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Using Consumer Debt to Increase Income while Reducing Risk (Guest Blog)

by Prosper on 10/28/11

The following is a post from our guest blogger Mr. William Jordan, President of William Jordan Associates, Inc. a Registered Investment Advisory firm. Mr. Jordan is not employed by or affiliated with Prosper Marketplace, Inc.  The opinions expressed in his blog post are his own and do not necessarily represent the views of Prosper Marketplace, Inc.

Using consumer debt to increase income while reducing risk

About a year ago I was introduced to Prosper by a client of mine. As a wealth manager and someone who stresses to my clients that reducing risk is more important than chasing high yields, the concept of investing in unsecured consumer debt seemed an obvious bad idea. However after I took the time to seriously consider the Prosper platform, and after I looked at the facts, I had to conclude the risk adjusted returns were some of the best I have seen.

In the wealth management arena, risk comes with the territory. So it is never a matter of avoiding risk, but more importantly making sure the client is being compensated for the risk taken. When I first looked at Prosper all I saw was the potential for defaults.  However after an extensive process of analysis I discovered the risk was priced into the interest rates with room to spare. Here was an opportunity to generate exceptional yields for my clients, with a level of risk which was appropriate.

Given the severe losses experienced with some of Prosper’s early loans, you may wonder how I could come to be comfortable with the level of risk. First, take a look at how Prosper’s notes fared in 2008, and compare the results to many other alternatives.

US Government bonds +13.32% (VFITX)

Prosper notes -3.36% (all notes issued in 2008)

High yield bonds -21.29% (VWEHX)

Preferred stocks -29.79% (VCVSX)

REITs -36.98% (VNQ)

S&P 500 -38.49%

Prosper’s losses, when looked at in the context of what was happening in 2008, are frankly excellent. At first, the normal assumption about high risk and defaults in this type of a loan are the main concern, and rightly so. Notes issued during 2008 had a charge off rate of 22.65%! What everyone forgets to look at though is the actual interest earned which came in at 19.29%.  Still a loss, but nowhere near the loss rates I have heard some people talk about.

While no one likes to lose money, losing a net of 3.36% in one of the worst financial years in living memory is nothing less than impressive. In fact my average wealth management client lost 14% in 2008 and I was justifiably proud because most planners saw losses from 20% to 40% that year.

In addition, some of the losses can be attributed to the differences in how loans were priced and scored at that time. In 2009, Prosper went through a massive overhaul of their entire risk pricing model. Upon relaunching their platform we would hope to see an improvement in the default levels…and we did. For loans issued between July 1st of 2009 and 2010 the average default rate as of June 21st, 2011 was 5.1% and the net returns since relaunch are in excess of 10%.

Lastly, great emphasis should be placed on maintaining a well diversified portfolio of notes through Prosper, just as with any investment. As a general principle, the larger the number of notes in an investor’s portfolio, the more predictable the return will be. As seen in the chart below, the Prosper investors with the largest portfolios have achieved even better returns than other investors.

Source: Prosper

Within the Prosper accounts I have managed for my clients, the average interest rate at issue is 18.8%. This means if every default happened the day the note was issued (no interest earned), we would conservatively expect to see a yield of approximately 13.7%.  I have actually planned for a default rate of 8%, based on my allocation, leaving a targeted return of 10.8%…which is pretty close to Prosper’s actual reported returns of 10.4%. In a final concession to risk, you could double or even triple the actual losses on the loans mentioned above, and you would still have a net gain of 3.5%…how’s that for protection!

As a result, I have found Prosper to be an excellent opportunity for my clients.  The fact that these returns can be achieved, while helping borrowers save money on their interest rates, is one of those situations where everyone involved benefits.

William Jordan is President of William Jordan Associates, Inc. a Registered Investment Advisory firm, and manager of the Prosper Managed Fund, LLC. William has been featured with Maria Bartiromo on CNBC and on many other financial broadcasts as well as being quoted in the Wall Street Journal, Forbes and other top financial publications. William’s firm specializes in managing wealth with an eye towards reducing risk while increasing income. Past performance is not an indicator of future results and you should perform your own research before investing in anything.



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Notice: Blogs and other materials posted on or linked from this page that use the name "Prosper" generally use that name to refer to Prosper Marketplace, Inc. if published before January 31, 2013 and to refer to Prosper Funding LLC if published on or after February 1, 2013.