Peer-to-Peer Lending for Banks, Too?

Prosper, the largest "peer-to-peer" lending site, is opening itself up to financial entities that want to list their performing loans and auction them off to average-Joe investors in miniature increments.

The first financial firm to participate is Consumer Portfolio Services(CPSS), an Irvine (Calif.)-based specialist in auto financing for consumers with past credit problems, low incomes, or limited credit histories. CPS began posting the first of a few hundred loans on what Prosper calls its "open market" on Apr. 28. Chief Executive Chris Larsen hopes this will make more loans available for autos, small businesses, and the like—at least in Prosper's own little way. "These markets are still completely shut down," Larsen says. "This solves the key problem of securitization in that you will have that direct line of sight to the loan itself."

Prosper and other peer-to-peer lenders specialize in connecting borrowers who need up to $25,000 in cash to fund small businesses or refinance their credit cards with individual investors who bid on those loans in amounts as small as $50. Prosper has originated $179 million of loans that way since its founding in 2006.

Waiting on SEC Approval

But the recession has brought stunningly high default rates to some peer-to-peer loans. And Prosper has been on regulatory hiatus since October while it worked to get approval from the U.S. Securities & Exchange Commission for its existing market as well as the new market for institutional loans. It still hasn't received SEC approval. Instead, it is moving forward under an obscure loophole that permits companies to seek a one-state exemption; Prosper received the go-ahead from California state regulators to reopen in that state only.

The overall marketplace, as of Apr. 28, will be open for California lenders only, and only California financial companies will be permitted to post their loans on Prosper. A secondary marketplace for all of Prosper's loans, which has been in the works for some time, will follow soon after, although again only in California to start.

How will peer-to-peer lending work for financial institutions? Just as in any regular loan, the financial institutions—banks, car dealerships, community lending organizations, and the like—will lend to people buying a car or running a business. The loan must then gestate for three months. After those first three payments have been received, the financial institution can post the loan for bids on Prosper. This is not meant to be a place to unload toxic bank loans (there are other places for that), and only loans up to $25,000 that are current on payments may be posted.

Extending the Terms

The bidding will work similarly to the site's typical small-timer loans: Borrowers post for money and lenders bid eBay-style (EBAY) for pieces of each loan. After there are enough bidders to fill the entire loan (for example, 100 bidders of $50 for a $5,000 loan), increased bidding lowers the interest rate. That allows the financial institutions that posted the loans to make money off the spread between what they're charging the original borrower and what they owe Prosper's lender/investors.

Unlike Prosper's historical business—which is entirely three-year, unsecured loans—these new institutional loans can have terms from three months to seven years, and they can be secured or unsecured. Investors will see the details of each specific loan and its payment history, as well as the credit-rating report details that are on all Prosper loans. So, for example, the page might show that the borrower had taken out a $10,000 installment loan to buy a Prius and made eight on-time payments to date. As with all peer-to-peer loans, the bidders won't know the borrowers' identities.

The financial institutions will continue to process and collect the money from the borrower. If a loan defaults, it will be up to the institution to collect the funds. For small-time Prosper investors, if the bank can't collect and writes it off, their portfolio will similarly suffer. "It makes sense since Prosper has this platform and exchange," says Jim Bruene, editor of Online Banking Report. "I think financial institutions will be interested."

Ranks of P2P Players Is Thinning

It's an intriguing move at a time when peer-to-peer lending has gone from an arena of promise to a forgotten stepchild of the financial crisis. (Disclosure: As I chronicled last year for BusinessWeek, I became a Prosper lender in early 2008, putting together a small, diversified portfolio of A- and B-rated loans. My annualized return, after one default and a handful of late payments, is around 8%. Given how the rest of my portfolio has suffered, this is, bizarrely, my best investment.)

Over the past year, the array of P2P players has dwindled. Britain's Zopa, for example, pulled out of the U.S., and a number of hyped new entrants never opened. Prosper's chief competitor, Lending Club, got SEC approval last year and is now open with both a primary and secondary market. Prosper, meanwhile, had not been making any new loans or talking about its business as it struggled to get SEC approval, spending millions on regulatory filings. "It's a little frustrating," Larsen says.

Last year, total peer-to-peer loan originations were flat, at roughly $100 million, according to Bruene. The total is likely to decline this year, to between $75 million and $90 million, he figures, before turning back up again. "If everything comes together, and the economy tilts further down, then it should start growing again in 2010," Bruene says. He still believes that "long term you're talking about originations in the billions." But he has pulled back from his earlier projection of an overall market of $9 billion by 2017.

Burned Lenders Speaking Out

Meanwhile, default rates at Prosper have risen to shockingly high levels. Since inception, Prosper's net charge-offs have totaled 17.4% of all loans. For Prosper's AA-rated loans (corresponding to a credit score of 760 or higher), 7.4% have been charged off, while for loans rated HR or "high risk" (corresponding to a credit score of 520 to 559) that number is 39.2%. (By comparison, credit-card charge-offs recently reached 8.8%, and Moody's (MCO) has said that it expects double-digit charge-offs by yearend.)

While no one could have predicted the financial crisis and economic squeeze that many borrowers are feeling, the allure of peer-to-peer lending for investors did not include massive default risk. Prosper's once-largest lender—Greg Bequette of Livermore, Calif., a finance employee at Lawrence Livermore National Laboratory who invested $800,000 with 173 borrowers—has been publicly fuming that he's suffered so many defaults in his concentrated portfolio that he's deep in the red.

Moving to More Disclosure

Just as equity investors learned the hard way about diversification and risk last year, so did peer-to-peer lenders. "It wasn't like when people started lending on this thing that they thought they weren't taking risk," Bruene says. "They were lending in a new marketplace with low-doc loans online. But you can see why people are not happy that things turned out worse than they expected."

More typical, says Prosper, is a low positive return: Its data show that the average investor with at least 20 loans has gotten a return of 2.8% to date, and that more than two-thirds of such lenders had a positive return.

Over the years, Prosper has moved away from subprime loans and toward increased financial disclosure in an effort to reduce defaults and charge-offs. With Tuesday's relaunch, it is continuing its move away from being a mass lending platform and to one that will serve good borrowers and institutions. Prosper upped the minimum required credit rating for borrowers to 640—a move designed to keep troubled loans off the site—and created a new risk rating based on detailed default data from the past three years. Adding financial institutions to the mix, Larsen says, "brings a ton of inventory of good loans."

Tough to Gauge Future Default Rates

It's too soon to say what impact these moves will have on the default rate. In fact, one big problem is that despite Prosper's voluminous daily updated data on loans and defaults, there's no way to know what that historical default rate might mean for the future in today's uncertain economic climate, nor what the averages might mean for any one person's handpicked portfolio of microloans.

Still, Erzo Luttmer, a professor at Harvard University, along with three colleagues, recently studied Prosper and found that its investors are able to determine the creditworthiness of borrowers from information in their online postings. "One of the things that tells you is that this is a bona fide marketplace and not a form of charity or an implicit way for people to entertain themselves," Luttmer says.