Sunday, May 18, 2008 - here's what you should do with the lawyers

When we invest in loans, we make a deal with prosper. The lender buys the loan, and prosper retains the right to service the loan and charge a fee for that service. This would be fine if prosper did a good job of servicing loans, but they don't.

Don't get me wrong. Prosper has done many things right. The idea was great. They built an incredible web site. They just don't service loans well, which unfortunately is a critical thing.

In any other situation I can imagine, if I owned a loan, I could decide who services the loan. That way there would be competition. If my loan servicing guy proved to be incompetent, I could move to another loan servicing guy. This sort of competition drives everyone to be serious and pay attention to business. (Economics 101)

If you're locked in to one loan servicing guy, then what's his incentive to actually care about your loan?

In the case of Prosper, you might think the incentive would be that their survival ultimately depends on this. If, over time, the world learns that their product is bad, then no one will want their product. I'm not the only one who has said things like this.

John Witchel (Prosper CTO) wrote (in private correspondence) on 05/09/2007:

Prosper is heavily motivated to keep defaults in line. If they aren't tractable everyone's returns go to the dogs and Prosper fails, and there's no amount of "new blood" that will keep that problem at bay

Today 3,215 of Prosper's loans have gone in the toilet (ITT). I'm counting loans that have defaulted, as well as loans that are at least 2 months late, which by past Prosper performance means they will almost certainly end in default. In other words, these are loans where the lenders have been stiffed.

Prosper has originated 18,819 loans that are now at least 3 months old (ie old enough to be at least 2 months late). For the record, those 3,215 loans in the toilet are 17.1% of Prosper's total 18,819 loans old enough to be ITT. (Gosh I hope I don't read any more of those newspaper articles that say Prosper has a default rate of 3%.)

(You can get all these numbers for yourself from Prosper's performance web page, or from one of the third party stats sites, etc.)

But that 17.1% is not the really interesting fraction. Prosper has insulated itself from the loan-making decision, so some would say the high default rate is not entirely Prosper's fault. Read on.

For almost all of those late loans, all Prosper ever did was send the borrowers emails and phone calls, asking them to pay. In other words, Prosper did almost nothing. To be certain, there have been some small improvements. For example here's an improvement announced earlier this year:

Doug fuller quote (from prosper blog)...

One of the many activities aimed at improving collections undertaken in the last couple of months was the testing and implementation of an ?Early Delinquency? letter series. Although borrowers were already receiving reminder emails and phone calls during the early delinquency period (1 -30 days past due), we thought it worth seeing if an actual letter might drive additional payments.

Oh boy! Now they send a letter. An improvement. But ... Frankly, a letter ain't much, and Prosper's collections is still super-wimpy. Prosper management just doesn't take this stuff seriously. They don't take handling your money seriously.

When Prosper was conceived, the founders didn't realize that bad loans, deadbeat borrowers, defaults and collections would be such a bad problem. They had a notion, now proven to be incorrect, that the "community" aspects of Prosper would create loans which went bad at a lower rate than other consumer loans, credit cards, etc. That aspect was widely hyped to lenders. (Remember those web pages where they talked about Joe the fireman, and how after he joined the fireman's Prosper group he would feel an obligation to all other firemen, so would keep his loan current?) Turns out: It ain't so.

I don't fault the founders for getting this wrong. In every startup the founders envision some future business, an act which forces them to predict how the future will turn out. As the saying goes "Predicting is really difficult. Especially the future." Some part of the vision is always wrong. You have to adapt. Prosper management hasn't adapted.

(And for the record, I still believe there is value in the community aspects of Prosper. Its untapped. I'll write about that in a future blog.)

To be fair, they have made changes which attempt to reduce the rate at which loans go bad. They added a post card to verify the address of the borrower. They increased the lower bound on credit score for HR borrowers, to cut off some of the really bad credit risks. Finally they added bidding guidance in an attempt to scare naive lenders away from high risk loans. Good stuff... but no real improvements in the collections department, where thousands of loans sit rotting.

Because the Prosper founders didn't think collections would be much of a problem, they didn't devise a good method to fund collection activities. The existing legal documents (lender agreement, borrower agreement) don't provide mechanisms that would fund legal action against borrowers, even when it is clearly in the interest of lenders. In other words, we have lenders willing to pay for action, but Prosper unable to act. Prosper could have adapted, and changed these agreements, inventing the new mechanisms to fund the functions they now saw were needed, but they have not. They're still tryin' to run collections on the cheap.

More discussion about funding collections can be found in my Open letter #2 to Prosper management, written almost exactly a year ago. Much of it is still on point.

Lets get back to those 3,215 loans in the toilet. 1,458 of those have already defaulted, ie were sold to junk dealers, so they're gone, and there's nothing we can do about them. The remaining 1,757 in the toilet loans are still in Prosper's hands, and they could do something about those, if they had the desire to act.

They have taken some action, but I want to show you how tiny that action is. Back in January '08, Prosper started a "legal test" where they took 66 very late loans, in California only, and initiated legal action. Oh boy! There are several small problems.

First, that's 66 out of (1757+66) = 3.6% ! They only initiated legal action against 3.6% of the late loans in their hands that are in the toilet.

Are you a lender on some of the other 96.4%? Sorry. Your loans are going to default. Nothing is being done. The "legal test" should be 10 times larger.

Second, I said they "initiated" legal action, but that's almost too strong a word. Remember the project started in January. In May they filed the first "proof of service" documents with some of the courts, meaning that the complaints have actually just now been served against some of these deadbeats. Slooow. No requests for summary judgement have yet been filed. No court dates have yet been set. If we run at this pace, it will take a year before we have any results. During that time, more thousands of loans will default due to Prosper's inaction. This is irresponsible. This may be the most economical way to proceed, but it is not the most responsible.

Here's my request of Prosper's management:

You have, in your hands, 1,272 loans that are 4+ late. (For the record some of this group are as much as 10 months late, such as loan #901.) Establish objective criteria to pick half of those loans that are worthy of legal action, in other words about 660 loans, ten times the size of the existing legal test, and begin legal action on them immediately. Take lenders, and your obligations to them, seriously.

Make the changes in the legal documents required to allow you to fund this legal activity while complying with the terms of the documents. This won't help you for the existing loans, but at least it gets you straight with the lawyers for future loans.

Oh, and please make the process transparent.

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