We wanted to talk in more depth today about the relationship between expected losses, actual losses, and the effect those losses have on lenders’ portfolios. At the simplest level, lender returns are a function of two things: the interest rates on their Notes and the number of borrowers who fail to make their payments. Again, we’re simplifying, but the general equation to keep in mind is Interest – Losses = Return.
That said, Prosper is now delivering very strong returns for our lenders – over 10% ROI, they’re easily the best in their class, and we think they make for an excellent addition to any investor’s portfolio. Those returns are clearly a real credit to our continued focus on risk management. In the last two years, we’ve used our deep experience with peer-to-peer lending performance and vast amounts of data to design and implement a customized credit scoring model – the first in the industry.
It’s that kind of rigorous analysis that allows us to determine appropriate pricing for a particular loan request – a straightforward idea, but one that can be quite difficult to implement. Keep in mind that returns can fluctuate early in a loan’s life – in the first 30 days, no payments are received, so the overall return is essentially zero. For the next four months, loans can become delinquent but cannot default, so returns are likely to be overstated. Our internal analysis shows that return calculations start to stabilize after 10 months of “aging” – that’s why the headline return rate on our site only includes Notes that were issued at least 10 months ago.
As we said, the reason we are delivering great lender returns is our great risk performance. Here is a chart showing our actual loss performance compared to the expectation for each Prosper Rating. All of the charts below show data for Notes issued between July 2009 and February 2010:
Of course, we’re not the only company in the consumer lending industry, so we also work to benchmark our performance against our competitors, including Lending Club. Based on publicly available data and our own understanding of loss timing, their performance for the same period reflects the challenges of getting this balance right. Losses are well in excess of expectation in every grade, and in some cases are actually more than four times expectations:
Note: Some components of the Actual Loss Rate calculation are estimated because Lending Club does not make them publicly available. For full details, we’ve posted the Excel 2007 workbook with detailed commentary here:
This severe under-pricing of risk across the spectrum has clearly helped Lending Club to grow its borrower base, but that growth has come at the expense of their lenders’ actual returns:
Because we don’t have access to Lending Club’s full payment and performance data, we’ve elected to use a simplified method here to estimate average returns for both companies’ portfolios. In Prosper’s case, that simplified method results in a slightly lower estimated return (9.85%) than our actual 10.1% return*.
Our analysis of Lending Club’s loss performance and returns is based on data publicly available on their site. We have made all of our analysis public today in the attached spreadsheet, and we believe it is as accurate as possible based on public information. We would welcome any feedback you have on our analysis, and we would be happy to answer any questions to clarify what we have done.
It takes a rigorous approach to risk management to ensure that peer-to-peer lenders get the returns they’re seeking – and we’re committed to that here at Prosper.
* Net Annualized Returns represent the actual returns on Borrower Payment Dependent Notes (“Notes”) issued and sold by Prosper since July 15, 2009. To be included in the calculation of Net Annualized Returns, Notes must be associated with a borrower loan originated more than 10 months ago; this calculation uses loans originated through February 28, 2010. To calculate Net Annualized Returns, all payments received on borrower loans corresponding to eligible Notes, net of principal repayment, credit losses and servicing costs for such loans, are aggregated then divided by the average daily amount of aggregate outstanding principal for such loans. To annualize this cumulative return, the cumulative number is divided by the dollar-weighted average age of the loans in days and then multiplied by 365. Net Annualized Returns are not necessarily indicative of the future performance of any Notes. All calculations made as of December 31, 2010.