It was a hot Saturday afternoon, August 5th 2006. I was driving to Long Beach to have dinner with a bunch of folks -- 25 fellow Prosper.com lenders -- who I had never met.
That's not quite true. I had met them over the internet. For several months I had been vigorously corresponding with these folks (day and night) as we worked hard to decipher the risks and necessary disciplines for lending money to anonymous strangers via the internet. We were spending several hours a day reviewing loans, corresponding with borrowers and each other, doing statistical studies, debating our hypothesis about what makes a good borrower. For example.. Historical data said that "homeowners" are better risks, but would that still be true now that housing lenders had gone nuts and strange people were buying with no money down and flipping homes left and right? There seemed to be a million such issues, and a lot of different opinions on each one.
Was I nuts? I had never done anything like this before. A face-to-face meeting with people I knew only by pseudonyms (their Prosper screen names)?
I drove 100 miles, but some came from much larger distances. Prosper CEO Chris Larsen flew down from San Francisco. One lender flew in from New York.
The get-together was arranged by a fellow lender I knew only as DebinVenice. She gave me an address and said "I'll be standing under a big horse." As I drove past the Queen Mary I wondered if there would be a horse or a woman standing under it or what that even meant. (I had never been to a P.F. Changs, so I didn't know they all have giant horse statues out front.)
Sure enough Deb was standing under the horse with a small crowd when I arrived. I felt like I knew all these people. After all we had spent hundreds of hours talking online. Online we had talked mostly about specific borrowers, and various Prosper technical issues and frustrations but by this time we knew a lot about each-others' politics, family life, etc. We did not however know what each other looked like. Screen names don't give you much of a clue about who is male or female, who is black or white, short or tall, etc, and the mental images I had formed needed considerable adjustment.
One couple walked up to me (seeing the screen name on my badge) and thanked me for bidding on their loan. Wow! Borrowers in the flesh! Unexpected. It seemed very personal.
This was the time of the most amazing excitement for the early batch of Prosper lenders.
I remember sitting across the table from Prosper CEO Chris Larsen, as he explained how tough he was gonna' be on fraud and deadbeats. He was gonna make an example of these folks, so borrowers would know that Prosper is tough.
Chris Larsen, CEO of Prosper.com (center) talking with lenders (folks who lend money to strangers over the internat via Prosper.com) over dinner, Long Beach, August 5, 2006. (Photo credit DebinVenice)
To those of us who were actively participating, observing how borrowers interacted with lenders, observing how loans were performing, some problems became clear. The population of Prosper borrowers was obviously heavy with fraudsters and deadbeats. A tremendous amount of animosity developed when specific examples of borrower fraud and dishonesty were exposed by lenders time and time again, and Prosper management just didn't want to hear it. Lenders who made the "mistake" of exposing such fraud were routinely censored and censured by Prosper management. Chris Larsen "shot the messenger" instead of learning about the problem and taking action to fix it.
I've written much about the rate at which Prosper loans are going bad. To get some historical perspective, lets look back at the guidance Prosper gave lenders in those early days. Prosper published statistics which developed from credit bureau Experian's experience with credit card customers. The purpose was to help lenders understand the Prosper credit grades, which at that time were just highly quantized Experian credit scores. This data showed that borrowers in Prosper's "AA" credit grade would be expected to default at the rate of 0.20% per year. What actually happened is that loans to AA borrowers went bad at a rate of about 5.00% per year. Wow! That's 25 times worse than Experian's vast experience seemed to predict! Somehow Experian's credit score and their historical credit experience didn't quite predict the behavior of Prosper borrowers. (Note: You can see how "AA" credit grade loans have performed by looking at rateladder's graphs. Find the 1 year point on the X axis and look at the "AA" curve.)
Experian's experience didn't provide the right insight, from which we conclude...
Apparently Prosper attracted a "different" crowd.
Making a successful business in P2P lending requires that you understand this fact. If Chris Larsen had taken the time to realize what was happening, he might have put in place superior fraud checks, serious verification steps, a serious collections department, etc, as appropriate to deal with the substantial fraction of fraudsters and deadbeats who were attracted to Prosper, but that was not to be.
I'd love to give you the details (ie names) and amazing stories of specific deadbeat Prosper borrowers who stiffed me personally. Anecdotes often communicate better than statistics. I won't, because giving you personal information on these borrowers could be interpreted as violating the terms of the lender agreements I signed with Prosper. One of my deadbeats was a former state senator from New Hampshire who is still routinely quoted in the political press. (Rated "A" by Prosper.) One of my deadbeats wrote a book on how to avoid collection agencies! He sells it on the internet! Man that's a deadbeat's deadbeat. (Rated "AA" by Prosper.) Both these guys are highly visible. Its not like all Prosper deadbeats have skipped town. Some sit right in front of your face and don't pay. You'd think that with highly visible people like this stiffing Prosper's lenders, management would want to take some action. Maybe sue some people. Get serious. No, they just had a collection agency call them repeatedly on the phone. Damn weak effort.
In late 2007, Prosper hired a collections expert, Doug Fuller, as VP of Operations. Prosper introduced this new employee as if he were an attack dog who was going to eat deadbeat borrowers for lunch. On October 2, 2007, Prosper published an "interview" of Fuller by a fellow Prosper employee. This was published on Prosper's official forum, on Prosper's web site, but has since been deleted. Fortunately, some lenders kept a copy, and you can read it here. I'll quote a few snips, but you should read the entire interview for yourself. It paints a strong image.
Q: Do you have experience with suing people?
A: Oh yes. Between First Select and Credigy, I have been responsible for making the decision to sue more than 150,000 people. There are a lot of lawyers that can’t claim that number of suits in a lifetime.
Q: Okay, so you need to decide who to sue, then what? A: Put quite simply, my philosophy is this – if you won’t pay, but can (or will in the future) be able to pay, I’m going to sue you. If I sue you I’m going to win.
Q: That sounds kind of arrogant, can you back it up?
A: Courts in seven states have recognized me as an expert at consumer debt litigation. At Credigy, if a case got really nasty, I would go testify live. I refuse to lose.
Q: Really? What’s your win/lose record? A: In my last 18 months at Credigy, I testified live at 42 trials. My record was 41-1. By the way, I fired the law firm where we lost.
Big hat, but is there cattle?
In January 2008, Fuller selected 66 loans out of the 1800 Prosper.com loans that had defaulted by that time, and he organized a "legal test" in which he would sue these 66 borrowers, and demonstrate that he was able to produce results like the ones he described above. Fuller personally selected these 66 loans. Fuller told us that he picked loans where he believed he had good contact information on the borrower, and where the borrower had the ability to pay. Presumably he also took care to choose loans where he believed he had the best chance to win. (He did not include my state senator or deadbeat's instruction manual author.)
Although Prosper kept the status of this project secret, many courts publish information about ongoing lawsuits, so lenders were able to observe that the lawsuits were not going well. I wrote about this in October of 2008. What I observed is that many of the suits were being dismissed! We couldn't tell exactly what was going wrong, because courts publish limited information.
Some of the lawsuits were dismissed by the court because Prosper was never able to find the deadbeat borrowers to serve them. Oops. Other borrowers were served (ie were found), but the cases were later dismissed by the court. Some suits were being dismissed at Prosper's request! Something more was going wrong. It was mysterious. Sure looked like Prosper was just pulling the plug. Lenders wanted information, but Prosper would not tell us what was happening.
The legal test was a horrible failure. Prosper demonstrated that it doesn't know how to collect on late loans even when it tries, even with expensive lawyers helping. How could this be?
Prosper has been mute on this subject -- for almost two years -- until a few days ago, when Doug Fuller wrote about the results of the legal test project in Prosper's official blog. (Because Prosper has often deleted their blog entries which proved embarassing, I point out that a copy of Fuller's writeup is archived here.) Its a worthwhile read.
Now we know some of the numbers, and more about what went wrong. In summary: Everything went wrong. It is as it appeared. The legal test was a horrible failure. What's worse, to most observers it seems obvious that every step could have been carried out in a much more competent fashion. It was a three stooges operation.
Here's what we learn by reading Fuller's recent admissions. (I'm not the first to dissect Fuller's writeup. I follow the outline given by Prosper lender ira01 here. Read ira's message for more technical legal details.)
They started with 66 hand-picked charged-off loans. Of these, they discovered that 3 borrowers had moved to a different state, so they gave up. (Mind you, it is possible to sue in all 50 states, but Prosper just gave up, preferring the convenience of only suing people resident in Prosper's home state: California.)
Next there were 13 loans where Prosper's legal team was unable to locate the borrower, in order to "serve" him, so they gave up. Its pretty outrageous that 13/66 = 20% of his hand-picked borrowers can't be found.
What did they do to find these people? They don't say. It is possible that they did nothing except try the address they had on file. Fuller offers the excuse that in his experience, the address shown in Lexis is usually accurate, but wasn't in these cases. I guess Fuller believes these people just vanished without a trace. Given Fuller's background, we expected him to be skilled at skip-tracing, or know how to hire someone who was.
Doug offers the observation that Prosper borrowers don't seem to fit the pattern of his prior experience. Here I agree. Prosper borrowers are different. Two years after he joined us, he's beginning to figure it out.
One possibility is that these 13 people never existed. Prosper.com has an obligation to purchase "identity fraud" loans from the original lenders, therefore they don't like to consider this possibility.
There's something else fishy about giving up on these 13 borrowers. In California, if after diligent effort you haven't been able to find the defendant to hand him the paperwork, you can satisfy the requirement for service by printing a notice several times in a newspaper. This allows you to proceed with a suit, and hopefully get a default judgment against the deadbeat, even tho he's hiding from you. Then when you do find him later, you have a legal advantage. Apparently this was too hard for Prosper, so they gave up instead.
Doug then tells us that in 21 more cases, the borrowers filed bankruptcy after Prosper filed suit! Doug also tells us that is a huge unexpected number. Another clue that Prosper borrowers are different.
I do wonder about those 21 bankruptcies. In the past there have been some cases where a borrower told Prosper that he had filed bankruptcy, and Prosper took the borrowers word for it, when in fact there was no bankruptcy. I wonder if they actually checked these cases with the court. I also wonder whether Prosper has filed paperwork with the bankruptcy courts in these 21 cases. Perhaps we'll figure out how to track down these bankruptcies (or lack thereof) another day. (After all, we know the names of most of the defendants, because we found them while searching court records to track down the status of these lawsuits during the 2 years when Prosper was silent.)
66 minus 3 minus 13 minus 21 ... just 29 loans left.
More than half the suits died before they even got started. Remember Fuller's words? "I’m going to sue you. If I sue you I’m going to win. "
At this point Fuller stops giving us precise numbers. He proceeds to explain a number of different things that went wrong, and the fact that he's unhappy about them. He's not the only one.
A typical early step in this kind of lawsuit is to ask the court to grant a "default judgment", meaning that the facts are so clear that there isn't any use wasting time with a trial. (Default judgements are common when the defendant doesn't bother to show up, etc.) Doug explains that they had a little trouble with this: "the vast majority of courts rejected the requested Clerk’s Judgment." Well huh. He doesn't explain why. Dude, we want to know why, because there's something very wrong here. Maybe you should diagnose the problem and fix it. Maybe you guys are putting the carbon paper in backwards.
And a clerk's judgment is just the easiest kind of default judgment. If you fail that, there's another kind you can apply for. So we expect, well you know ... follow-thru. Fuller says that as he was getting ready to do that, Prosper entered its "quiet period", because of Prospers SEC filing, intended to straighten out the regulatory issues Prosper had with their lenders. Fuller decided to not proceed with the necessary court filings during the quiet period. Well the quiet period lasted nearly a year, so this was quite an interruption! Prosper missed legal deadlines and the courts dismissed most of the remaining cases.
There is a bit of a hole in this story. Prosper filed their first S1 with the SEC in October of 2007, before the legal test project had even started! Another hole in this story is the fact that the registration with the SEC has to do with the relationship between Prosper and lenders, and has nothing whatsoever to do with borrowers. I know Fuller agrees with me on this point, because he has used this argument himself. In an earlier blog entry, describing one case which he won, he tells us that the defendant (borrower) raised the issue of the SEC boondoggle, and Fuller was able to counter with an explanation that the SEC matter didn't affect the relationship between Prosper and its borrowers. Given that the courts hearing these cases had no problem with the SEC entanglement, I can only presume that it was overcautious lawyers advising Prosper on the SEC matter who told Doug to shut down. They harmed lenders by doing so.
Doug says he's going to try again on some of the cases that were dismissed. I'm glad to hear it. He didn't say when. We've blown two years on this "test" so far, and we have nothing to show for it.
By the way, we've been out of the quiet period for several months now. If the quiet period was the thing keeping Fuller from proceeding with legal action, he should have fired up the suits again by now, but he has not. I question his intent.
Well, at least they did win at least one case out of 66.
Many times we've been told they were going to treat nonpaying borrowers seriously, but looking back these statements have never been truthful.
While they're firing up the 2nd try on many of the dismissed lawsuits for this initial batch of 66 borrowers, there now are another 7,933 that's right seven thousand nine hundred and thirty three Prosper borrowers who have defaulted on their loans, with nobody even thinkin' about legal action on any of these folks. There is simply no credible story that they're ever gonna get any material legal action going against deadbeat borrowers.
What have we learned?
Prosper borrowers are "different". While most of them are very nice people, like the couple I met in Long Beach, a substantial fraction of Prosper's borrowers are hardened deadbeats, attracted by the sweet odor of naivete. Prosper lenders cannot succeed without better mechanisms to protect against against these zombies.
Deadbeat borrowers are a big problem.
Prosper has a Three Stooges legal strategy.
Prosper management has never taken these issues seriously.
Prosper management's talk about how they would handle deadbeats has been hot air from the very beginning.
It was such a wonderful concept. It seems such a shame.
In order to stay alive, Prosper.com needs a new round of venture capital funding some time in the next few months. If I were one of the VCs considering an investment, I'd be lookin' to replace Chris Larsen. Mr VC, if you're reading this, that is what I suggest you do.
PS: Great discussion among P2P lenders is found at prospers.org .