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August-16-2007,
Rolling the Dice with Online Lending at Prosper.com (Part II)...By Jay Graziani

Last article introduced you to lending on Prosper.com, the online marketplace for small-value loans. I sent $500 to Prosper 6 weeks ago to give it a test run. Here's what I found about online lending.

Discretion is the better part of valor, at least when it comes to online lending. While Prosper does provide some verification of borrowers' identities, the information you get is minimal. With thousands of listings available at any time, it pays to be picky. Something sound funny about the listing? Skip it. Seems like maybe a borderline investment? Move right on to the next listing. Keep your criteria high to avoid getting stuck in a bad loan.

Particularly, pay little attention to any of the "self-reported" information. This includes budgets, the reason for seeking the loan, explanations of "errors on the credit score", and any cute pictures the borrower might include. Also be hesitant of anything in the "Endorsements from Friends" or "Questions and Answers" sections, as these can easily come from unverified, anonymous accounts. The "Groups", set up to foster a further sense of trust, often seem more like slicksters trying to push risky loans for their meager cuts of the profits. Anyone making a cut on the transaction should probably not be counted on to provide an unbiased opinion. The bottom line is that you have a limited amount of verified data to deal with (most importantly, the credit score), and that's what you should focus on.

Because of these risks, diversifying across your loans is key. Look to spread your investment among as many lenders as possible, to prevent one big default from destroying your bottom line. The minimum bid on any listing is $50. I don't see much reason to bid more than the minimum on any single listing. The information at your disposal is limited, and tying your money up in 100 $50 loans is much safer than 5 $1000 loans.

You should look to diversify not just across lenders, but also across credit grades. Just as your investment portfolio should be diversified among stock and bonds in different risk categories, at Prosper you should look for a mix of borrowers, some providing a safer investment at low rates, and others providing a riskier but more profitable loan. You should also probably avoid any borrowers with less than "D" credit - the maximum rate of 25% through Prosper is likely not worth the downside of taking on high-risk lenders in a mostly unregulated environment. Manage your portfolio to minimize your risk while still providing an acceptable rate of return.

Chasing after subprime loans can quickly lead you into trouble. If it seems too good to be true, you just might want to pass on it. Keep in mind that many borrowers turn to Prosper because they can't get a reasonable loan elsewhere. Sub-prime lenders got that way for a reason, and the risk of default is high. While adding a few high-risk loans to your portfolio is reasonable, make sure to limit your downside risk to an acceptable level.

When browsing ads, limit yourself to those closing soon. I usually restrict myself to those closing within 24 hours. Like most auctions, getting in too early is a waste of time -- listings can be withdrawn or voided, rates can be bid down dramatically, or there might not be enough interest from other lenders to fill the whole loan. Focusing on listings that expire soon and are mostly filled (90% funded or better) narrows down the amount of sifting you have to do and focuses your attention on those listings most likely to result in an actual transaction. Many listings will never be funded, so why bother reading them? There is little advantage to getting in early anyway. Narrowing your search criteria in this way dramatically frees up time better spent looking more carefully into individual listings.

Another important principle applies here as much as it does to other auctions - don't chase a losing bid. The auction process is great at getting buyers (lenders) to think they are missing a great deal, inciting them to raise their bid to keep a good deal from slipping away. Prosper will send you emails telling you when you are outbid. Ignore them. When you make your initial evaluation of a potential loan, set your target price, enter your lowest acceptable rate, and ignore it from there.

If you have come in with strong evaluations, then stick to your guns and let losing bids pass. There are plenty of lending opportunities available daily, so resist the temptation to give up a little of your target price just to get a loan filled. When bidding, set your minimum bid high, at a rate you feel is too good to pass up. If you get outbid, there are plenty of other options out there.

In the six weeks that I've been a Prosper.com lender, I've made seven loans and pocketed a cool $4.11. A true grind to say the least. Yet, I am sitting on an average return of better than 16% if it all pans out. As they say, "slow and steady wins the race", and Prosper certainly has the potential to provide a return better than your local bank's money market account, at least for a small part of your investment portfolio, provided you have the patience and risk tolerance to make it work.

08-16-07
Jay Graziani
MajorWager.com
graziani@majorwager.com

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