Wednesday, July 16, 2008

What if We Could Buy Lazyman’s Prosper Loan Endorsement? What Signal Would it Send?

Lazyman, a personal finance blogger, often blogs about an internet peer to peer lending site, Prosper. On the Prosper website potential borrowers write up their personal financial history and a loan request (here is an example). Prosper collects the borrower’s social security number, runs a credit check, and assigns a risk grade. Then potential investors can bid on an interest rate for part of loan. Loans average in the thousands of dollars and many investors put in only $50 (the minimum investment).

Now to Lazyman's post. He cites (netbanker) who points out that investor who have put in a bid on a loan can endorse a loan and leave a short description of why they endorsed the loan. Endorsements appear to help as

1. Single endorsed loans are performing 35% better than similar loans without that endorsement
2.Multiple endorsements bidding are performing 50% better performance

Lazyman, uses his economic intuition, to deduce that for borrowers it will be better to have an endorsement so why not sell your endorsement. In other words a borrower gives a potential investor $75, the investor keeps $25 and invests $50 in the loan and endorses the borrower.

I could see this having numerous potential impacts on the Prosper market and this subject would make an excellent theoretical economics paper.Let’s take one possibility.

Suppose two things
1. Selling an endorsement is legal and everyone knows endorsements can be sold.
2. That each borrower has a better knowledge of the probability that they will be able to repay the loan then the lender.

You might think these endorsements are worthless now, but they might not be. This set up could create a signaling equilibrium (see this Wikipedia article). In short high quality borrowers would be willing to pay the cost up front (of paid endorsements) for lower interest rates, while lower quality borrowers would not be willing to pay it since they know the gains in lower interest rates are smaller to them since they are less likely to repay. This should result in good borrowers buying more endorsements, which will help them be separated from bad borrowers.

I recall using a similar model in graduate school to explain why Michael Jordan might endorse Nikes. Jordan saying “Just do it!” isn’t really telling us anything more than a paid prosper endorsement. It does tell us Nike was willing to use money to show their product is good.

There are other possibilities, but I’ll leave those up to a non-lazy economist .Bookmark and Share

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