To the Graduate School:

The members of the Committee approve the thesis of Charles R. Christensen presented
on November 5th, 2007.

Sherrill Shaffer
Chairperson

Gary Fleischman
Graduate Faculty Representative

Lee Sanning

APPROVED:

Robert Godby
Department Chair
Economics & Finance

Don Roth
Dean
Graduate School
Christensen, Charles R., Failure to Prosper: Risk Premia in Peer to Peer Lending,

M.S. Finance, Economics & Finance, December 2007.

Peer to peer lending is a new product available to investors. The offering allows potential

borrowers to post their request for a loan online and then lenders bid on whether to lend

money and at what rate. I analyze a 22 month history of these loans at one major site.

Thus far the default rate has been close to 8% at Prosper.com. Most of the borrowers are

subprime, making this topic a timely one. I use logit and probit estimation to show the

determinants of default. I estimate the determinants of the risk premium with OLS. This

will determine if the market is efficient in terms of return on investment increasing with

added risk.

1
 FAILURE TO PROSPER
RISK PREMIA IN PEER TO PEER LENDING

by
Charles R. Christensen

A thesis submitted to the Department of Economics &

Finance and The Graduate School of The University of
Wyoming in partial fulfillment of the requirements for
the degree of

MASTER of SCIENCE
in
FINANCE

Laramie, Wyoming
December 2007
 UMI Number: 1449789

UMI Microform 1449789

Copyright 2008 by ProQuest Information and Learning Company.
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 Table of Contents
WHAT IS PEER TO PEER LENDING ............................................................................................................. 1
POSITIONING PEER TO PEER LENDING...................................................................................................... 3
MOTIVATION AND RESEARCH QUESTIONS ............................................................................................... 9
DATA ...................................................................................................................................................... 12
MODELS ................................................................................................................................................. 17
RESULTS ................................................................................................................................................. 19
CONCLUSION.......................................................................................................................................... 24
WORKS CITED......................................................................................................................................... 28

ii
 What is Peer to Peer Lending
Peer to peer (PTP) lending is a fairly new online offering to the investment arena.

There are three participants in each loan made through this process: the investor or lender

who is willing to put her capital at risk, the borrower who is attempting to secure a loan

for herself and the PTP lending site that processes the transaction. Each loan can

potentially have multiple investors, but will have only one borrower. Currently there are

two or three sites that act as an intermediary, processing the loans and providing the

framework used by both borrowers and lenders.

The idea of peer to peer lending is that borrowers who are unable to secure credit

at conventional credit granting institutions are able to apply for a loan at one of these PTP

sites. These borrowers may be unable to get a loan due to their past credit history, lack of

credit history or the unconventional nature of the loan request. Investors, through their

market participation, have the decision on how much to lend the borrower and at what

interest rate the loan should be made. If and when the loan is fully funded, the interest

rate is bid down by lenders willing to fill the same position at a lower rate. When the

listing expires the loan is processed by the site. The principal amount is collected from

lenders and issued to the borrower. Typically the processing site takes a percentage of

the principal from the borrower, an origination fee, then takes a small percentage of each

payment that the borrower makes. The typical loan made from these sites is for between

$1,000 and $25,000. The term of each loan is 36 months and the loans amortize over that

period. No prepayment penalty exists for the borrowers. As such, a high rate of

reinvestment risk exists for these investments.

1
 Potential benefits exist for all involved parties. Borrowers are granted loans for

which they might not otherwise be qualified. Investors are potentially able to generate a

high level of return on an investment while diversifying across many borrowers. The site

is able to make money upon the prosecution of each transaction. However, like all

investments, as these markets become more efficient there should be no opportunities for

excess returns. In an efficient market, investors are only rewarded for the risk that they

assume. In the current economic atmosphere these loans may not seem like such a great

investment. Even with the backlash against subprime lending seen in the early months of

2007 by banks, investors are still issuing even riskier loans to less creditworthy borrowers

through these PTP lending sites. Due to the recent subprime market disruptions and the

resulting Federal Reserve policy actions this topic has increased relevance. A majority of

the PTP lending is subprime or lower, so this directly relates to that topic.

The information used by investors to decide whether to fund a loan includes,

among others, a grade, which is determined by the site from the borrower‟s credit score.

With this information, along with some borrower generated information such as debt to

income ratio, house ownership status and a reason for seeking the loan, the investors

make the lending decision. These loans have some uniform characteristics including loan

term, payment structure and all are unsecuritized. When a bank aggregates deposits and

makes loans, those deposits are insured by the Federal Deposit Insurance Corporation.

However, the funds invested in PTP lending are uninsured, thus the lenders are fully

exposed to the risk of default. As compensation for that added risk, borrowers are

required to pay a higher interest rate than would be necessary at a bank, if a bank would

2
lend to them. Due to this fact, a disproportionate amount of PTP lending takes place with

borrowers that are not deemed creditworthy by traditional financial institutions. While

these may be somewhat risky lending categories, the community aspect, where both

lenders and borrowers feel some attachment to the community, may keep default rates

lower than in a sterile environment.

Given that PTP lending sites provide numerous choice variables for the lender to

review prior to bidding on a listing, borrower default characteristics can be analyzed.

This paper aims to determine characteristics, which can be observed prior to default, that

predict default for a loan. These characteristics are compared to those for other types of

unsecured credit to determine if the community effect is affecting the crowd. In addition,

these same characteristics are analyzed as predictors for the required risk premium,

allowing the attachment of a risk premium to each credit grade. An analysis of whether

the risk premia being charged correlate to the added default risk is also be undertaken.

Positioning Peer to Peer Lending

While no firm product category exists for the PTP lending offering, the product

can be positioned in the market through a comparison to three somewhat similar forms of

lending. Rotating savings and credit associations (ROSCAs) exist mostly in lesser

developed countries. Microfinance also exists mostly in lesser developed countries

though the Grameen Bank has entered the U.S. market as of late 2007 (Krebsbach, 2007).

The closest comparison that the U.S. has offered to PTP lending is credit card lending.

Through a thorough analysis of each of these credit offerings the author hopes to better

position the PTP lending market in terms of its borrowers and its lenders or investors.

3
 In order to best understand where PTP lending fits in the market, the default

characteristics of the investment must be understood. A brief discussion of credit scoring

will precede the discussion of default for PTP lending. Credit scoring models have been

built on the premise that past repayment of debts is the best indicator of continued

repayment. The extant literature has uniformly shown that credit scores are indicative of

loan performance including default and delinquency (Avery et. al., 2000). Credit scores

now depend less on borrowers past credit and more on their past general behavior,

leading to the assertion that what we now have are behavioral models (Hand et al., 2003).

Credit scores are assigned based on scoring models in use by the various credit agencies.

Fair, Isaac develops models for two of the three large scoring agencies. These models

take over 100 characteristics of the borrower into consideration. However, the categories

most affecting the score include the borrower‟s payment history, income, amount owed,

amount of new credit and the mix of credit. These models are used to assign a score

between 300 and 850 to each person that has had credit in the past. A score above 680 is

typically deemed to be prime, whereas a score between 575 and 680 is subprime.

Borrowers with a score below 540 are likely to be denied credit by a traditional financial

institution (Credit Scoring, 2003). More than 50% of PTP borrowers would be classified

as subprime, with another 18% below subprime.

Table 1 shows the credit ratings and default characteristics of the U.S. as a whole

and of the PTP lending market. As the table shows, the average borrower in PTP lending

has a much lower credit score than does the traditional borrower. Also, the rate of default

4
on PTP loans is higher than the expected rate for traditional loans in most of the assigned

credit categories.

Table 1 Credit Score Characterisics

AA A B C D E HR
Score 760+ 720-759 680-719 640-679 600-639 560-599 520-559
% Population (est.) 35.00% 17.00% 12.00% 12.00% 9.00% 6.00% 5.00%
% Prosper 10.11% 9.39% 12.09% 17.09% 17.85% 15.09% 17.35%
% Pop. Default 0.20% 0.90% 1.80% 3.30% 6.20% 10.40% 19.10%
% Prosper Default 2.04% 1.19% 2.40% 2.95% 4.49% 11.14% 17.86%
Differential 1.84% 0.29% 0.60% -0.35% -1.71% 0.74% -1.24%

Sources: Experian, Fair Isaac, Prosper.com

PTP borrowers have lower credit scores than do traditional borrowers. In all categories other than C and D, PTP borrowers also have a
higher rate of default than traditional borrowers.

The higher than expected default rates on high grade loans are probably due to

information asymmetries, which are typically larger for unsecuritized loans, like those at

Prosper. The borrowers may not be truthful about the use of the loan, introducing a

moral hazard problem. If the funds are used for purposes other than specified or for

which a loan could not typically be obtained, then the possibility arises that old

assumptions about default rates for these people may be completely inadequate. The C

and D categories, which consist of the upper end of the subprime borrowers, may

experience less default because these borrowers have had some trouble in the past, but

are not past the point of recovery. They are more likely to be working their way out of a

credit mess and are truthfully using the money to help with this process. Since these

borrowers still have a credit reputation to keep, and would like to return that reputation to

a higher grade, they may be more willing to pay than the average person in that score

group. Most of the borrowers in the lowest grades have little to lose by taking another hit

to their credit rating. As such, a new loan means more money to spend just as a new

5
credit card does. These lower grade borrowers may not have the income to be taking on

this amount of debt, which will actually decrease their credit ratings subsequent to the

loan being issued. Many of these borrowers may be borrowing with no intention of ever

repaying the loan. The moral hazard and adverse selection problems in these categories

may be little understood by most PTP lenders.

Micro lending works on much the same premise as does PTP lending. While

ACCION pioneered the microfinance concept in Colombia, the Grameen Bank is perhaps

the most well known microfinance institution (Easton, 2005). The Grameen Bank uses

five person groups to help ensure repayment of a loan. They require no legal documents

but do require the group of fellow borrowers, who serve as credit counselors of sorts,

although the group makes no promise of repayment. Using this system the bank

generates a repayment rate of 98.4% (Yunus, 2007). The principal of the bank is

investing in the potential cash flow of an idea, person or business rather than basing their

decision on the collateral offered (Dempsey, 2000). Research on microfinance around

the world has proven that these low default rates persist elsewhere. In fact, microfinance

institutions claim default rates between 1% and 3% (Easton, 2005). Microfinance also

serves as a good investment in that it has a very low correlation with other marketable

assets (Krauss and Walter, 2006).

PTP lending is much like microfinance in that groups can be used to add some

credibility to the borrower. Microfinance research has shown that group monitoring

systems not only lower default rates but also ensure a better or more efficient use of the

borrowed funds (Pellegrina, 2006). Admittedly this concept is not applied in the same

6
manner, but the concept is present. PTP lending can be a type of microfinance for the

U.S. While we have typically looked at the ability of the concept to help those in

developing countries, there is no reason that it couldn‟t be just as helpful for the credit

constrained in the U.S. Easton (2005) asserts that “When financial services are available

to them, the poor, just like the rich, snap them up.” PTP lending is providing a service to

a historically underserved market, just as microfinance does. Microfinance has been

fairly successful in eliminating the problems of adverse selection and moral hazard.

Having adopted some of the same concepts we may expect that these issues may not be

as big a factor in PTP lending as they otherwise could be.

Microfinance and group lending built upon the idea of peer lending that already

existed in another type of financial institution, the rotating savings and credit association

(ROSCA). A ROSCA operates within a community of lenders and borrowers. It is a

multi period model of savings and spending. Each period the community meets and

members contribute money to a common pot. At each meeting a predesigned process is

used to determine which member will receive the pot from that meeting. The ROSCA

reduces saving time for large purchases for those members that get the pot in all but the

last few meetings. The meetings run until all members receive the pot. ROSCAs are

maintained through the group or peer lending concept. Relation to the community and

the possibility of reputational sanctions keep the group members from exiting the

ROSCA early. The system can be viewed as loans being made to those that receive the

pot early, with the lenders also being the savers that do not receive the pot until the latter

meetings. Again, default rates in this system are low due to the sanctions that await those

7
that walk away from their commitment. ROSCAs are similar in form and structure to the

early credit unions found in America (Williams, 2004).

While credit cards are issued for unspecified amounts of credit, the credit limit for

each card can be closely compared to the principal of a PTP loan. A borrower that maxes

out a credit card and defaults may be the same type of borrower that will default on a PTP

loan. Many PTP loans are also made in order for the borrower to consolidate credit

cards. As such, the loans could be seen as a method of clearing the credit cards of

balances so that they may again be spent. Ash et al. (2007) speaks of different types of

borrowers, but also the fact that the possibility exists for types to change given certain

circumstances. Thus it is possible that borrowers intend to pay their loan back but under

changed circumstances drop that intent.

Calem and Mester (1995) analyzed the credit card market and found that

cardholders with higher balances have a higher probability of default. Dunn and Kim

(1999) analyzed determinants of default in the credit card market and find that the most

important variable is the total minimum payment required to income ratio. They

explained that this is due to the fact that people are maximizing utility subject to the

minimum payment rather than their income constraint. They found this to be a better

short term approximation of default tendency. For a longer time horizon she postulates

that debt to income may work better. She also found that the remaining balance gave the

consumer an opportunity to move their payment obligations to the future. However, she

makes the assumption that this cannot go on, as it is a type of Ponzi scheme, revolving

8
balances from lender to lender. She also finds that the debt to income ratio for the

defaulting group is about twice that of the non-defaulting group.

Another important factor in credit card lending is that the loans tend to fully

season between 18 and 36 months (Ash et al., 2007). This means that in this time period

the default rates max out and level off or decline. With PTP loans we may expect to see

similar results as in the credit card industry. However, it may be difficult to tell because

only a few of the loans made by PTP lenders have been in existence for this 18 month

time period.

The literature on credit cards points to many comparisons that could be made to

PTP lending. Default rates increase with a higher level of principal. They also increase

with a higher debt to income ratio. The seasoning of credit cards typically peaks in the

18-36 month range. These findings may be similar to those of PTP lending.

Other forms of lending, such as pawn shops, may seem applicable. However, as

Easton (2005) states, pawn shops only lend to those with assets, they lend based upon the

value of the assets and collateral cannot be used to fund further business as can deposits.

Thus, only those markets that allow for lending with no collateral are examined as these

are the credit markets that most closely represent the PTP lending market.

Motivation and Research Questions

Much of America can still be categorized as developing. Thus, when we read the

research on developing nations we should constantly be thinking of how we can apply

these grand ideas to our own society. The World Bank reports that a strong correlation

exists between a lack of financial access and low incomes. Earlier research showed that

9
the presence of a strong financial system boosts economic growth and benefits the low

income population (Easton, 2005). “Families with access to credit invest more, consume

more and save less than those without access (Easton, 2005).” However, even though the

U.S. has a sound financial system, not all have access to the traditional version of that

system. This is where peer to peer lending steps up and provides an avenue for

increasing the standard of living of those that otherwise would not have access to the

financial systems.

PTP lending relies on lenders persisting for its survival. Default is the single

factor that will potentially drive lenders away. An investor with $2000 invested in PTP

loans at the average interest rate of 18.4% would expect a return of about $350 in a given

year. Given that the investor is fully diversified, lending only $50 to any borrower, and

one borrower defaults, the investor‟s return falls to $300, which represents a return of

15%. Given the average default rate of 8%, this would drop the return to 10%. Default is

an issue for all types of lending. However, with PTP lending the loans are made to

people that may be deemed un-creditworthy by traditional financial institutions, which

have become expert at default risk analysis. Again, these loans are being made to

borrowers who were unable to garner traditional loans even during the easy credit period

of the past five years. Therefore, the default rates can be expected to be higher than

forms of unsecured credit granted by traditional lenders. The subprime lending debacle

of the past few months makes this an especially relevant topic and adds to the importance

of finding the determinants of default for PTP lending. The high levels of return offered

10
investors by PTP lending are not enough to keep lenders interested; the community must

work toward a better rate of repayment.

Some of these loans may be made at artificially low rates due to the usury laws in

force in the states where the borrower resides. Table 2 shows the lending limits for each

state, some states have different limits depending on the amount of principal. Not all of

the usury laws are limiting on the PTP loans; however, some of them are, and may lower

the interest rates below what investors may otherwise demand. Investors still have the

choice of whether to lend or not; however, if they would lend otherwise the lending laws

may cause them to do so at a lower rate.

Table 2 Usury Lending Limits by State

Alabama (AL) 30% Montana (MT) 30%

Alaska (AK) 16% Nebraska (NE) 16%
Arizona (AZ) 24%-30% Nevada (NV) -
Arkansas (AR) 10.25% New Hampshire (NH) 10%-30%
California (CA) 19.2%-30% New Jersey (NJ) 16%
Colorado (CO) 21% New Mexico (NM) 30%
Connecticut (CT) 12% New York (NY) 16%
Delaware (DE) 10.25% North Carolina (NC) 30%
District of Columbia (DC) 6% North Dakota (ND) 30%
Florida (FL) 18% Ohio (OH) 25%
Georgia (GA) 30% Oklahoma (OK) 21%
Hawaii (HI) 12% Oregon (OR) 30%
Idaho (ID) 30% Pennsylvania (PA) 6%
Illinois (IL) 30% Rhode Island (RI) -
Indiana (IN) 21% South Carolina (SC) 12%
Iowa (IA) 21% South Dakota (SD) -
Kansas (KS) 21% Tennessee (TN) 11.75%
Kentucky (KY) 9.25%-30% Texas (TX) 10%
Louisiana (LA) 12% Utah (UT) 30%
Maine (ME) 18%-24% Vermont (VT) 18%
Maryland (MD) 24% Virginia (VA) 12%
Massachusetts (MA) 12%-20% Washington (WA) 25%
Michigan (MI) 25% West Virginia (WV) 18%
Minnesota (MN) 19.2%-30% Wisconsin (WI) 18%
Mississippi (MS) 30% Wyoming (WY) 21%
Missouri (MO) 30%

The highlighted rates are limiting the average borrower, and therefore limiting lenders. These usury laws may
be reducing rated for PTP lending

11
 The remainder of the paper will analyze interest and default rates for PTP lending.

A regression of defaulted loans on the available decision factors for lenders determines

which variables most affect the rates of default on these loans. Another regression of the

risk premium on those same factors determines the predicted risk premium for each loan.

These are compared to the actual risk premia to determine if lenders are demanding

enough of a default premium from the borrowers. Finally a regression of the status of the

loans on the characteristics serves as a robustness check on which factors are associated

with greater likelihood of default. The remainder of the paper is as follows. Section 4

describes the Prosper data on PTP loans and provides descriptive statistics on loan

characteristics. Section 5 describes the methodology. Section 6 provides results on

default determinants, risk premium factors, and checks of robustness. Section 7 provides

conclusions.

Data
The data used for this analysis was provided by Prosper.com, one of the first peer

to peer lending sites. The company compiles data on each loan originated. The data is

comprised of 14,100 loans, the entire history of loans made by Prosper.com prior to

September, 2007. Prosper.com provides multitudes of data; however the data used in this

analysis are presented in Table 3. The loans are broken down by age, size, and grade.

Two of the variables, debt to income ratio and the interest rate were winsorized at the

95% level as in Nissim and Ziv (2001), Dittmar (2004) and others. Winsorizing limits

the effect of outliers. A higher percentage of the loans are being made to borrowers that

are classified in the C grade or below, which represents subprime and below, than at

12
traditional financial institutions. This suggests that Prosper lenders are chasing the higher

returns associated with the higher risk of this credit class. This may be a dangerous

method to achieve the desired results. The lower grade loans have higher default rates,

which potentially leads to a lower rate of return. This may expose the business structure,

along with the investors, to a high degree of risk in the form of higher default rates.

Table 3 Descriptive Statistics

Mean σ Min Max

Age in months 7.985 4.725 1 22
Principal 6035.16 5538.06 1000.00 25000.00
Borrowing rate 18.4% 6.5% 8.0% 29.0%
Debt to Income 0.214 0.151 0.03 0.60
Loan term 36 0 36 36

A higher percentage of PTP borrowers are subprime than would be the case in a
traditional financial institution. The average loan is made for $6,035.16 at an interest
rate of 18.4% and is almost 8 months old.

For each loan Prosper uses 10 categories to describe the status of a loan. These

categories are combined to more broadly define the groupings into three categories. The

current group will hold only those loans that have been paid or are current. A middle

group will hold those loans that are late but less than four months late. The default

category, in which we are most interested, will hold all loans that are more than three

months late on their payments. Table 4 presents descriptive statistics by the three

categories.

Table 4 Loan Status at Prosper.com

Loans Paid Payoff Current Late 1 late 2 late 3 late 4+ late Default Cancel Repurch
Current 12175 1318 31 10826
Mid 931 238 258 243 192
Default 994 263 672 8 51
Total 14100

The majority of loans are still in the current category, paid off or current. However more than 7% have defaulted already, and another 7% are on the way to default in the mid
category.

13
 Table 5 displays the correlation coefficients between the variables used for the

analysis. As Table 5 indicates, none of the variables have correlations in excess of 0.50.

The borrowing interest rate is moderately correlated with a few other variables. Other

than that, there are very few variable pairs with a correlation above 0.20 and none higher

than 0.45 in absolute value. As such, the author assumes that the effects of any

multicollinearity on the regression analysis will be minimal.

Table 5 Correlation of Variables

AAGR AGR BGR CGR DGR EGR HRGR NCGR lnprin dti age_mo rate
AAGR 1.000 -0.108 -0.124 -0.152 -0.156 -0.141 -0.154 -0.034 0.096 -0.106 -0.019 -0.448
AGR -0.108 1.000 -0.119 -0.146 -0.150 -0.136 -0.148 -0.033 0.163 0.021 -0.041 -0.335
BGR -0.124 -0.119 1.000 -0.168 -0.173 -0.156 -0.170 -0.038 0.190 0.085 -0.054 -0.234
CGR -0.152 -0.146 -0.168 1.000 -0.212 -0.191 -0.208 -0.046 0.140 0.082 -0.050 -0.090
DGR -0.156 -0.150 -0.173 -0.212 1.000 -0.197 -0.214 0.016 0.016 0.095 -0.040 0.134
EGR -0.141 -0.136 -0.156 -0.191 -0.197 1.000 -0.193 -0.146 -0.146 0.000 0.090 0.368
HRGR -0.154 -0.148 -0.170 -0.208 -0.214 -0.193 1.000 -0.046 -0.358 -0.155 0.079 0.406
NCGR -0.034 -0.033 -0.038 -0.046 0.016 -0.146 -0.046 1.000 -0.093 -0.106 0.073 0.061
lnprin 0.096 0.163 0.190 0.140 0.016 -0.146 -0.358 -0.093 1.000 0.251 -0.195 -0.113
dti -0.106 0.021 0.085 0.082 0.095 0.000 -0.155 -0.106 0.251 1.000 -0.200 0.105
age_mo -0.019 -0.041 -0.054 -0.050 -0.040 0.090 0.079 0.073 -0.195 -0.200 1.000 0.055
rate -0.448 -0.335 -0.234 -0.090 0.134 0.368 0.406 0.061 -0.113 0.105 0.055 1.000

No significant correlation exists between the independent variables used in the analysis. Some of the independent variables are correlated at a somewhat higher level with %rate,
one of the dependent variables.
Where: AAGR = AA grade borrower; AGR = A grade borrower; BGR = B grade borrower; CGR = C grade borrower; DGR = D grade borrower; EGR = E grade borrower; HRGR =
high risk borrower; NCGR = borrower with no credit history; lnprin = natural log of loan principal; dti = borrower's debt to income ration; age_mo = age of loan in months; and rate =
interest rate on the loan

Of the variables to be analyzed for effect on default rates, grade, which

corresponds to a borrowers credit score, may have the largest effect; the distribution of

loans based on grade is fairly uniform. Table 6 shows an consistent increase in the

interest rate for each credit grade. This pattern holds for the other credit worthiness

variable, debt to income ratio, as well. For those borrowers that have had access to credit

markets each subsequent grade has a slightly higher DTI. The DTI for the low grade

groups are low, probably due to the fact that these borrowers are unable to attain debt

from other sources. The majority of the loans were made to borrowers between C credit

and high risk credit.

14
 Table 6 Descriptive Statistics by Grade

Grade Loans Principal Rate DTI

AA 1426 8212 9.68% 0.167
A 1324 9152 11.60% 0.224
B 1705 8647 14.27% 0.249
C 2410 7156 17.09% 0.242
D 2517 5627 20.26% 0.245
E 2128 3920 24.07% 0.214
HR 2447 2632 24.15% 0.163
NC 143 2325 22.30% 0.055

A majority of the loans fall into the subprime category, where interest rates
are high, but default rates tend to be high as well. The shaded area
represents the subprime and lower loans.

Another important variable to analyze is age. The default structure over time

should give insight as to the default rates that will prevail in the long run, as there is

currently not enough data to show the true default rate. The loans are not yet fully

seasoned; thus, the observed default rate may be misrepresentative. One point that must

be made is that the oldest loans in this data set correspond to the age of the company.

Not many loans were made in the first three months, which may have some effect on the

data for that period. Table 7 shows the profile of the loans made in each month since

Prosper.com started their business. Following Table 7 are Figures 1 and 2 which give a

picture of how the site has grown and how interest rates and default rates have changed

through time. The growth in loans processed is beginning to slow and in fact is leveling

off. After the initial period in which lenders did not take much risk, the default rate and

interest rate jumped.

15
 Table 7 Descriptive Statistics by Age

Mo. Number Principal Rate DTI Default

1 980 6730 17.88% 0.225 0.00%
2 936 6903 17.51% 0.234 0.00%
3 953 7413 17.97% 0.246 0.21%
4 1070 7201 17.86% 0.256 0.00%
5 1101 8010 17.79% 0.257 0.36%
6 1161 7008 17.23% 0.244 1.89%
7 906 6166 18.16% 0.215 5.19%
8 1020 6140 18.63% 0.218 7.35%
9 969 4650 19.16% 0.204 8.57%
10 701 4731 19.60% 0.212 11.70%
11 743 5107 19.63% 0.197 15.07%
12 615 5117 19.80% 0.198 12.52%
13 772 5080 19.91% 0.186 16.19%
14 551 4268 19.23% 0.170 14.70%
15 521 4108 19.25% 0.159 18.43%
16 461 4531 18.17% 0.145 14.10%
17 294 5216 17.90% 0.148 19.73%
18 241 4495 16.73% 0.135 22.82%
19 75 6106 12.78% 0.112 12.00%
20 8 5640 9.13% 0.165 12.50%
21 9 3432 8.38% 0.049 0.00%
22 13 3677 11.69% 0.099 0.00%

This table shows the characteristics of the loans made in each month since Prosper.com
began their business. The number of loans issued is beginning to level off.

Figure 1 also shows that the default rate is low for new loans, indicating that borrowers

begin to default around the fifth month of the loan. The default rate increases from there.

As can be seen, the peak of default is at approximately the 18th month, similar to the

results for credit card lending documented by Ash et al. (2007).

16
 Figure 1
Age of Loans in Months
1400

1200

1000

800

600

400

200

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Figure 2
Changing Interest and Default Rates
25.00%
Default Rate Interest Rate

20.00%

15.00%

10.00%

5.00%

0.00%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Models
Two separate regression models test different aspects of lending behavior and

performance. A third model will extend the first and serve as a check on robustness.

17
First, a logit regression will be run in order to determine the effect of the various

variables on loan default, the model used for the regression is:

PR( Default) AAGR AGR CGR DGR EGR NCGR DTI principal age _ mo
1 2 3 4 5 6 7 8 10

Marginal effects of the model are estimated at the mean of each variable to determine the

effect on the probability of default. The logit model will determine the percentage

change in the probability of default when there is a one unit increase in the variable under

analysis.

An ordered probit regression will be used to refine the results from the original

logit regression. This regression will take the following form:

Status AAGR AGR CGR DGR EGR NCGR DTI principal age _ mo
1 2 3 4 5 6 7 8 10

Again, marginal effects calculated at the means will be used to determine each variables

effect on status. This will show how the independent variables affect the status of a loan.

The status categories to be used in the regression will be in the following order: paid,

payoff in progress, current, late, one month late, two months late, three months late, four

or more months late and default. The cancelled and repurchased status categories have

been omitted due to the inability to rank them.

Finally, OLS regression analysis of the various explanatory variables on default

rates will be used to predict what risk premia should be given the current loan profiles.

The model used is:

Risk Pr emium AAGR AGR CGR DGR EGR NCGR DTI principal age _ mo
1 2 3 4 5 6 7 8 10

Risk premium is the interest rate on the loan less the one year constant maturity t-bill rate

for the day that the loan was issued. This regression will provide a predicted risk

18
premium from which a comparison of the actual premia to analyze market efficiency is

made.

Results
The results of the logit regression are presented in Table 8. This shows the

maximum likelihood estimates as well as the marginal effects calculated at the mean of

the variable under analysis.

Table 8 Logit Output Marginal Effects

β σ T Marg β Marg σ
AA grade -10.476 0.587 -17.86 -0.575 0.660
A grade -9.889 0.575 -17.21 -0.543 0.623
B grade -9.668 0.558 -17.31 -0.531 0.609
C grade -9.402 0.537 -17.52 -0.516 0.592
D grade -8.823 0.519 -17.01 -0.485 0.556
E grade -7.882 0.498 -15.84 -0.433 0.497
HR Grade -7.038 0.471 -14.94 -0.387 0.443
NC grade -6.436 0.502 -12.81 -0.354 0.405
ln (Prin) 0.404 0.058 7.03 0.022 0.025
DTI 0.201 0.283 0.71 0.011 0.013
Age_Mo 0.236 0.009 25.73 0.013 0.015

The table shows that all grades have a negative effect on default. The remaining variables,
principal, debt to income ratio and age, have a positive effect on the probability of default. σ
is the standard error of the coefficient β. Marg σ is the measure of the standard error of the
marginal effect Marg β.

The interesting outcome of this analysis is that the borrowers with no credit (NC)

are indeed the most likely to default, yet lenders are willing to lend to them at lower rates

than high risk (HR) borrowers or E grade borrowers as shown in Table 6. This may

indicate that lenders are naïve, or it may show a social lending aspect of PTP lending,

where lenders may be interested in helping the borrowers with their troubles rather than

merely profiting from an investment. Available data cannot distinguish between these

two possibilities, although the fact that PTP lending is a new product might suggest a

possibility of the former.

19
 The debt to income ratio (DTI) proved to be insignificant in this regression. The

data show why this may be the case, since the HR and NC borrowers are actually at lower

levels of DTI than the A borrowers. This leads to low levels of default being associated

with low levels of DTI for the high grade borrowers as well as low levels of DTI and high

levels of default for the lower grade borrowers. The credit card literature found that the

default group had an average DTI nearly twice that of the non-default group. If this were

the case at Prosper.com, DTI would have much more explanatory power.

Higher levels of principal lead to higher default rates. The natural log of principal

was significant, showing that principal had some consequence even after taking into

account the effects of the different grades. Higher levels of principal give the borrower

more incentive to default, producing a larger gain by doing so. This is the root of the

adverse selection and moral hazard issues present in any lending situation. However,

these issues are even more prevalent in PTP lending because it is nearly impossible for

the lender to monitor the actions of the borrower. As such, these loans can become much

like a credit card, where the borrower spends the principal and forgets about it.

The most significant effect comes from the age of the loan, an effect known as

loan seasoning. New loans nearly always begin repaying on schedule even if the

borrowers are very risky and ultimately default. Only several months after origination do

delinquencies and defaults typically begin to show up. This effect was shown in Figure

2, where the default rate on the loans is close to zero for the first five months of a loans

existence then grows drastically from there. None of the loans at Prosper.com have

20
reached maturity yet, so additional seasoning may ultimately reveal higher default rates

for some of these loans.

In addition to loan seasoning the age of the company could be affecting the data

in an unknown way. This effect, known as product seasoning, is due to the fact that the

company is still very young. In fact, there has not even been one full cycle of 36 month

loans observed. This will make it difficult to distinguish between loan seasoning and

product seasoning, as they could potentially have the same effects on the data. The

company and product have seasoned over the same period of time as the oldest of the

loans issued, which also corresponds to the time period of this data set. As such, there

may be some undeterminable effects caused by these two phenomena.

Table 9 Status Probit Model

AAGR AGR BGR CGR DGR EGR HRGR NCGR lnprin dti age_mo
Paid 0.237 0.197 0.171 0.143 0.116 0.057 -0.015 -0.089 -0.038 -0.034 -1.5E-03
Payoff 0.004 0.003 0.003 0.002 0.002 0.001 0.000 -0.001 -0.001 -0.001 -2.5E-05
Current 0.058 0.048 0.042 0.035 0.028 0.014 -0.004 -0.022 -0.009 -0.008 -3.7E-04
Late -0.028 -0.023 -0.020 -0.017 -0.014 -0.007 0.002 0.010 0.004 0.004 1.8E-04
1 mo late -0.032 -0.027 -0.023 -0.020 -0.016 -0.008 0.002 0.012 0.005 0.005 2.1E-04
2 mos -0.033 -0.027 -0.024 -0.020 -0.016 -0.008 0.002 0.012 0.005 0.005 2.1E-04
3 mos -0.028 -0.023 -0.020 -0.017 -0.014 -0.007 0.002 0.010 0.004 0.004 1.8E-04
4+ mos -0.041 -0.034 -0.030 -0.025 -0.020 -0.010 0.003 0.015 0.007 0.006 2.6E-04
Default -0.136 -0.113 -0.098 -0.082 -0.067 -0.033 0.009 0.051 0.022 0.019 8.6E-04

Breaking the status of a loan into more categories shows us that the low categories are less likely to be paid or current and are more likely to be late. The remaining categories, including
E, which includes all subprime categories, are more likely to be in the current category or better than in the late or default categories. Principle, DTI and age have a negative effect of the
current or better categories and a positive effect on the lesser status categories.

Again, the probit model for status serves to refine the results of the default logit

model. Table 9 shows the results of the status probit model. The table shows how each

variable affects each status of a loan individually. We see that while all grade variables

had a negative effect on the default variable, the bottom two grades actually have a higher

likelihood of being late status or worse. Principal, debt to income ratio and age have a

negative effect on probability of a current or better loan and a positive effect on being late

or worse. This is in complete agreement with the default model where these variables all
21
had a positive effect on default. The status probit model confirms and clarifies the results

of the default logit model.

Table 10 Risk Premium Model

β σ T P
AAGR -0.1118 0.0040 -28.00 <.0001
AGR -0.0985 0.0041 -24.21 <.0001
BGR -0.0730 0.0040 -18.08 <.0001
CGR -0.0415 0.0039 -10.53 <.0001
DGR -0.0061 0.0038 -1.58 0.115
EGR 0.0386 0.0038 10.30 <.0001
HRGR 0.0482 0.0036 13.45 <.0001
NCGR 0.0363 0.0047 7.67 <.0001
lnprin 0.0176 0.0004 39.68 <.0001
dti 0.0467 0.0022 20.84 <.0001
age_mo 3.9E-05 7.0E-05 0.56 0.5729

This table shows the results of the risk premium regression. The D grade
and age variables were insignificant at the 95% level. The highest five
grades decrease the risk premium, while the rest raise it. This regression
had an r-squared of .9361 showing that the explanatory variables do a fine
job of explaining the risk premiums.

The results of the risk premium regression are shown in Table 10. As shown in

Table 6 the higher graded loans are funded at a lower interest rate. Increasing principal

increases the risk premium, which may be due to the high levels of information

asymmetry and moral hazard. The lenders are unable to determine if the borrowers are

honest people and what their intent is with regard to the loan. As such, a dishonest

borrower may look to take the largest possible loan to benefit more from the „free

money‟. A higher debt to income ratio also causes a higher risk premium for the

borrower. As can be expected, the age variable has an insignificant effect on risk premia,

since the interest rate is set at the beginning of each loan and all loans have the same

original maturity.

22
 This regression has an r-squared of .9361, showing that the risk premia of the

loans are well explained by this model, and in fact the model provides a tighter fit than

standard theory may predict. The t statistics on the variables are of a great magnitude as

well. The dummy variables for the grades were very significant along with loan size and

debt to income ratio. This indicates that the lenders decision is probably based almost

entirely on these choice variables. The lack of significance in age helps to answer the

question of whether loan seasoning or product seasoning is affecting the data. As age is

largely insignificant we can assume that loan seasoning is the main driver and product

seasoning is not as much of an issue. The overall fit of the regression indicates that the

lenders are using all available data to make their decision, indicating that the lenders are

fairly sophisticated.

Table 11 Comparison of Predicted and Actual Risk Premia

AA A B C D E HR NC
Predicted Risk Premium 5.44% 6.19% 8.64% 11.46% 14.58% 18.41% 18.67% 17.26%
Actual Risk Premium 4.74% 6.66% 9.33% 12.16% 15.31% 19.09% 19.17% 17.28%
Difference -0.70% 0.48% 0.70% 0.70% 0.74% 0.68% 0.51% 0.02%
Predicted Grade Premium 0.75% 2.45% 2.82% 3.12% 3.83% 0.26% -1.41%
Actual Grade Premium 1.92% 2.67% 2.82% 3.16% 3.77% 0.09% -1.89%
Default Rate Increase -0.85% 1.21% 0.54% 1.54% 6.65% 6.72% 17.81%
Extra Premium Charged 2.77% 1.46% 2.28% 1.61% -2.88% -6.63% -19.70%

Predicted risk premia were calulated using the grade coefficient from the regression along with the principal and dti coefficients multiplied by the average of those
variables for the given grade. While none of the differences (actual risk premium - predicted risk premium) are statistically significant at the 95% level, they may be
economically significant. The remainder of the table shows the predicted premium between grades compared to the actual value. The increase in default rate between
grade is thensubtracted from the grade premium to find the extra premium being charged by lenders. These premia will be examined further in Table 12.

Table 11 shows the difference between the predicted risk premia using this model

and the actual premia being charged for each grade. The data show that investors are

making fairly accurate decisions regarding the rates that they charge, given the limited

information, as none of the risk premiums are statistically different from the predicted

premiums. However when we compare the premiums being charged for each successive

grade to the increase in default for that grade a different story emerges. The increase in
23
risk premium should equal the increase in default rate, as default risk is the only risk that

varies between grades. Investors are overcharging all but the lowest of the subprime

borrowers and below, as indicated by their charging a higher premium between grades

than is necessary to cover the additional default risk. This is probably due to

inefficiencies in the market, with lenders being unwilling to lend at lower rates. The rates

for the riskiest of borrowers are far too low, to the point of being unprofitable and

unattractive for risk averse or risk neutral investors. This is probably due to the usury

laws in inexistence in the borrowers‟ states. An examination of return on investment in

Table 12 will discuss this further.

Conclusion
Even though PTP lenders are pricing the lower grade loans higher, they may not

be charging enough of a premium to cover their default exposure. With the current levels

of default the lenders are bound to lose some of their return due to high default rates. If

the rates are not high enough this may cause some of the lenders to abandon the site

entirely. These high rates are enticing to any investor, especially when so much

diversification is available. However, default is a real problem for PTP lending and will

continue to be so. Table 12 shows the anticipated rates of return given the current default

rates.

24
 While these returns on investment (ROI) seem very reasonable given the current

economic conditions, the danger exists to lenders that default rates will continue to climb.

These loans are not fully seasoned; when the ultimate default rates are truly known the

ROI on these loans may be far lower than it currently is. The borrowers have the ability

to make Prosper.com a workable business, not the lenders. If the borrowers are true to

their promises and default stays at a relatively low rate then Prosper.com will thrive. If

not, the business model will fade away due to an inability to fund loans.

The differentials for the lower grades are too great; lenders are being too easy

with their credit. One explanation for this could be the usury laws governing these loans.

These usury laws could be biasing the interest rates downward. However, if this is the

case then the lenders should choose not to fund the loans for the three lowest categories.

Given this solution loans will not be made, by a risk averse or risk neutral investor, to any

borrower with credit E grade or below. As fully one third of all loans have been made to

this group, the future of the business model would come in to question. Borrowers with

D grade or better credit can typically borrow from traditional financial institutions and do

not need PTP lending.

25
 Default rates are too great for PTP lending to be a viable business under the

current circumstances. A risk averse or risk neutral investor will lend only to borrowers

that are above grade D. These borrowers are not the ones that need this product offering

the most. The lower grade borrowers simply have too high a default rate to attract a

knowledgeable investor. Given that more than one third of loans are being made to

borrowers in these categories, the investors must either be risk loving or there are other

factors at work within the framework. The social lending written of above would help to

explain why the lower grade borrowers are still being funded.

However, unless the issues with the lower grade borrowers are addressed the

business model has a high likelihood of failing. In the U.S. most everything comes to

money. The low grade loans are not making the type of money that they need to be in

order to survive in a truly capitalist system. PTP sites need to build a more tight knit

community to attempt to introduce ROSCA and microfinance type default rates for these

low grade loans. The current group forming structure is superficial. The groups need to

be actually monitoring the activities of the members, not merely giving them an upfront

sponsorship.

This could be accomplished with a social network type framework. Other

solutions might include having borrower groups that are responsible for each others

payments. This would encourage groups to form only between people that can depend

upon one another. The balance of a first loan could be limited so that the community has

the opportunity to see the borrower in action. Group leaders could be held responsible

for the credit of the group members; not necessarily financially, but within the

26
framework. Installing some of these improvements may help to lower default rates,

allowing the business model to prosper. However, without intervention of some sort, the

data seem to suggest that PTP lending is an unneeded service. The bottom line seems to

be that banks have a reason for not lending to borrowers below subprime, and for

charging very high interest rates to borrowers with no credit history. Why should lenders

believe that they are able to do something that banks have not found a profitable method

of achieving throughout thier history?

Future research may want to address some of the following. Prosper records data

on whether the borrower is a homeowner or not; this may be a good explanatory variable

that will extend this analysis. Borrowers also report a reason for taking the loan. This is

in a narrative format and there is no standardized form; as such, it would be quite labor

intensive to pin down. However, this may have a strong relationship with default rates;

as some loans are being made for purposes for which people could not borrow money in

the past. Probably the best extension would be to use continuous credit scores rather than

the arbitrary grade buckets defined by Prosper. This would be a powerful measure of

whether clustering is occurring with borrowers lumped into the same category. The data

for this extension may be difficult to obtain. The author attempted and Prosper denied

the request, citing the fact that it is proprietary data.

27
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