Join Now   Sign In | Help


Why Prosper’s Auction Model Was Worth The Wait

07/29/09 posted by Kirk Inglis    

The current financial crisis has put enormous stress on our economy and unfortunately everyone in the consumer lending business, including Prosper lenders, are feeling the effects. Although credit losses are always unwelcome, they are an unavoidable fact of consumer lending and only represent half of the return equation. The other half of the equation is of course the price that lenders earn for investing their money in consumer loans. Because everyone has a different tolerance for risk, the ability to price for risk and to control price is critical.

Prosper is the only consumer lending model that allows lenders to truly control the way they price their investments to match their risk tolerance.

A common mistake that is made with respect to evaluating risk is to view it as a specific number rather than a range of likely outcomes that are summarized by an average. If the range of possible outcomes around the average was the same for an AA rated asset versus a B rated asset, even though the absolute loss for the B assets was higher, pricing for risk would be a simple matter of adding your required return to the projected loss rate. If this were true, lenders should be happy with the same estimated return for a diversified portfolio of AA rated loans or a diversified portfolio of B loans. 

A better way to think about risk is in terms of the range of possible outcomes associated a given level of risk. In general, the higher the risk, the wider the range of expected outcomes. A simple way to think about this is to calculate the impact on return of a 20% variance in estimated loss for AA Prosper rated loans and B rated loans. If you assume a loss rate of 1.0% for the AA rated loan, then a 20% increase loss equals 0.2%.  If you assume a 5.0% expected loss rate for a B rated loan, a 20% increase equals 1.0%, five times greater than for AA rated loans. If you required the same 5.0% return for each class of loans you might price the AA loan at 6.0% and the B loan at 11.0%, and believe you had adequately priced for risk.

However, if losses are 20% higher than expected, your return for the AA portfolio would be 4.8%, but only 4.0% for the B rated portfolio of loans. Of course if the losses were 20% lower, the B rated portfolio would outperform the 0.8%. Because the return is less certain on the portfolio of B loans (has a wider range of outcomes) lenders may want to require a higher return on the portfolio of B loans to compensate for the greater uncertainty, and this is where Prosper’s auction model is so important.

Everyone has a different tolerance for risk and it is important to consider these tolerances when deciding the types of loans you are willing to invest in and the rate you are willing to accept. If you are more risk adverse, you may want to invest in higher quality loans that require less risk premium and have more predictable returns. If your bias is for high returns, you may choose to invest in riskier loans, but then you may decide to require a higher return as compensation. Without the auction mechanism, lenders have no way to incorporate these preferences and have to accept the relationship between risk and price established by a third party that is both not taking risk and may have to balance other factors that likely are not in an investors interest, such as attracting borrowers.

Prosper’s auction model allows lenders to set the minimum price they are willing to accept for each individual listing based their risk return preferences. The lender will never receive a rate lower than the minimum they set and will often receive a rate that is higher based on the results of the auction. Prosper is the only consumer lending model that allows lenders this degree of pricing control.


Leave a Comment

(required)
(required) Email will not be published.
 

Comment Policy

 

*
To prove you're a person (not a spam script), type the security word shown in the picture. Click on the picture to hear an audio file of the word.
Click to hear an audio file of the anti-spam word

2 Responses


Robin | July 31st, 2009 at 11:51 am

this is a useful article. I wish Prosper would put more stuff like this up. Perhaps simpler. I have been interested in peer to peer lending and will invest in the AA through C - seems like that is the best bet.

please do more like this - it is helpful.

Trackbacks


Posted in Employee, Featured, Financial, Lend To Others, Lenders, Misc, Prosper, Prosper News, p2p lending, peer-to-peer lending

 

Get Involved

Subscribe to Blog RSS Feed
  • Google Reader or Homepage
  • Add to My Yahoo!
  • Subscribe with Bloglines
  • Subscribe in NewsGator Online
  • Add to My AOL

Want to contribute to the blog? Submit a Post

Lenders

Prosper’s Media Roundup – 11/17/2009

By Prosper Blog on 11/17/09   [ ]

Prosper News Updates:
November 11, 2009
Fast Company: Peer-to-Peer Lending Explained: Brother, Can You Spare $100? By Lydia Dishman

November 11, 2009
Gerson Lehrman Group: The 5Cs of Credit, P2P Lending, Social Lending, Self-Directed Lending By Ronald Ingram
October 22, 2009:
NetBanker: Peer-to-Peer Marketplaces Join Forces to Influence Lawmakers with the “Coalition for New Credit Models By Jim Bruene
October 21, 2009:
American [...]

Read More

The Results From the Legal Collections Test

By Doug Fuller on 11/3/09   [ ]

Before discussing the results of the test, let’s review what we were testing. In November 2007, 74 loans that would have been included in the December Debt Sale were selected for a test of applying a legal collections strategy. These loans had an outstanding principal balance of approximately $705,000. They were placed at Hunt & Henriques, a prominent [...]

Read More

Collections – Hardship Arrangement are Benefiting Lenders

By Doug Fuller on 11/2/09   [ ]

One of the key challenges in collecting on unsecured installment loans is providing the borrower an incentive to continue to making payments when they come under financial distress. If you don’t make a payment  on a credit card you can’t keep charging on it. In the case of a house or a vehicle loan, the lender [...]

Read More

« Older Entries

Monthly Archive

Home | Personal Loans | Invest | Trade | Online Investing | About Us | Help
Site Map | Developers | Investment Opportunities | Privacy & Security | Policies | Terms of Use | Legal Agreements | Legal Compliance | Prospectus

Prosper, Prosper.com, and the Prosper logo are registered trademarks or service marks of Prosper Marketplace, Inc.
Copyright © 2005-2009 Prosper Marketplace, Inc. All rights reserved.
This site has chosen a Thawte Certificate to improve Web site security Site privacy statement reviewed by TRUSTe