debt to finance their car instead. This potentially makes every person a micro-issuer of their own debt. Obviously this is similar to the initial innovation of Prosper’s peer-to-peer finance model, but it goes much further in its flexibility. In fact, this mechanism also creates a means for doing micro-securitization.

Differing terms and face amounts. In a typical shelf registration statement for debt, a company files a maximum offering amount and a description of the proposed security. The company can then issue debt from the shelf registration statement from time to time with key aspects varying such as length of term, interest rate and face amount.

At a surface level, Prosper is creating a kind of shelf registration statement. They are registering $500 million which they intend to sell from time-to-time. However, they cannot actually create a true shelf registration now because they do not yet meet certain SEC requirements. That’s why they have filed an S-1. This is typically called a debt IPO. Needless to say, it’s quite unusual for a tech company to do this kind of offering. It’s also unusual to try to create a shelf registration statement on form S-1 because the issuer has an obligation to keep the registration up-to-date for material changes. That’s a little different here because the material information for this debt does not relate to Prosper, but to the individuals for whom Prosper has issued debt. More on that below.

So Prosper is creating a pool of debt out of which they can establish specific notes that match all of the individual pieces sold in a given auction to the various lenders. That process will recur thousands of times before the pool is exhausted. The risk is that there are so many unique pieces of debt that the notes remain very thinly traded. That’s why micro-securitization could be more attractive.

No apparent reporting requirements. Now for a potential road bump. While Prosper will be obligated to continue to update their financial information as a public reporting company (which creates some interesting IPO dynamics and opportunities) Prosper will not be updating the borrower’s credit data, in particular credit score. This seems problematic. It means that a new buyer of the notes will only see what was provided when the loan was initially issued even though the credit quality of the person could have improved or declined since the start of the loan. For instance, the person may have defaulted or become delinquent on their other debts in the interim, which might be reflected in their credit score. That would remain unknown to the new buyer if the borrower is still current on their Prosper debt. From the selling lender’s perspective, if the person’s credit has improved then they may accept a lower offer than they should on the note.

Not updating the information seems contrary to the spirit of ongoing reporting for a registered security. No doubt it is expensive to rerun credit scores frequently, but Prosper is charging 1% on the trade, so it seems they should absorb the cost as part of facilitating the market. The downside of this for the borrower is that running their credit score can negatively affect it, especially if done frequently. That obviously adds complexity.

Reasonable transaction cost. Prosper charges 1% or 2% of the total loan amount (depending on credit quality) to facilitate any given auction. There is also a 1% servicing fee per annum. Given that Prosper is facilitating the registration of sub-$200 notes, which in aggregate make up the total loan to a given borrower, this is amazingly reasonable. For debt resale, Prosper intends to also charge 1% for the resale market. With the face amount of the notes typically in the $50 to $150 range, paying $0.50 to $1.50 also feels reasonable. Having transaction fees at this level is obviously fundamental to creating a workable exchange.

In concluding, Prosper has proposed something new for the capital markets. If the SEC approves the structure, it could prove to be the leading edge in a new approach to syndicating debt, even if it’s not part of a peer-to-peer process like Prosper.

Prosper’s Brilliant Regulatory Innovation

On Tuesday Prosper filed with the SEC to create a mechanism that will provide a secondary market for trading loans originated through its marketplace. This addresses an important limitation of the current system – the ability of lenders to sell loans they’ve purchased. It also represents a brilliant innovation in U.S. securities markets if approved by the SEC.

Unlike eBay where an item is bought and delivered with no ongoing relationship between buyer and seller (ignoring disputes!), Prosper creates a long-term arrangement between the borrower and their many lenders. While a borrower can repay their loan at any time and terminate the agreement, lenders have been locked in.

So how does the creation of  non-recourse notes enable a secondary market? According to the prospectus filed by Prosper:

The Notes are promissory notes representing three-to-five year, unsecured, fully amortizing credit obligations of individual borrowers. If and when a borrower listing placed on the [Prosper auction] Platform is matched with a bid in, or multiple bids totaling, the amount of a requested borrower loan, Prosper makes the loan to the borrower and evidences the borrower’s obligation by separate Notes in the amount of each individual’s winning bid. Each Note is thereafter sold and assigned by Prosper to each respective winning bidder…

Prior to the date of this prospectus, there has been no trading market for the Notes. As soon as practicable after the offering of the Notes covered by this prospectus commences, Prosper intends to establish a secondary trading market online auction platform, or the Resale Platform, on which the Notes may be resold after three months following the date that they are acquired from Prosper by the winning bidders.

There is a major regulatory innovation here. Prosper is  facilitating the sale of registered debt by individuals. In the equity market context it is commonplace for individuals to register their shares in a given stock for resale. Importantly, this is for a single stock trading at a single price. Here, Prosper is effecting the registration of many, many different pieces of debt:

  • with different terms and face amounts
  • from many individual issuers
  • with no apparent reporting requirements
  • at a reasonable transaction cost.

Undoubtedly the SEC will appreciate the magnitude of this innovation. The question is whether the examiner and the more senior folks at the SEC will play along or force substantial changes to the structure, including ones that effectively kill it.

Tuesday’s filing reflects the impressive innovative drive of Prosper, especially in the regulatory arena. My concern remains that the underlying premise of the platform with its current focus on medium term consumer debt may not be working. See my earlier post – Prosper, Strangely Flat.

Prosper, Curiously Flat

I haven’t looked at Prosper for a while, so I decided to check in and see what was going on. 460,000 members and $95MM in loans seems pretty good, but when I went to the Marketplace Performance page and looked at the results, I was pretty surprised by the ROI estimates. The returns ranged from 9.27% to 10.69% going from Credit Grade A to E. Well that’s pretty flat. Which is intriguing in itself.

Now if you hit the reset button, which eliminates two very important conditions auto-set by Prosper when you first go to the Market Performance page, and set the date range the same, you get a VERY different result. The expected ROI now ranged from 8.54% for AA to -10.56% for Credit Grade E. Holy Hallucination Batman.

Taking these results at face value, this suggests from a practical perspective either one of two semi-contradictory conclusions. Either (A) You should never, eVeR, EVER lend to anyone who doesn’t have a AA credit grade or (B) you should only lend to people with Credit Grade E (on a very diversified basis!) who meet the criteria used by Propser (no current delinquencies and credit inquiries between 0 and 2) on the assumption that at worst you’ll get the same return as the AA’s but hey, who knows maybe the actual default rates will be lower and you’ll make some extra money. Of course they could be higher.

Option B doesn’t really appeal to me since it feels like the risk for each percent interest is too skewed. Of course, you could always use groups to screen loans and shoot for higher returns, but there’s something deeply unsatisfying if these results really indicate what it seems they do – that the credit card companies are underwriting risk appropriately in the first place.