Sub-prime Mess And Prosper

This blog post got me up and thinking on the sub-prime mess and how it interacts with Prosper. Since I'm sure there will be lots of articles to follow, I wanted to stake out my positions before the posts are flying fast and furious. I've been following this slow-motion train wreck for about a year and 1/2 on Calculated Risk's blog (and, as an aside, you can see that CR did great diligence going back into 2005).

By all accounts, the basis of the sub-prime implosion was two related problems: people who shouldn't have been given loans were, and "creative" loans were given in place of easy to understand ones. Sometimes this was done fraudulently, other time criminally, but times were good, homes were appreciating, and everyone was an easy refinance away from calamity. And then the houses stopped appreciating, refinancing wasn't easy, and people face the worst possible outcome: default and home loss. All of the financial engineering, securitization, collateralized debt obligations, stated incomes, slicing, and dicing exacerbated the situation because someone made money at every step and there was little incentive to do proper diligence with everyone else lending like crazy people.

It should be noted that about 6 months ago, the Prosper lenders went through a similar meltdown. There was a collective realization that borrowers with HR credit ratings shouldn't be getting $25,000 loans at 15% because they were horrible risks. In the Prosper situation, there wasn't much of a wind up - Prosper loans are not complicated, came due quickly, loud lenders provided feedback, and the market corrected itself as statistics became available. It was dangerous for lenders who jumped in with both feet at the beginning, but this underscores the importance of having a good model before lending. This resulted in a flight to quality, with AA - C grade loans getting much more attention despite their lower interest rates.

There are lessons and warnings for Prosper lenders from the sub-prime mess, however. First, avoid stated income loans. Prosper does verify the claimed incomes of borrowers before a fully funded listing proceeds to a loan. Look for borrowers with verifiable income and check a borrower's budget against their income. Be careful with listing descriptions that claim a spouse's income - it's not verified and you're trusting them to state it correctly. Second, guard against collateral damage from the sub-prime implosion. Realtors, mortgage brokers, construction workers, and house flippers will be under financial stress as the housing industry slows down. Tighten up your lending criteria if a listing mentions the real-estate industry in their job or listing description or if they live in danger areas. Ask borrowers about their mortgage terms, and avoid California, Arizona, and Florida unless you're ready to put in the additional vetting work, for these states are over-exposed to the sub-prime contagion.