P2P Lending & P2P Loans

One of the most often misunderstood issues I see popping up on the official forums with some frequency is that of reinvestment risk. To be absolutely clear, the kind of “reinvestment risk” that I’m referring to here is that which is taken on when good borrowers make their payments or pay off their Prosper loans (remember that there are no prepayment penalties) - and lenders are, naturally, put into the position of having to attempt to re-deploy that money into a new loan (or new loans).

• As Prosper offers no interest on deposited funds at this time, having funds repaid puts the lender in the situation of earning zero return on those dollars (and having to find new loans to fund). This causes a (usually small) period of dead money, while lenders wait to find a new listing that they feel comfortable bidding on (or wait for their SO to do the same).
• In addition to the selection time involved in finding a new listing, one must also wait some number of days for that new listing to close. So, now you’re looking at 2 (business) days of undeployed funds while your borrowers payment (or payoff) clears, plus X amount of time for selection of a new listing to invest in, plus X number of days for that listing to close, plus X number of times you have to repeat this process in the event that you are outbid from your selection(s) or in the event that your selections do not fully fund.
• Add to this another 1-7 days (usually somewhere around 5 days, on average, currently) for Prosper to verify the borrower’s details (post-auction) and actually originate the loan. You don’t make any money during this downtime either - and there’s no guarantee that the borrower will pass verification. In the event that they don’t, you’re back to step 1 again.

In my opinion, the above issues (aside from the issue of Prosper not providing some sort of investment vehicle which offers interest on unlent funds - the desirability of which they ARE painfully aware) are marginal, in the grand scheme of things, and not really worth worrying about given the likely small amounts of both money and time involved. However… there are some follow-on issues which I do believe are worth giving some serious consideration:

• Defaults occur unevenly in time. That is to say: Defaults occur at different points during the lifespan of any particular loan. If a loan defaults in month 30, you will suffer less of a loss (maybe even still managing to make a small profit, depending on rate) than if a loan defaults in month 3.
• Since defaults occur unevenly in time, it is instructively necessary to plot aggregate loan performance data in order to get some rough idea of the default behavior we should expect over the life of the average 36-month Prosper loan.
• Plotting this data yields us a “default curve”. The default curve is simply a visual representation of the behavior (over time) of Prosper loans. We look at the totality of the loans made in the marketplace (though you can certainly be more specific, if you’d like) and say “x loans defaulted in month one, y loans defaulted in month two, etc”, all the way up to 36 months, and then present this information in “bar graph” format. We then fit a single line to connect each peak on the graph in order to form a curve. Basic stuff.
• You may find it helpful to think of this curve as something like a “roller-coaster”. Every new dollar (and every reinvested dollar) that you invest in a Prosper loan can be thought to follow this curve, from origination at month 0 to payoff at month 36.
• Keep in mind, though, that there’s no “safety restraint” holding individuals borrowers to their seats: borrowers may pay early or pay off their loan entirely, at any point and with no penalty (ie, they may jump out of their “car” at any point during the ride). They may also default at any point in time.
• When reinvestment is necessary, either because of borrowers making their normal payments or paying off early, the dollars that you have invested with them (that they have just repaid) are sent to get back in “line” and to be reinvested into a new loan (”to go for another ride on the Default Curve Express”).
• Why does that matter? It matters because, just as with a roller coaster, some parts of the default curve are more dangerous (or “exciting”) than others. We only have approximately six months worth of viable data at this point, but there is already a clear initial incline (just as many roller coasters start by pulling you up to some height) - an incline which, it is hoped, will be followed by a distinct drop and levelling off (of defaults).
• Let me say that in another way: If, for example (and I’m not saying this is the case, it’s still too early to tell), the first six months of a loan are when it is most at risk for defaulting, then, each time you have to reinvest repayments into new loans, you are forcing those dollars not only back “into line” (and into the delays mentioned above), but also, once the new loan originates, those dollars will be travelling the riskier initial parts of the default curve. (ie, your dollars were tooling along in the virtual flats, post loop-de-loop, of the latter parts of the ride, coming safely back into the station - but, a few bucks decided to get off early, and now they get to start over and do the “fun” parts again).
• When you take this default curve behavior into account, you are able to approximate the risk differential (or expected return) between a loan aged, say, 3 months (still travelling the dangerous first parts of the ride - with plenty of track left to cover), and a loan aged, say, 30 months (that has already successfully passed most of the risky parts of the curve - and therefore presents less of a risk).
• Quantifying this risk is difficult, due to the lack of historical data. But, it is a safe bet that there will be parts of the curve that are more risky than others - perhaps substantially so.
• Though we can’t extrapolate out very far from the data that we do currently have, there are, at least, some hypothetical assumptions (probable psychological effects) that may come into play and give us some idea of what to expect (such as a possible slope in default behavior toward the latter part of the life of a loan, perhaps driven by something like a “no sense ruining your credit now that you’ve only got six payments left to make” or an “almost-there” effect). That kind of thing is exceptionally hand-wavy and uncertain, but it does underline the uncharted-ness of the territory, and the lengths one has to go to in order to “guess”.
• The indisputable, and non-hand-wavy, fact, though, is that subjecting repaid funds to another go on the 36-month default curve roller coaster incurs an increased level of risk for those funds. We might not know exactly what it is yet, but it’s certainly there…
• The fear that follows from this uncertainty is thus: That good borrowers will make their payments on time or pay off early, and that, since the “good” borrowers return funds to us that must be reinvested (and since the bad borrowers do not return some percentage of funds to us), that there may be an amplification of negative effects. Since our money is so often made to travel the riskier parts of the curve - and, since it is therefore, much more often than we would like, exposed to new borrowers in new loans - it is therefore to exposed to the higher risk of default/loss. Couple that with the fact that at the beginning of a loan we have the most outstanding principal, “good money”, at risk (exposed to the entirety of the “risk track”) and you begin to see why this may become a non-negligible issue in the long-term (and one that should certainly be watched in the short term).
• In particular, if loans that will default will also tend to default early in the life of the loan, then we may find ourselves open to losing larger (initial) amounts of principal at an increased frequency (increased, at least, from the frequency that one might think if one considered only “default rate” in their risk calculations).