Friday, July 27, 2007

RGF Rocks!

I stumbled onto RGF via RateLadder's two posts on him. RGF is a Prosper lender who identifies himself as an underwriting manager at a bank with 15 years experience in collections. I'm putting all his posts on my required reading list as he's got all good material. A sampling is below:

On Bankcard Utilization:

I don't really worry about credit card utilization so long as total unsecured is under 3 months salary.

Let's say you have someone making $50,000 a year, is middle aged, has only a single charge card with a $4k limit, and has a $3k balance. He's requesting $3k on prosper to term out the card. Let's say he has A credit, so he clearly could open more cards if he wanted to, but apparently has chosen not to. Is that 75% utilization supposed to scare me? It just doesn't. I'd say he's just financially conservative.

Unsecured debt:

For those still awake, I'll give another ratio you should consider. Note my recommendations are conservative, it's hard to find postings that will hit all these. But I would try to stay as close to them as you can.

Unsecured debt. Ideally, total unsecured debt should be 3 months salary or less, or 25% of annual income.

I assume revolving debt is credit card debt. Unfortunately, prosper mashes home equity lines of credit into revolving, so some of the revolving might not be unsecured. But if you don't know you have to assume the worst, that it's all unsecured.

Debt Ratio:

To get his true debt ratio, like the banks do, you first need to get his gross monthly income. He gives his net income as $4,933. To get gross income (pre-tax), you could estimate it by multiplying it by around 1.2x, or around $5900 (this is an estimate, it all depends on deductions). You can simply divide his monthly mortgage or rent into his monthly income, and add that percent to his prosper debt ratio. His monthly housing is $1200, divided by the $5900 we calculated, and housing is 20%. Add that to his Prosper debt ratio (39%) and his debt ratio is 59%. For unsecured lending, most banks will not go over 50% debt ratio, and would strongly prefer people be under 40%.

Yes, steadily losing money at a known rate is not "risk", it's a known loss. For example, a monthly car payment.

I don't think you read my whole post, for any investment you have to consier both the average return and the risk. If the average return is negative, it's a bad investment regardless of the risk (like craps or lottery tickets).

Now, go read all of RGF's posts

Tuesday, July 17, 2007

Tips For Borrowers

In my effort to fund a few more Prosper loans, I've been looking at tons of listing descriptions. I've developed a set of criteria I look for and I want to pass it on to those borrowers who are interested in writing better listings.

Let me begin by saying that if I'm seriously looking at your listing description, I'm prepared to fund it. I use custom searches that pick interest rate and borrower details so that I only spend time on pre-screened listings that meet my criteria. From here, I'm looking to understand that you're taking your finances seriously and that this loan makes sense. All you can do is lose me at this point, so here's how to keep my attention.

Be Specific
It's not enough to say that you need the money to pay bills or consolidate loans. What bills and what loans? Don't just list the credit card company names. List the amounts and interest rates for all your outstanding debt. When you list your income and expenses, be verbose. Gory details and the whole nine yards - rent/mortgage, food, gas, property taxes, rent, video games, newspaper subscription. You're trying to convince me that you know your financial situation. You'll pay the cost if you don't want to discuss your financial situation. Remember, every lender who passes you by increases the interest rate you pay if your listing gets funded.

Have Numbers That Make Sense
I will check your claimed monthly (net) earnings against your income range and sanity check all the expense numbers. Back in the earlier days, there were borrowers who truly wrote that they could feed a family of 4 on $100 / month. This raises a red flag. I concede that this may be possible, but I won't believe it if you have a $2000/mo mortgage so explain anything you're doing that may create odd-ball numbers. Equally, if your income and expenses show a huge monthly cash flow, but you still need the loan, I'll think you're hiding something. Sometimes I will ask you to clarify, other times I'll just move on.

Situation Killers
I want to see that the loan will improve your situation. If you seek a 20% loan to consolidate a bunch of 17.99% credit cards, I won't believe you want to improve your situation. If this somehow improves things for you, explain it to me. Getting a Prosper loan to "improve your credit rating" is not sufficient. Handle your debt well and your credit rating will follow. The same applies to consolidating student loans that are at a lower interest rate (a big red flag). And finally, I will pass on loans for a down payment on a house or car. This is a red flag that you're a higher credit risk than Prosper's credit grade indicates. If you've got a house and bragging about your equity, explain why you're not using a home equity line of credit.

I have always been impressed by the listing description quality from the No Bull Investors group. Check out some of their listings for some good examples.

Monday, July 9, 2007

Prosper's July Feature Additions

Over on the Prosper forums, the Announcement category had the new features added in July. The lender relevant changes are listed below, but, for the most part, I'm underwhelmed:

Updated marketplace performance page
We've improved the marketplace performance page by bringing the "Estimated ROI" table to the top of the page, and by setting some default loan criteria (0 current delinquencies and 0-2 recent inquiries) so that you can just click "View matching listings" or "Convert into standing order" and earn a 9-11% interest rate on listings with those criteria. We've also added some "Sample criteria" like "Zero delinquencies" and "Homeowners only" that you can just click on to see how applying those criteria to past loan portfolios would affect your ROI.

Group joining process streamlined
If you've ever tried to click the "Join this group" link from a group page as an unregistered user, and actually joined the group, you know that the process of joining Prosper and then finding the group again to join it is not obvious. Now, when an unregistered user clicks "Join this group", he or she is sent to a combination page where he or she can both join Prosper and make a request to join the group. Just click "Join this group" when you're not signed in to check it out.

Group leaders now have a landing page for joining Prosper and their group
Using the same process described above, GLs can now link outside web sites or their email signatures to a landing page where prospective group members can both join Prosper and request membership in their group all on the same page. If you're a GL, just go to the "Link to group" link at the bottom of your group page where the link to your landing page can be found.

Added running account balance column to account activity page
One small piece of feedback that seemed obvious to fix is that there wasn't a simple "Cash balance" column in the account transaction activity page, that would let you track how individual deposits and withdrawals were affecting your cash balance as they were processed. Note that the column is available in the default view (sorted by date), but will disappear if
you sort by any other column.

Improvements to the API
We have gotten a lot of great feedback from developers over the last few months, and we have improved the real-time API in a couple of significant ways. First, the five primary objects are now available through the API: bids, listings, loans, members, and groups. Second, all of those objects can be queried via the API. These changes, along with a few added fields (for convenience and performance), significantly enhance the usefulness and usability of the API for developers. We expect that this will yield many great new applications for borrowers, lenders, and group leaders.

Sunday, July 8, 2007

Defaults Have Higher Interest Rates

Matt over at Prosper Lending Review posted an article on how loan interest rates vary within a credit grade. One of his conclusions is that defaulted loans have a higher average interest rate than current loans.

So, what do these numbers tell us? Well, if we look at loans in the B through HR categories, the loans that defaulted had a 1.7% through 2.6% higher interest on average than other loans in that credit grade. What this means is that prior to defaulting lenders considered these loans a higher risk and didn't bid down the interest rate as low as they did for other loans.

The difference is even more pronounced when you look at the difference in interest rates between loans that are current versus loans that have defaulted. Lenders put as much as a 3.74% risk premium on loans that ended up defaulting - clearly lenders were seeing something they didn't like in the listings compared to other listings of the same credit grade.

I didn't find this at all surprising:

... If we assume that lenders are doing a reasonable job pricing loans, then the interest rate is proportional to the default rate (I made such an argument and have stats to go with it). I'd then expect the default group to have a higher average interest rate.

So, now a thought experiment to back this up. As I previously pointed out, Prosper lenders do assign higher interest rates to more risky loans. Lets model this as a 1% increase in interest for a 0.5% increase in default rate. This is NOT based on Prosper data, but chosen to be convenient for this exercise. Lets look at 1000 loans each at 11% - 15%, and the number of defaults that occur.

Interest RateDefault RateBad Loans
Good Loans

It's obvious from the table that the bad loans in this exercise weight more heavily toward the 15% interest rate while the good loans weight toward the 11% interest rate. This can be expressed empirically by taking the weighted average of the interest rates. The math give the bad loans a 13.5% weighted average versus the good loans with a 12.99% weighted average, just as Matt had found.

Tuesday, July 3, 2007

Modeling the Value of Loans

A lot of highly debated topics in the Prosper forums (default sales for example) get heated, but the discussions often degrade into "Prosper sucks for doing this". Very rarely do the discussions attempt to model the financial consequence of the current (or poorly implemented) policy - they only discuss anecdotal impacts on one or two loans in their portfolio. That is why it is critical to have a method of modeling loan value. With this model, the impact of various scenarios can be predicted and lenders can adjust their bidding appropriately.

From the lender's point of view, loans can be modeled as:
ROI = LoanRate - ServiceCharge - DefaultPenalty
The loan rate (LoanRate) is well known. It's important to take the loan rate as seen by the lender as opposed to the borrower's rate, which includes group leader rewards. For the service charge (ServiceCharge), Prosper takes 0.5% for AA, A, and B loans and 1% for C - HR to pay for servicing the loan. The skill is in modeling defaults (DefaultPenalty), and I'll cover various methods in the coming weeks.

When I bid on a loan, I want an ROI at or above some threshold. To figure out the minimum rate, I rearrange the model to MinimumLoanRate = ROI + ServiceCharge + DefaultPenalty and bid accordingly.

Interesting Disclaimer For E & HR Loan

I was writing up another post and clicked to bid on a random loan and discovered an interesting treat. Prosper has added disclaimers for E and HR loans to the bidding page. We have previously highlighted the default risk present in auto funded loans. Prosper expands on this and provides interesting statistics that include the effects of prior delinquent accounts.

First, the E graded loans:

Impact of additional credit attributes
For Prosper loans made to E borrowers with origination dates of Jun-Nov 2006, as of Jan 2007.
Criteria Estimated
default rate
Borrowers with 2 or fewer delinquent accounts at time of listing who did not choose automatic funding 9.2%
Borrowers with 3 or more delinquent accounts at time of listing who chose automatic funding 35.3%

And now the HR graded loans:
Impact of additional credit attributes
For Prosper loans made to HR borrowers with at least 5 years credit history and origination dates of Jun-Nov 2006, as of Jan 2007.
Criteria Estimated
default rate
Borrowers with 5 or fewer delinquent accounts at time of listing who did not choose automatic funding 17.5%
Borrowers with 6 or more delinquent accounts at time of listing who chose automatic funding 52.1%

Update: Also covered on Prosper Lending Review

What Is Factoring?

I've seen factoring referred to several times in listings for business related loans. Most recently in this one (full disclosure: I've bid on it)

... Usually it takes about 45 to 60 days to get your invoice processed; this is how transportation industry works. I could have factored my invoices but I am better off with prosper loan than factoring, for those of you that know about trucking industry.

Ok, so what's factoring? Fortunately, the Wikipedia knows all:

Factoring is often used synonymously with accounts receivable financing. Factoring is a form of commercial finance whereby a business sells its accounts receivable (in the form of invoices) at a discount. Effectively, the business is no longer dependent on the conversion of accounts receivable to cash from the actual payment from their customers, which takes place on typical 30-to-90-day terms. Businesses benefit from the acceleration of cash flow by obtaining cash from the factor equal to the face value of the sold accounts receivable, less a factor's fee.

Ok, got that? I'm a business that performs a service for a customer. It's typical for customers to have 30 - 90 days (depending on the industry) to pay up. When a business factors their invoice, someone fronts them the money and then collects on the invoice after the 30 - 90 days. Sounds great, but what's the downside? The financing company charge a service fee of 1% - 5% of the invoice amount. I found a few "discount" places on the web that charge 2% for 30 days account receivables. This corresponds to a 27% APY. No wonder businesses are looking at Prosper instead of factoring.