Back in 2007 cash flow was positive, consumer optimism was high, the Dow was approaching 14,000. The bubble was still big and unburst. Banks were still trusted and admired. Around that time I felt I had a little money to experiment with and I discovered a great site,
http://www.prosper.com/, which enables members to borrow and lend from each other, a sort of grass roots effort to help each other out and make some money at the same time. Lending members pool their money together to fund loans for anything from small business investments to helping someone consolidate credit card debt. I uploaded $500 and made 10 separate investments of $50 each, spreading them across mostly borrowers with high credit ratings but a few with lower ratings. These lower ratings were clearly higher risk but consequently also allowed me to charge higher interest rates, just like a real bank. My experiment started off well and I was excited to learn about another facet of investing -- little did I know I had just started on a roller coaster ride that would be the bane of many greater bankers than I!
As the stock market crashed, lending ground to a halt and loan defaults skyrocketed across the U.S., I got a front row seat with my little lending experiment. I realized quickly I had got caught up in the same fervor as the big banks when I let myself make subprime loans, in the hopes of a higher return. Surely, I figured, if other banks are giving them loans then it's safe for me too! I wonder how many loan officers at Lehman Brothers or Merill Lynch regret the same thought.
Another problem I soon discovered was the lack of liquidity in my loans. In my case, Prosper simply wasn't set up to sell loans (they've changed that since then), but it mirrored the situation large banks got into when the value of their loans dropped so much they became junk. Even if I wanted to cash out, I couldn't. I had to sit by and watch while several of my borrowers defaulted. In some cases I got a small portion of my money back from collection agencies (minus the agency's fees), and in others I got nothing at all. A few honest souls (or "continuously employed souls" is probably more accurate) continued paying off their debt, even though interest rates dropped tremendously and they were still stuck paying off my loan at much higher rates.
Since all loans were three year loans, I finally received my last payment today and took stock of my investment:
Total invested for three years: $500.00
Total return on investment: $430.76 (-5% APY)
Credit rating of AA that defaulted: 25%
Credit rating of A and above that defaulted: 29%
Credit rating of B and below that defaulted: 100%
What did I learn? I need to go read Jordan a bedtime story now, so that will need to come in a future posting!
