Democratizing Finance @ Prosper

BY KENNETH CLINE

Prosper CEO Chris Larsen says the current credit crisis helps his company by attracting better quality borrowers and lenders.

|SYNOPSIS | Chris Larsen, CEO and co-founder of Prosper Marketplace Inc., says person-to-person (P2P) companies such as his have the potential to "democratize" finance over time by using "servant infrastructure" to reduce the role of financial intermediaries, such as banks. But Larsen also eschews anti-bank rhetoric in favor of a tight focus on improving Prosper's product, which is the facilitation of loans between private individuals. He says the recent credit crisis has helped Prosper by driving more high-quality credit borrowers and lenders to its Web site.

Does person-to-person (P2P) lending have what it takes to go the distance' Prosper Marketplace Inc. is about to find out.

As recession fears loom amid a deepening credit crisis, San Francisco-based Prosper has seen defaults soar on its own subprime loans. But CEO and co-founder Chris Larsen says that's not the whole story. As he explains in the following interview with BAI's Banking Strategies, San Francisco-based Prosper has found that the contraction in traditional bank credit has actually driven higher-quality borrowers and lenders to Prosper's Web site.

“We think the credit crunch is broadly positive for us, an opportunity for us to show a different kind of market, one that’s more transparent and direct,” Larsen said. “That message will resonate in this kind of environment.”

Prosper doesn’t underwrite the loans it offers on its marketplace but rather, like eBay, earns a fee for facilitating the transactions between individuals. Its business model depends on providing lenders with an attractive spread on the loans they agree to fund and the borrowers with a lower cost-of-money than they could get from traditional sources, such as banks.

Larsen, who previously headed another Internet lender called E-Loan Inc., has learned from the 2000 dot com crash not to over-promise what can be achieved with the Prosper business model. No “we shall bury banks” rhetoric from him. But he does think P2P companies, by functioning as “servant infrastructures,” represent the leading edge of a “democratization” of finance that could, over time, reduce the ability of banks to earn spread income.

It’s a bold concept. But if Prosper and its peers such as Zopa, Lending Club and Virgin Money USA can go the distance, it’s one bankers will increasingly need to keep an eye on.

Q: Do you consider yourself to be a maverick in financial services? Is Prosper Marketplace Inc. a conscious attempt to build a new financial services model? 

Larsen: Finance is uniquely connected to policy and regulation, so change takes longer. But there’s no question that a big change is occurring in finance, just as in media and entertainment, and generally, that change is going to be good for people. It’s going to democratize the economy, which will be fun to be part of.

In the early days with E-Loan, we took a more strident, anti-bank view. As we move forward, that’s kind of irrelevant in a way because that view doesn’t really build anything. In fact, with Prosper, we take more of an infrastructure viewpoint. If servant infrastructures are going to take over, then our role is to be more of a servant infrastructure.

Q: A servant infrastructure?

Larsen: That means it’s not really up to us to dictate the change but to build the tools and the technology so that people can do what they want and take control of the process. We just need to watch over it; make sure it’s safe and regulatory-compliant as we build the tools. That kind of welcomes banks to the process as well.

In the early wave of the Internet, there was a little bit too much bluster about “killing the incumbents” and all that kind of stuff. At the end of the day, those are just words. You have to watch out for the kind of chest thumping that says, “We’re the smart tech heads out here who have all the answers.”

Hopefully, in this boom, people are a little more humble and focused on product. The last Internet boom was focused on marketing but in this boom marketing actually comes last. What matters at the end of the day is how many new technology iterations you got out in the last three months. It had better be two or three or you’re falling behind. You’ve got to get the best engineers. And your team had better be half engineers at this point and not half marketing people.

Out of the ashes of the 2000 crash emerged companies like Google, which had their heads down and were focused, unlike the guys doing the big sexy deals like AOL/Time Warner.

Q: At various times, you’ve described Prosper as the ”eBay for money and credit” and also as an “Internetcredit union.” What model have you been following and how has it evolved?

Larsen: The eBay-for-money idea was attractive initially. E-Loan was actually half that equation in that we offered customers improved access to the mortgage product. But we didn’t have the other side of the change. We were still selling to warehouse lenders and getting lines of credit and selling to the capital markets. So you had all those constraints. It was kind of frustrating in a way, but the reality is there was no way to do an eBay-for-money back then. The technology just wasn’t there.

At the same time, the credit union analogy seemed appealing. It’s about people banding together and helping each other. Where does the money come from? It comes from your neighbor. It’s a model where money and credit go be-yond cold hard facts; where you have social ramifications. It’s also imbedded with policy, politics and regulation, which is why I think the finance revolution will take longer but also why the implications are much more powerful.

What’s cool about the Internet and technology is that we can bring back all the stuff we idealized about credit unions, the early building and loan societies—the “George Bailey ideal” from It’s a Wonderful Life. You can bring that together with diversification, liquidity, risk management, all the things that capital markets actually do well, but whose structure has killed the social goodness component.

Capital markets are super efficient, super liquid, but they’ve put so many layers between buyer and seller. People have lots of motivation to move the product, but no responsibility for what happens to it, which is a total moral hazard. With collateralized debt obligations (CDOs) and structured investment vehicles (SIVs), and all that alphabet soup out there, you don’t even have the connection between the investment and the asset anymore.

Q: What lessons should bankers take from these changes occurring in technology and society?

Larsen: I would think more about servant infrastructures. That’s a big part of this particular Internet wave. E-Loan was a tech company, but it was very traditional. At the end of the day, it was still us dictating the product to the consumer. One of the lessons of the last boom is that it’s really more about building the tools than pushing product down. You can see that in companies such as eBay, Craigslist and YouTube. At Prosper, we’re just the infrastructure, more like a telephone exchange.

It seems like banks have a little bit of both worlds. They definitely are infrastructures, being tied to the Automated Clearing House (ACH) and international money-moving systems. But then, they’re also traditional product pushers as opposed to getting their customers a little more engaged.

In finance, this is the great unanswered question. There’s definitely a reward for democratization in entertainment and in media; no one’s fighting that trend anymore. But does that social democratization you see in entertainment bleed into things like finance, health care, energy or food?

I believe the answer is yes, but if you’re a bank executive, you can ask whether it’s like television phones, which never really happened. That’s kind of the dilemma of established companies—and why it makes it easier for companies like ours.

The bank model is based on spread. And my personal belief is that in the future you won’t be able to make money on spread anymore. At Prosper, anybody with money can make loans; they don’t have to give their money to somebody else as deposits in order to participate in lending.

Q: Prosper facilitates the transaction, which generates afee, but you don’t actually earn the spread, correct?

Larsen: That’s right. We take a fee on the transaction just like eBay would. I think everything’s going that way because owners are empowered. The agent who has the property of the owner shouldn’t be able to make a profit on it. They’re only making a profit on it because the owner has been prevented from doing it.

Q: What is the profile of your typical borrower and lender and what are they trying to achieve?

Larsen: Borrowers are really typical middle Americans and they’re spread all over the country, with income in the $50-70,000 range. They’re split fairly evenly male/female and their objectives are mostly to replace credit card debt or replace more expensive debt. The second objective is to start a small business or fund a small business. Their motivations are mostly to get a lower rate on the loan.

Lenders tend to be heavily male, with slightly higher incomes, in the $50-100,000 range. They also tend to be younger, 25 to 35 years old, compared to a 35 to 55 skew for borrowers. I don’t know if that’s because younger folks are more comfortable trading their money. The motivation for lenders is mostly to make a good return on an asset class, imbedded with some sense of achieving a social good.

Q: Can Prosper be viewed as a place for people who can’t get bank loans?

Larsen: That was definitely the media’s narrative when we started: “Now people with bad credit can get loans from other people!” That really wasn’t our message.

We’ve seen a dramatic change in credit quality, for the better, which I interpret as the market adjusting. For example, prime borrowers now account for over 40% of funded loans on Prosper.

Also, we’re giving a lot more guidance and can present more data. Toward the end of last year, we noticed a sense of the market going mainstream, with more prime borrowers coming to Prosper and some competitors coming into the category. Over $120 million had been funded in two years and the perception changed. One headline recently proclaimed: “Online Lending Gets Easier and Safer.”

We like that narrative better. The concept has evolved to Prosper being a place where you can get a better deal because it’s more direct. It’s like eBay, which successfully pivoted from offering quirky collectibles you can’t get anywhere else to a place where you can get everything.

Q: There’s kind of a paradox here in that the profile of your borrowers is improving at the same time as the financial services industry is seeing spreading credit problems, not just in subprime mortgages. Are you starting to worry about credit quality more in your portfolio?

Larsen: We think the credit crunch is broadly positive for us, an opportunity for us to show a different kind of market, one that’s more transparent and direct. That message will resonate in this kind of environment.

The credit crunch has pushed more high-quality lenders and borrowers to Prosper at a time when banks are pulling back, on home equity loans, for example. Lenders now have more to pick from and they’ve learned the lessons of 2006 and 2007 about how subprime performs.

We saw the subprime component of our borrowers go down from 25% at the beginning of 2007 to about 5% now. Why did that happen? I think it’s because our early lenders had terrible performance with their subprime loans—way higher defaults than any of us would have expected.

Keep in mind, we don’t underwrite the loans. We don’t decide what gets through and what doesn’t; we let the market judge that. In the early days, I think you saw a lot of lenders chasing high-rate note listings, like 25%. But the default rate for high-risk credit, people with credit scores in the 520 to 559 range, is now 20%. And 22% are four months or more delinquent. So we’re tracking a 40% default rate in the high-risk category, which means a 25% note rate isn’t much of a deal.

People have gotten a lot more used to looking for the overall return on investment (ROI). So now it’s about bidding at 14%, for example. If the default rate is 3%, your return might be 9%, still a lot better than a savings account.

Perhaps most significantly, we continue to build tools to help lenders zero in the loans they want, including those with the most attractive ROIs. One of the most important things we were able to do is switch to Prosper-specific default performance data. When we first started, all we had were averages from Experian; that was the most relevant data. As of last October, after about $100 million in loans and almost two full years, we had loans across the credit spectrum and enough statistically relevant data. So now we can show the lender the likelihood of default for loans they’re bidding on and that’s been huge.

Since last October, we’ve seen a huge shift in the number of funded loans with attractive ROIs, where the return makes sense for the risk. Those have been up over 200%. And, at the same time, funded loans with unattractive ROIs are down 80%.

We’ve also started giving much more guidance to borrowers based on that data. We can give borrowers more information about how lenders are going to view them and provide competitive rate suggestions based on performance data so that they’ll get more activity with their listings.

So in some ways, we’re kind of in our second stage at Prosper. The data people are trading on is actually Prosper data, rather than our best estimates based on Experian default data.

Q: But your data is still based, in part, on credit scores and there’s a lot of criticism now about credit scores performing badly in the subprime mortgage crisis. Does that worry you? 

Larsen: Well, actually, we have changed. The default estimates we show now are actually really based on statistically relevant slices of the marketplace that can be derived from a plethora of variables, such as delinquencies, public records, credit inquiries, income, revolving credit balance, bankcard utilization, homeownership and income level. There are also social capital variables to take into account, such as whether or not a friend or family member has endorsed and bid on the loan, group affiliation and payment performance of previous loans on Prosper.

What you see now are AA slices with default estimates of 30 basis points and AA slices that will have default estimates that are over 10%. So credit scores provide very relevant information but not enough. Other variables have to be taken into consideration.

The good news is, we have that data now in our actual data set and we can pop that up right at the point of bidding. So anybody who’s lending now will see that and is able to make their bids accordingly.

Q: If the economy went into recession, as many people now expect, would that dramatically affect the appeal to Prosper lenders? Could the defaults get ahead of your statistical analysis so that adverse selection becomes a problem?

Larsen: Obviously, recessions are bad for the job market and unsecured credit is definitely correlated to jobs. But many Americans still have jobs and are doing quite well; they’re just being punished by a seize-up in the credit markets. From what we’ve seen so far, we’re actually getting a flood of people with higher credit quality, which is an opportunity.

Q: How do affinity groups impact your credit quality?

Larsen: Our experience has been that small groups actually work pretty well by improving default performance and garnering slightly lower rates for borrowers.

With the big groups, we had some unintended consequences where we actually incented some adverse selection. The original group leader incentives that we had in place led to the formation of some very large groups that lacked any real sense of community loyalty or social pressure. And instead of cultivating members who were new to Prosper, many of these large groups were simply harvesting people who were already on the site.

The magic number seems to be groups of 100 people or less. And that actually makes sense. The motivation of a small group is based more on community, less on profit.

One other tactic that we introduced about a year ago, which we’re really excited about, is the idea of friends bidding on their friends’ loans. When a borrower is listing a loan, we ask them, as a last step, “Why don’t you invite your friends to bid on this or endorse you?”

If they just endorse you, it doesn’t really have much lift. But if they endorse you and bid on you, it’s very powerful. So, that’s where I think this whole idea of social networking and finance comes in. If you’re sort of a Facebook-type friend, there’s not much there; you have just a large collection of people. But if you have a friend who’s actually willing to bet even $50 on you, it makes a big difference.

We just started letting people search for that particular criterion. The data, which is just coming in now, is very positive and we’re planning to beef that up. The message is, social capital does work, just like it did in the early building and loan societies. That’s more powerful than being connected to some institution on Wall Street.

We’re going to look for more tactics as well. But I think, especially in a credit crunch, that we’ll end up having more meaningful variables than the capital markets have, because of the social motivations. That can be incredibly powerful as we move forward here.

Q: You’ve done about $120 million in loans so far. How big can this grow and are there any limits to growth? Can you just keep growing exponentially or is there some cut-off that you can see?

Larsen: My sense is that if we can continue to be a safe marketplace and maintain our servant infrastructure, where everybody’s on an equal playing field, whether it be institutions or individuals, we can show that yes, there’s value here.

We’re still in that early period. Some parts of it were rough when we started out. But we’ve got meaningful data now for people to make good decisions and that’s being reflected in the performance. If we can continue along with that while we’re in a credit crunch, I think it’s possible you might get a breakout and people across the country can go, “Oh, yeah, it’s like that eBay thing.”

Think about how eBay really spread through the culture. People liked it, they got engaged by it. That’s a very powerful thing for any company and we see it when we bring customers together at our “Prosper Days” community conference.

I wouldn’t hazard putting a number out there because it can jinx you, but I think we’re on a good path here.

Q: Right now, your company is funded by venture capital, which typically has a five-year horizon. What are your plans for the transition, because obviously you need another source of capital long-term?

Larsen: I’m pretty confident that, given the liquidity out there these days, if the company is working and the metrics look good and the idea is catching the attention of people, that there are a lot of options for us.

After E-Loan went public, I actually had to raise money in a private placement. It was very painful and it came at a terrible time because the dot com boom had already started crashing. We got lucky and we had some good partners to help us out. But you don’t want to be in that position.

At Prosper, we bulked up ahead for what we needed. We have raised a total of $40 million in three rounds, most of which is sitting in the bank. So we feel good about that. And the great thing is, now we can really focus on product. After going public at E-Loan, it seemed like I spent all my time meeting with investors and not working on the product. Here, we can focus on the product as long as possible and make sure we’re looking ahead.

Not that there’s anything wrong with going public. But I don’t think companies should go public too soon. You need to have the predictability in the numbers well before you think about that stuff. The ability to go public alone shouldn’t be the driver. It should be: is the company ready? It’s just one financing strategy among many others.