Peer to peer lending for personal and small business loans have been the latest incarnation of the micro finance trend. Traditionally confined to borrowers that banks otherwise would not lend personal and small business loans to in developing nations, such as the Oprah endorsed Kiva, peer to peer lending has gone upstream to a more retail markets. Prosper, described “…as an online community for lending and borrowing money…” for personal and small business loans, has a distinctively more mid-America focus to it than traditional micro financiers. Prosper works on a pretty simple premise: borrowers post for desired personal and small business loans and lenders bid on the interest rate they are willing to lend monies to such persons. Loans are unsecured (i.e. not backed by collateral in the event of default) and capped to relatively modest terms of 3 years and no greater than $25,000 a loan.

I am neither pro Prosper or anti Prosper; like any other alternative investment, it is important to understand what you are getting yourself into and understand risk/reward before proceeding. Thus, I took a look at the loan documentation consisting mainly of a promissory note and the Sale and Servicing Agreement (aka the Lender Registration Agreement). I am looking at this purely as an investment vehicle. Hence, my focus on the lender side documents.

I do not have too many comments to the promissory note; it is commercially reasonable and, as an unsecured note, its effectiveness to collect money, despite multiple clauses to help the lender, is limited by the fact there is no collateral securing performance of payment. The only clause I will highlight is what is known as the acceleration clause (see section 8 of the note) whereby upon default the entire principal and interest to be paid due and payable immediately (it is a typical clause but if you are lending for the first time please note its impact). My comments are primarily on the Lender Registration Agreement.

Let’s be clear- you are lending to Prosper who is lending to the borrower. Prosper is the bank.

Prosper, on one level, is analogous to a traditional bank in that we deposit money to the bank and the bank lends it out (in other words, the bank is using other people’s money). On another level, it is not. You get to pick what loans to fund whereas the bank picks for you. Depending on your risk tolerance, this is both a good or bad thing. Bankers are hated for a reason- in theory, they only lend to the safest borrower’s possible. They do the due diligence for you and, on a personal loan basis, they are mostly conservative. In Prosper, you pick your loans but Prosper is the bank in the sense that it is lending your money to the borrower as stated in the first paragraph:

“…you are not actually lending your directly to Prosper borrowers, but are, instead, making loan purchase commitments and purchasing promissory notes representing loans made by Prosper to borrowers. All loans originated through Prosper are made by borrowers by Prosper Marketplace, Inc. from its own funds and sold and assigned to you…” [emphasis is my own].

In other words, Prosper is the primary lender who mitigates its risk by transferring loans to you (granted you picked the loans) on the day after the bid period ends [see section 3(c)]. Keep this mind- Prosper itself has no down-side risk (as explained below). Despite the marketing spin, Prosper’s business model is the same as the banks- it takes your money, charge you fees for taking your money and lends it out. The only difference is you pick who the money gets loan out to but…

You own the loan but Prosper controls the administration

In section 5, the agreement states “Prosper will sell, transfer, assign, set over and convey to you…the Notes; provided however, that Prosper will retain the Servicing Rights…” [emphasis added]. What are Servicing Rights?

They deal with anything as mundane as the administration of the loan (filing, book-keeping, backing up computer records) to “any and all rights to service the Notes…any payments to or monies received by Prosper for servicing the Notes…” and, in return for such services, the Servicing Fee is paid. What does this mean in plain English?

Prosper collects the borrower’s payment into their bank account and disburses it for you. Prosper provides reports and Prosper makes sure you know if a loan is late, a cheque bounces etc.

What happens if a loan goes bad?

Prosper collects it for you (although you get to pick collection agencies) as part of Prosper’s servicing of the loan (see section 6). They will contact the borrower as a reminder of non-payment and, when payment is 30 days past due, Prosper will assign the loan to a collection agency and the collection agency does its thing. If the loan cannot be recovered 120 days after it is past due, it is “charged off” (i.e. written off) and sold to a 3rd party (and, you guessed it, you give authority to Prosper to sell the Note at whatever price it sees fit- if it can).

Here is the thing to note- Prosper is not a guarantor (nor should it be in an unsecured loan) [see section 10] and you are not allowed to take any action yourself to collect the delinquent loan (such as contact the borrower, sue them in court, contact the collection agency who is doing the collections) other than set out in the agreement [see section 14(d)-(g) and (i)].

Is this a good or bad thing that I have given Prosper the right to enforce my loan?

Depends.

Pros

• someone is doing the “dirty work” for you
• there are “professionals” collecting money for you (although most collection agencies resort to verbal thuggery quite quickly rightly or wrongly- it is just part of the game trying to collect loans from riskier borrowers)
• collection may be difficult if the borrower lives in another state and you need help

Cons

• Prosper has little down-side risk and thus no added motivation to collect. It is your money at risk. It may make honest attempts at collection but, after 120 days, its off to the collection agency but how motivated can someone be if down-side risk is quite limited? To use a real life example, would you be more motivated to collect if you lent a book to someone and they didn’t return it or if the library you work for lent a book and it wasn’t returned? Professionally speaking, you would make an effort to get the book back if it was the library’s but it doesn’t affect your bottom line directly so how much extra effort would you put in?
• the collection process is the same whether you are lending $5,000 or $25,000- hardly seems fair if you lent the latter
• Prosper has a right to sell the uncollected loan at pennies on the dollar if that’s what it can get for it

If you are interested in Proper of any of its competitors, one of the key questions to ask yourself is

Prosper’s website states from the period of Jan. 1, 2007 to Dec. 31, 2007, the ROI on a loan to AA borrowers (the best borrowers) was 7.07%. Is your risk tolerance high enough to invest in unsecured loans to achieve this level of return?

I’ll let you make your own judgment based on your own personal situation but I hope I shed a little light into what you would be getting yourself into. I would make a few comments though:

• don’t invest in any p2p lending because you believe it is the way to stick it to the “man” and start the collapse of the banking system (recent history suggests that it can do that without any of your help). Investing out of spite is not a path to financial independence. Spite investing begets more spite.
• Don’t believe the hype on any investing trend. Do a thorough review of its track record, do your research and test the waters before plunging in. In other words, read the fine print and not the marketing print
• only invest what you are willing to lose in unsecured investing (that includes stocks)

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For more information, the Pro Prosper blogger camp are tagged onto their website.

Here are the anti-Prosper bloggers (for lack of a better term)

My Money Blog doesn’t think the numbers add up

The author of the book Freakonomics wades into the topic of p2p lending (the comments are interesting in and of itself)

Four Pillars on why he doesn’t invest in P2p lending networks.

Good luck. Any one willing to share their experiences on Prosper on any p2p lending network?