Thursday, April 12, 2007

Auto Funding Risks

Automatically funded loans are another topic that gets thrown around in forums as a risk items for loans. There is some logic to the idea that auto-funded loans are risk items: borrowers who are willing to accept a higher interest rate to get the money now are more desperate, desperation results in people taking risks, higher risks mean higher distress and default rates. Thanks to our handy-dandy statistics processing, we have the distress rates (i.e. late or worse) for auto funded loans (Close When Funded) versus competitive bid loans (Open For Duration):

Credit GradeOpen For DurationProsper AverageClose When Funded

From the table, it's obvious that auto-funded loans are a risk item. For all but AA grade listings, it results in a 2x - 3x distress rate. This is a large and statistically significant spread. It's dangerous if you're using the Prosper average for bidding criteria as you'll be under-pricing risk for auto-funded loans and over-pricing open market loans.

Unlike unverified accounts, however, it's possible to price the loans appropriately to handle the risk for all but the HR loans. Remember, risk is not bad, as long as you're compensated appropriately for taking the risk. The rule of thumb I've been using is that every 1% increase in the distress rate should be compensated for by a 1% increase in interest rate.

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