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.