I was trying to run some more recent numbers to update my most recent concerns regarding person-to-person loans at Prosper.com. Essentially I was wondering if the loan performance would continually get worse over time. I was curious because it’s one thing to advertise 8-12% returns when the loans are new, but what really matters is the performance at the end of the 3-year term.

While trying unsuccessfully to churn those numbers, I ran across this related chart from the very analytical Prosper lender Fred93’s blog. The graph is essentially % of loans defaulted vs. loan age. Fred93 explains further:

These charts show statistics for the performance of all prosper.com 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 now days since month of loan origination. All data comes from Prosper.com’s performance web page.

If you look out one year from origination (ie 360 days) you will see that about 20% of Prosper’s loans have gone bad. You can also see that this is remarkably consistent from month to month (ie the different curves). One can only conclude that the default rate of Prosper loans is in the neighborhood of 20% per year. Loans originating after Feb’07 are going bad at a slightly lower rate, probably because Prosper increased the minimum credit score required for a Prosper loan at that time.

I learned also that he makes these conclusions because (1) historically over 85% of Prosper loans that reach 1 month late eventually go into default, and (2) the recovery rate after being sent to collections is terribly low. Together, you have his statement that ~20% of loans go into default each year. For a three-year loan, that ain’t good!

The slope (default rate) does seem to be slightly lower for the newest loans, but what concerns me the most is the constant linear deterioration of loans. This confirms my fear that loan performance consistently gets worse as the loan ages.

Now, I know this chart doesn’t tell the whole story, but I do think P2P lending is still very new and has a lot of growing pains to overcome. For borrowers, it can be a great deal. But as much as I want to be grabbing some solid returns this way, I’m still wary of committing significant money given this information.

(I haven’t found similar numbers for competitor LendingClub yet. They are still young, but they seem to be doing better in defaults so far. I’m waiting for more loan data to accumulate.)

Related P2P Lending Posts

• $25 Sign-Up Bonus For Lending On Prosper
• Free Experian Credit Score via Prosper Lending
• Lending Club P2P Initial Review, $25 Bonus Promotion
• Update #1: Will Returns Drop As Defaults Increase Over Time?
• Prosper.com Person-to-Person Lending Review, Part 1: First Looks
• Prosper.com Person-to-Person Lending Review, Part 2: The Numbers

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How would you like to get returns linked to the S&P 500, with no chance of losing a penny? You can with the Index Powered CD, a certificate of deposit being sold by a variety of smaller banks including Brentwood Bank. While the concept has been around for a while, it has been enjoying renewed popularity was people continue watching their 401(k)s shrink. Unfortunately, this is yet another product that uses clever marketing to hide important details from the less vigilant public. Here’s the pitch:

“Enjoy the stock market’s ups and not fret about the downs”!

The Index Powered® CD is a new FDIC insured certificate of deposit tied to Standard & Poor’s 500 Index. The Index Powered® CD was developed with today’s investor in mind and is available exclusively through community institutions. Enjoy the peace of mind of having your principal guaranteed and FDIC insured (up to $100,000.) while offering the potential higher returns of the stock market.

What The Average Person Thinks This Means
If the S&P 500 goes up a lot, I’ll match that return. If the S&P 500 drops – hey! – I’m FDIC insured so I can’t lose my money. Sign me up!! Let’s say this is a 1-year CD and here are the values of the S&P 500 for that year.

It starts at 100 and ends at 108, so you would expect your CD with a “100% Market Participation Factor” to return… 8%, right? Unfortunately, if you spend the time to read the 17-page disclosure statement, you’ll see that it is not true. To put it bluntly, they manipulate the definitions to their advantage.

What It Really Means!
The problem is that I can say something is “tied to the S&P 500” or “linked to the S&P 500” without actually getting the full return. While they tweak many of the definitions, in particular this sticks out. “Closing Market Value” is defined as “the arithmetic average of the closing values of the S&P 500 Index on the Pricing Dates.” This changes everything. Using the example above again we’ll use the values given:

By their definition, the “closing market value” was 103.4, and your starting value was 100. (Yes, the 100 is included in the average!) So your actual return would be a piddly 3.4%. Not exactly what you expected, huh?

And you know what? The S&P 500 Index they use doesn’t include dividends! That’s another 2% of annual return you’re missing out on.

There is no free lunch here. Not only do you on average less than half of the actual S&P 500 return if it does well, you also risk getting much less interest than a conventional fixed-rate CD if it does poorly. You cannot eliminate downside risk without giving up upside potential. Finally, this is actually a 51-month CD with heavy early-withdrawal penalties.

(For those that like “efficient” portfolios and optimizing risk/reward, here you are essentially taking on added volatility with no increase in expected average return. See my comment below for more details.)

Get your goals straightened out. Either you (1) have a short-term horizon with low risk tolerance and should get a conventional bank CD with a fixed guaranteed rate, or you (2) have a long-term horizon and are willing to accept the risk and full return of a S&P 500 index fund. Even if you don’t want to be 100% S&P 500 index and want less volatility, using a mixture of stocks and bonds would be the a much more cost-effective way of achieving this.

Again, I’ll avoid the word “scam” because this is technically a legal product, but the best weapon against such products is education. Know what you are buying and tell others!

I’ve already written about Millennium Bank – the offshore bank offering 8% certificates of deposit that are not FDIC-Insured, let alone highly regulated. More recently, a group called the Federally Insured Savings Network (FISN) has been advertising FDIC-insured Certificates of Deposit Paying Over 8%”. What’s the deal?

It definitely looks too good to be true, but let’s look at the fine print and see what we can find. I’ll just focus on the highlighted CDs paying a 8% and 8.25% APR to save some time.

These Are Long-Term Investments With Very Limited Liquidity
The maximum terms for these CDs are for 15 or 20 years! If you wish to withdraw early, you can be sure it will be with a fat penalty. However, it may not even be possible to re-sell them at all. From the disclosure: “Lack of Liquidity. The CDs will not be listed on an organized securities exchange. JPMSI may offer to purchase the CDs upon terms and conditions acceptable to it, but is not required to do so.” This could be worse than even taking money out of your IRA or 401(k).

High Minimum Investments
In this case, you need $25,000 to invest with FISN as your broker to JPMorgan Chase Bank.

They Are Callable, And That’s Not Good
A callable CD means that the bank can say “I found a better deal elsewhere, so I no longer want to pay you this much interest anymore. Bye!” You’ll get your principal plus interest earned up to that point, but this usually happens when interest rates fall, leaving you stuck with alternative paying a lot less than you were getting before.

On the other hand, you the depositor have no such flexibility. You’re still stuck for as long as the bank wishes. Again – up to 20 years! Put another way: Heads, the bank wins; Tails, you lose.

Not A Fixed Rate CD – 8% Rate Isn’t Guaranteed
When talking about a bank CD, you’re usually referring to a fixed rate CD. However with this investment, you may or may not get paid any interest based on the following criteria:

Interest is paid quarterly for every day the 30Yr Constant Maturity Swap (CMS) Rate is greater than the 10Yr Constant Maturity Swap Rate (Positive Yield Curve). If the 10Yr CMS Rate is greater than the 30Yr CMS Rate on any day (Negative Yield Curve) no interest is accrued for that day. Full 8.00% rate guaranteed for first year.

Trying to figure out exactly what CMS rates were made my head hurt. But very generally, if the long-term interest rates are higher than short-term interest rates (positive yield curve) you’ll get paid your fraction of 8% annual interest that day. However, if the curve goes negative, which it has for extended periods in the last few years, you don’t get paid any interest that day. So 8% is basically a best-case scenario. Over a 15-year period, I highly doubt you’ll be getting the full 8% each year. Earning 0% is the worst-case scenario.

I’m Not Interested
So yes, technically these are FDIC-insured to the extent that your principal is safe. But your money could be stuck sitting around earning nothing while inflation eats away at the actual value. And the bank will only keep paying the interest if it remains profitable for them. These seem to be sophisticated investments being marketed at the unsophisticated public. Buyer beware!