Sunday, December 7, 2008 - new prospectus good, but...

The new prospectus that filed with the SEC recently (12/5/08) will be approved. It is well written and covers all the bases. The only thing that will hold it up is the ordinary inclination of any regulator to look very very carefully at anything that follows a legal brouhaha.

As I predicted, they dumped the lawyers who wrote the first prospectus a year ago. The new prospectus is authored by a completely new legal team.

As I predicted, they've adoped a business model where the instruments sold to investors are obligations of prosper itself, ie derivatives whose payments are based on the payments (or lack thereof) on the underlying consumer loan. In other words, they copied Lendingclub.

The new prospectus is very thorough. Because the new instruments will be obligations of Prosper, all Prosper's financial detail is in the prospectus. Exactly the same stuff you'd see in a prospectus for a company that was issuing an IPO of common stock. How much cash they have, how fast they're burnin' it, salaries... a voyeur's paradise.

By the way, the filing is actually 6 documents. Serious investors should try to read at least the first two of these. Won't be easy. Nearly 4 megabytes of text here.
  1. The Prospectus (S1)
  2. The Indenture
  3. Borrower Registration Agreement
  4. Lender Registration Agreement
  5. WebBank/Prosper Loan Account Agreement
  6. WebBank/Prosper Loan Sale Agreement
I know you're probably thinkin' hey some of that stuff used to just be on the web site. Now its part of a prospectus? Exactly. We're moving into the regulated world. Prosper's statements about these investments are now cast in concrete (in the SEC's vault), instead of appearing only in fluid web documents changable at a whim, tracked only by a few lenders who frantically archived copies as unannounced changes whizzed by. Sometimes regulation is a good thing.

While this new prospectus probably satisfies all the SEC issues, it does damn little for lenders. The fundamental problems remain. I'll give you a few examples.

We all know that Prosper's lame efforts at collections are a very serious problem. I described it as a symptom of the more general "principal/agent" problem in my ancient open letter to prosper. Have they made any effort to do something about this? No. In fact, they have instead institutionalized the idea that doing almost nothing is ok, by explicitly saying in the S1 that they will do almost nothing!
We are obligated to use commercially reasonable efforts to service and collect the borrower loans, in good faith, accurately and in accordance with industry standards customary for servicing loans such as the borrower loans.
"We are obligated" .. I like that start. But what are those "commercially reasonable efforts" exactly? Don't have to wonder long. They define it pronto.
If we refer a delinquent borrower loan to a collection agency on or after the 31st day of its delinquency, that referral shall be deemed to constitute commercially reasonable servicing and collection efforts.
Whoa! Just the act of sending the loan to a collection agency satisfies their entire obligation with regard to collections! How conveeeenient. (Quarterbacks around the world rejoice! You can now just throw, without worrying about whether anyone receives!) Prosper explicitly takes no responsibility for selecting, checking up on, managing the collection agency, helping them, providing them with good information, or otherwise ensuring that anything at all is actually done. I imagine this cross-examination at some time in the future:
Lawyer: So after sending the package of loans, to the collection agency, you didn't check up to see if it had been received?

Prosper guy: Nope.

Lawyer: You didn't check to see whether the collection agency was working on them?

Prosper guy: Nope.

Lawyer: You didn't know that AmSher had ceased collection operations and become a beauty salon?

Prosper guy: Nope.

Lawyer: And were your actions in this matter reasonable?

Prosper guy: "Hey, we referred that loan to a collection agency. If they didn't do anything, like they didn't call the borrower or anything, hey that's not our fault. We satisfied our obligation as specified in the prospectus."
That's really weak.

Prosper is continuing their longstanding policy of shirking responsibility for the management and servicing of these loans. In one way, the new scheme is worse for lenders. Under the old prosper scheme, lenders owned the loans, so we could argue that prosper, our servicing agent, had a responsibility to us to service those loans competently. Under the new scheme, prosper owns the loans. Its more indirect. Lender's rights are more tenuous. It will be more difficult for lenders to force prosper to act appropriately.

But wait, there's more. Lenders have been concerned about the quality of Prosper's checks of borrower's identity and income since the beginning. In the prospectus, for the first time, prosper gives us some numbers:
For example between September 1, 2007 and August 31, 2008, we verified employment and income for only approximately 22.6% of borrowers. When we perform these verifications, we contact borrowers by email or telephone to request additional information.

If the borrowers fail to provide satisfactory information in response to an income or employment verification inquiry, we may request additional information from the borrowers or cancel the borrower’s listing or refuse to proceed with the funding of the borrower loan.

Of the borrowers undergoing income verification for the period from September 1, 2007 to August 31, 2008:
  • approximately 56.7% provided us with satisfactory responses and received a borrower loan;
  • approximately 37.7% did not provide satisfactory responses, or did not respond, and their listings were canceled; and
  • approximately 5.9% either withdrew their listings, or failed to receive bids totaling the amount of their requested loan.
Oh my. Depending on how you count that last category, something between 1/3 and 1/2 of borrowers failed income and employment verification! That's an awfully high proportion of liars. Of course this is only within the sample of 22.6% of borrowers who Prosper challenged.

We don't know what the results would have been if Prosper had verified income and employment on the remaining 77.4% of borrowers, but the numbers above give us reason to be concerned.

I tried to write an explanation of how to think about these numbers, but I decided that I had used too many words. Prosper member DakotahFury said it well in a recent discussion:
Holy crap...that is an astonishing, shocking, and infuriating figure.
If you were a factory manager, and 45% of the products you QC'd were faulty... how could you justify NOT checking every single product that went out the door? Heck, how could you justify not shutting down the line and looking for ways to structurally change the way you were going about business?
Indeed. It only takes a small percentage of bad loans to sour the mix.

There are lots more tidbits in there for careful readers. I want to hit just one more.

In the prospectus prosper discusses the legal black cloud (contingent liability they call it) associated with the sale of loans while Prosper was operating without SEC registration. There have been many forum discussions in which prosper members speculate that this could mean the end of Prosper. The liability after all seems huge. I don't think so.

Prosper issued $178M of loans prior to registration. Of these there have been $22.3M net chargeoffs. You can imagine some sort of worst case where class action suits might force Prosper to pay back lenders for all the loans that went bad. That $22.3M looks big relative to the approximately $10M Prosper has in the bank. This is too simple a model.

First, $22.3M isn't a worst case at all. If you look at my late loan curves, you can see that Prosper loans are headed toward about 40% of the loans eventually going bad. 40% of $178M is $71M. A super horrible number.

But then there's a one year statute of limitations. The first class action suit was filed 11/26, and if we look at loans originated in the one year prior to that, we find $77.3M of loans. If my prediction is right, about 40% of those may go bad. 40% of $77.3M is $31M. Well that's sounding less bad. There are situations where lawyers could argue that the statute of limitations should not apply, and these issues are complex and beyond my understanding, so who knows if the lawyers can limit the damage in this way.

But lets use that $31M number. It looks large relative to Prosper's cash in the bank, but that's not the right comparison.

Even if Prosper didn't have this risk, they'd need to raise money before the end of 2009. That's easily calculated from numbers in the prospectus. You might think it would be hard to raise money in their present pickle, and indeed be difficult to raise money for a business that is shut down, but Prosper isn't gonna stay shut down.

I predict that the prospectus will be approved, perhaps with minor modifications, and Prosper will be back running within a few months.

Because Prosper will need cash before the end of 2009 they will do another funding round with VCs. The VCs will invest, because they still believe in the concept. Most opportunities they see haven't built a membership of 800,000 people! It is likely that this will be a "down round", where VCs get shares at a price lower than their last investment, thus substantially diluting the founders. Lets say Prosper gets another $20M. (It might be structured to come in in small chunks, or some other magic which prevents Prosper from looking juicy to the plaintiff's lawyer.)

The class action suit will drag on for at least 2 years, unless Prosper takes initiative to settle it sooner.

In the meantime, Prosper will grow its business, and get itself on the road toward an IPO.

Getting ready for an IPO is hard work involving a lot of accountants and lawyers, but in Prosper's strange case, the accounting and legal work is already done. It had to be done to write the prospectus for "borrower payment dependant notes" that they have just filed. You could cut and paste from that baby, and do an IPO any time you like. ...except for the fact that a shut-down business is not the best candidate, and the fact that the stock market isn't in the mood.

One to two years from now all that will have changed.

If the class action suit proceeds, it will settle for 20% of the $31M of bad loans that get in under the statute of limitations wire, ie $6M. The money will likely come from VCs. (It is also possible that the IPO money could be used to pay the damages, but this is risky, because sight of IPO money would make the plaintiff's lawyer salivate.)

The stock market will recover. Prosper will do an IPO.

I should also mention that there will be a 34% chance of rain tomorrow, diminishing into the evening, with a slight chance of thunderstorms during the early morning hours.

Might be fun to sit in the board meetings, just to hear what the VCs think about all of this .

Tuesday, December 2, 2008 - 12/01/08 late loan stats update

Here's the December 1, 2008 update to to my late loan statistics charts.

These charts show statistics for the performance of all loans. Each curve represents the set of loans that were created in one calendar month. The vertical axis is the fraction of those loans that have "gone bad", in other words are 1 month late or worse (up to and including default). The horizontal axis is the observation date. All data comes from's performance web page.

Click on the chart to see a larger clearer version.

Here's a chart of the same data in which each curve has been slid to the left to a common origin. The horizontal axis is now days since loan origination month.

Explanation of methodology can be found in my prior postings in this blog, and in forum discussions on the old prosper forum, now archived at

The best discussion among lenders is found at

Monday, December 1, 2008 - More legal trouble

Many legal developments for in the last 48 hours. New lawsuits. New settlements. All are being reported elsewhere. I'll summarize the major links here for completeness.

An association of state securities regulators called NASAA has piled on, and Prosper has settled with them for $1M: NASAA Settlement (Although the name is similar, I don't think these are the same guys who do the space shuttle.)

A new class action suit has been filed against The complaint has now become public: Prosper Class Action Complaint

A new blog has appeared, which seems intended to keep us up-to-date on that class action suit: Prosper Class Action Blog

A dumbfounded lawyer blogs about What were they thinking?

With the legal front so well covered, I can now move on to more interesting subjects !