Friday, December 7, 2007

Digging For Gold Around Prosper's Portfolios

This was a guest post on Prosper's new blog.

When Prosper created their portfolio plans, they added a tool to help new lenders enter the marketplace. It assembles a portfolio of loans whose only objective is to track the average loan return in the specific market slices, much like index funds have done with the stock market. Want to play it conservative, you buy a S&P 500 Index. Feeling aggressive? Try the EAEF Foreign Stock Index. If a lender is interested in tracking the loan market, new lenders can establish portfolios without the learning curve of manual bidding.

Those of us who take a managed fund approach to our lending by using manual bids will have to be careful because the portfolio plans will change the bidding environment. If the portfolios are widely adopted, we should expect loans within the portfolio's umbrella to be in higher demand. Higher demand for certain loans will result in lower interest rates for those loans, lowering the possible return on investment. A similar effect has been found when the S&P 500 adds a new stock to the portfolio.

At the same time, it creates opportunities to find nuggets that are outside of Prosper's four portfolio plans. This is risky territory (otherwise it would be inside the portfolios), but risk is a problem for lenders when they're not paid appropriately to take on the risk. Careful efforts to mitigate risk can drive down the net defaults and appropriate bidding can compensate for the remaining risk. For example, non-autofunded C grade loans with 0 delinquencies and 2 to 3 inquiries are more dangerous than those with the balanced portfolio preferred 0 or 1 inquiries (-9.05% vs. -5.02% net defaults respectively). If you take those 2 to 3 inquiry loans and further constrain bidding based on other risk factors like DTI and loan amount (DTI less than 20%, amount less than $10k), it's possible to find listings that have better net defaults (-3.97%) than those found in the portfolio criteria.

This was just one of many opportunities. Prosper doesn't add these more finely tailored criteria to the portfolios because there aren't enough listings to support the volume of loans portfolios demand. For individuals willing to dig deep around the periphery however, it's a veritable gold mine.

Update: I'm pretty sure that the "C" credit grade standing order criteria shifted slightly since I wrote this. When I did my research, Prosper did not have DTI < 70% and the employment status criteria in the standing order. Why, oh why can't I wait until the last minute like all the other procrastinators?

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