June 3, 2008

In August 2006 I put $1,000 into each of two new microlending institutions. Kiva facilitates loans to entrepreneurs in countries such as Uganda, Ecuador, and even Iraq, and it doesn't pay people like me any interest at all. (The intermediate lenders can charge whatever interest rates they want.) Prosper lends to Americans and remits nearly all of the interest they pay to the citizens like me who fund the loans.

After nearly 2 years, I'm still doing better with Kiva than with Prosper. What broke my will to stay the course with Prosper was the failure of a AA-credit loan entitled "Very safe investment, you will not find one safer."

Prosper's idea is simple -- too simple. You can read some summary data on borrowers such as their credit rating (AA and A are excellent and good; E is poor) and their debt-to-income ratio (DTI). Borrowers also publish a photo and a blurb about what they intend to do with the money. The more diligent Prosper lenders even ask questions to learn more about the borrowers. I invested small sums, as little as $50, in loans promising 10% to as much as 29% in annual interest. Most borrowers have been paying on time, but 2 loans have defaulted and 2 more are in collections now. My losses from those bad loans will more than wipe out the meager profits I've made from good loans.

According to LendingStats, a third-party web site that tracks Prosper data, I've made about a 2.2% return on investment (ROI) annually. Among lenders that have invested more than $1,000 over a period of more than 18 months, the median ROI is about 5.6%. That median is little more than a savings account or CD would have paid over the last 18 months, and I could have earned a comparable amount of cash had I invested the money in a healthy dividend-paying stock like Con Ed. Furthermore, Prosper only offers 3-year loans, and most of my loans are still tied up for a year or more. I have no choice but to transfer payments out in drips and drabs before I'm totally done.

Of course, savings accounts and utility companies don't have heart -- and microlending is supposed to be about people helping people. With Kiva the loans are pretty self-explanatory: I've received full payments from a Kenyan maize saleswoman, a Cambodian seamstress, and a Nigerian grocer. These entrepreneurs have, at least in theory, been vetted by organizations that specialize in microcredit. By contrast, my Prosper loans include borrowers that describe themselves as a company providing "various forms of help to college students" (3 months late), a nascent restaurant selling wings and chicken sandwiches (defaulted after 4 months), and a homeowner with B-grade credit looking to make renovations (defaulted after just 1 payment). Without any independent auditing of borrowers, I don't know if any of these borrowers had any intention of following through on their promises.

The credit crunch in the U.S. has hit Prosper just as hard as other lending institutions. As a lender I'm encouraged to set up Portfolio Plans that bid automatically, but to make peer-to-peer lending work it's more desirable that I get to know the borrower before putting out money. A few people have made a killing on Prosper, including ROI champion csmio, whose portfolio has returned nearly 20% on investments in dozens of high-risk and high-DTI loans that he must have investigated himself. For the rest of us, Prosper's own lending stats are disappointing. Investors in AA-grade loans, the best creditors possible, net an average of only 6.85%. A-grade loans net 5.73% and B-grade loans net 2.25%. After that it's all negative. Unless you really know how to pick your high-risk borrowers, as a lender your only money-making strategy is to lend to folks with excellent histories and low DTI. These are the same creditors who could in all likelihood get a home equity loan or even a credit card with a lower rate than Prosper, so you'll need to investigate why they're using such a novel service in the first place.

How could Prosper do better?

Go more local. Kiva stresses community development by showing which countries and cities their borrowers represent. As the Internet has reached saturation levels, even the tiniest communities can gather on-line. (My neighborhood alone has at least 12 community-oriented blogs, for example.) This can also help identify risks. If a homeowner is trying to get a loan on Prosper and I know he's in Stockton, California, foreclosure capital of the nation, I'm going to stay away. If a Prosper borrower claims to have a great location staked out in Seattle, I can drive by to see if I think it's viable. Especially with the concerns over identity theft, I just can't trust myself lending even small amounts of money to Americans I haven't met.

Let lenders sell their loans. I want out of Prosper. The debt I bid for should be considered an asset, right? Why can't I sell that asset? Although this could be dangerous -- trading debt around was a major cause of the mess we're in as a nation -- it could let lenders like me cut my losses and move on to other things more quickly. Right now I'm powerless but to look on and wait.

Offer different loan terms. Especially for high-interest loans, which tend to get paid off more quickly if they are paid off at all, offer a 1-year term instead of the mandatory 3-year term. This means less interest payments for lenders like me, but it could help borrowers structure their payments more realistically. I want loans that get results, not ones that keep people barely hanging on to solvency.