Friday, April 27, 2007

Lenders Properly Assessing Risk?

Prosper provides a reasonable amount of information on the borrowers to allow lenders to estimate risk. I've been quite curious, however, on how well the lenders are interpreting this information and generating risk-adjusted bids on loans. To that end, it's time for some more data crunching.

My handy-dandy tools have calculated the distress rate (loans in all the bad status categories from Late to Defaulted) for various interest rate bands.

StartEndDistress RateSpread

Looking at the table broadly, risk is priced reasonably well except for loans below 7.5% and above 30%. The table's middle section has a slowly increasing distress rate that implies that, roughly speaking, lenders are placing risk reasonably. I have to assume that the loans below 7.5% are sweet-heart deals brokered between people who know each other, because it doesn't make financial sense. The CD rates (risk free) have been in the 4.5% - 5% range for a while, and a collateralized home loan has been around 6%. Well, for whatever reason it was a bad risk. Equally, anyone who wants a loan at over 30% appears to be a bad risk as the interest rates are obviously not covering the risk.

My rule of thumb has been that a 1% increase in distress rate should be compensated for by a 1% increase in the interest rate. This was captured in the Spread column. An increasing spread corresponds to improving lender return. Looking at the table, lenders are getting a good deal. Many ranges approach 2% increases in interest rates for a 1% increase in risk. The lender sweet spot is coming in for loans in the 20% area.

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