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Rolling the Dice with Online Lending at (Part I)...By Jay Graziani

The advent of "P2P" (peer-to-peer) internet applications has broadly changed the way we do business, from file sharing to internet auctions to online betting exchanges like BetFair and Matchbook. Now Chris Larsen, former CEO, chairman, and founder of E-LOAN, has brought P2P into the world of finance by creating Prosper, an online marketplace for those wishing to borrow or lend money outside of traditional banking channels.

For those who have experience dabbling in online markets, whether day-traders or sports handicappers, Prosper represents an interesting new income opportunity. The profit potential can be tempting. Three year CDs currently yield only about 5%, making a Prosper loan at 10%-plus seem extraordinarily attractive for mid-term investment.

Prosper launched in February of 2006, and has grown quickly since. It has garnered attention throughout the mainstream media, including The Wall Street Journal, USAToday, and Time. In June, Prosper announced that its membership had grown 50% in the prior 3 months (exceeding 300,000 members). Over $65 million in loans has been financed through Prosper since its inception.

Prosper describes itself as "America's first people-to-people lending marketplace". Its Ebay-esque interface makes listing and bidding on loans simple for even the least-savvy internet surfers. Loans can be requested for up to $25,000, and lenders can place a bid for as little as $50. Once enough lenders have bid to fill the loan amount, more bidders can come in and attempt to get a piece of the loan if they are willing to accept a lower rate. The rate can continue to drop until the listing closes, at which time Prosper processes the loan. Prosper facilitates the transfer of funds between the parties, taking their share of fees along the way.

Prosper is certainly targeting an attractive niche. With the advent of payday loans and high-APR credit cards (often due to penalties incurred when missing payments), many higher-risk borrowers are raked over the coals by their lenders. By eliminating the middlemen (bankers), lenders are able to get a better rate than they would get in traditional investments, and borrowers are able to get better rates than those available to them through existing channels.

The prosper marketplace is filled with a variety of borrowers trying to seduce you into funding their loan. Debt consolidators make up a large percentage of the listings. Entrepreneurs with new business ideas are another major demographic. And proving that opportunists infect every niche, A-grade borrowers will often create listings for loans to "reinvest in Prosper", a tactic a little too reminiscent of Charles Ponzi to get my vote of confidence.

Prosper provides data on loan performance for potential lenders (on their website, under Lend>Performance). Estimated ROIs average about 10% even after accounting for fees and defaults.

However, lending is not without risks. First, you have no real information on the potential borrowers other than their identity (verified by Prosper), and certain aspects of their Equifax credit report. Not a whole lot of detail for someone to whom you are about to lend your hard-earned money. Home ownership can sometimes be verified through Equifax if a mortgage is being reported. Otherwise, the rest of the information on the loan listing is self-reported, including employment, budgets, debt, and any stories as to what they are planning to do with the money. While Prosper does indeed offer a 100% identity theft guarantee, that's not much help if you are stuck with a deadbeat lender who has properly identified himself. Caveat emptor, indeed.

The online waters are always murky when it comes to financial transactions, and Prosper deserves a measure of caution. The loan listings can be dressed up a lot - tear jerking stories and pictures of children, or perhaps a 20-something coed looking for a "college loan" while dressed revealingly in her profile picture. Prosper provides areas for questions and answers, recommendations, comments from friends, and "group membership" for borrowers or lenders to band together. Since this information is not verified, it is mostly worthless, a smokescreen that distracts you from the real important stuff, the underlying fundamentals of the loan.

Keep in mind that those looking for loans on Prosper are likely not the most credit-worthy candidates. It seems that many listings are last-ditch efforts by consumers buried under mounting credit debt. Many businesses seem to turn to Prosper only when traditional lenders fall through.

Diversification is perhaps the most important aspect of lending - not just among different lenders but among different credit risks as well. A large institution can handle the risks of individual lenders by spreading that risk over the thousands of loans they provided. A small lender on Prosper doesn't have that same safety net, and a few bad selections can cause your ROI to end up in the red very quickly. Investing only in loans with 20% or greater rates exposes you to a lot of downside risk when your D-grade borrowers start defaulting. On the flip side, a vanilla portfolio of all A-grade lenders might protect you from defaulted loans, but it won't provide a return worth your while.

Back in June I funded Prosper with $500 to try the interface and get a feel for lending. In part 2 of this article, I'll give some tips for navigating the murky waters of online P2P lending and report on my first two months of grinding out a profit as a modern-day loan shark.

Jay Graziani

If you would like to make or read comments about this article, you may do so by visiting the Mess Hall forum at where a thread has been started. Please click HERE

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