Prosper was one of the first companies to market in the peer-to-peer space, and in hindsight its arrival at the height of the credit boom was incredibly ill-timed. If you lent money through Prosper back then, when most of its loans were extended, there’s a very high chance that you’ve lost money — in some cases, a lot of money. “Of investors with a portfolio of loans that are an average of at least two years old,” notes Gimein, “folks who have lost money outnumber those who’ve earned 6 percent annual return by more than six to one.”
Prosper was founded in the days before everybody had heard the term “model risk”, back when it made perfect sense that credit risk could be modeled accurately by a computer algorithm using little more than a FICO score.
One of the big problems that Prosper ran into — the massive credit crunch and the ensuing Great Recession — could reasonably be considered to be a one-off event with a low likelihood of happening again. But another is endemic to the model: Prosper borrowers with a given FICO score are inevitably going to be more likely to default on their debts than most other people with the same credit score.
It wasn’t meant to be that way. Peer-to-peer lending was meant to create a personal connection between borrower and lender, and therefore make borrowers more likely to repay their debts than people faced with large obligations to hated, faceless banks. But it seems that adverse selection effects overwhelmed the site’s attempts to be warm and fuzzy. As Gimein explained in an email to me,
I think in this case the adverse selection issues are insurmountable. Folks go to P2P loans almost always because they can’t get money through conventional channels, and often there is a reason. I’ve cut up the Prosper numbers in a bunch of ways, and one thing I’ve noticed is that some of the worst returns come from folks with okay credit who are willing to pay very high interest rates: they’re willing to pay a lot because their finances are in worse shape than they seem.