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Author Topic: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)  (Read 55555 times)

traveler505

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Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« on: December 23, 2007, 11:04:52 am »

[I posted similar comments in a thread in the LendingClub forum (registration required), but I thought this deserved greater readership.  My intent -- particularly since this is posted in "The Lobby" -- is to provide a place for serious speculation about the underlying reasons for what appear to be irrational business decisions by Prosper, rather than creating a "bash Prosper" thread.]

One factor limiting Prosper's growth is the fact that, as a finance company rather than a bank or credit union, it must comply with the licensing and usury laws of each state in which it has borrowers.  The result is a patchwork of state-by-state interest rate caps, some of which make it difficult for even prime borrowers to be funded.  Several of the most populous states (e.g. Texas and New York) have particularly limiting rate caps, and some states (e.g. Nevada) exclude Prosper entirely because it does not have a physical presence there. 

Zopa and LendingClub have partnered with credit unions and banks, respectively, to avoid the state-by-state regulation, and offer uniform rates and fees throughout the country.  (Under federal law, banks and credit unions are subject only to the regulations of their home states, even if they do business nationwide.)  But Prosper clings to its state-by-state licensing strategy, despite occasional hints that it is looking at a so-called "national license".

Why?

One possibility (aside from total wrongheadedness, which can never be ruled out as a factor) occurs to me, based on the emerging pattern within the P2P lending industry:

It is possible that somewhere in the reams of regulations governing banks and credit unions there is a provision that interest rates must be set based on objective criteria bearing a rational relatonship to credit risk.  (Or, at least, that banks and credit unions are sufficiently fearful of discrimination suits -- and value their licenses sufficiently -- that they are unwilling to do otherwise.)  IIRC, there is a regulation like this under the ECOA which governs credit scoring systems, so it's possible that somethig similar covers banks and credit unions.

Prosper interest rates are set by a bunch of oddballs (yeah, us) whose bidding criteria are far from objective or rational.  We sometimes give amazingly below-market rates to people we like and trust, even though the objective data suggests that they are horrible risks.  And periodically a Muleshoes wanders through, and throws out money at well below CD rates for borrowers without a chance in hell of paying it back. 

Now, imagine a bank or credit union being called before regulators to explain why it charged an AA with perfect credit and high income 12% interest, while it gave a loan at less than 1% to an unemployed HR member of MuleShoes' (now-defunct) group who has never met a debt he didn't default on.  Worse yet, imagine that the two borrowers are of different races, sexes, or religions.  It is possible that "because that's what our loan purchasers -- what Prosper calls "lenders" -- were willing to buy them at" isn't a good enough explanation for a bank, but works fine in the less-regulated world of "finance companies" (which is what PMI is).

On the other hand, LendingClub and Zopa, which do partner with banks or credit unions, set the interest rates for borrowers themselves, based on objective credit and income data.  (Zopa allows lenders to use part of their interest income to subsidize borrowers, but, without actually reading the legal agreements, I'm willing to bet that this is structured not as a change in the borrower's interest rate, but as a gift from the lender which is applied toward the borrower's payments.)

Of course, when the platform sets the interest rate for every borrower, much of the "fun" -- and the P2P feeling -- disappears from the site, as does the double-edged sword of allowing subjective factors to enter into the lending decisions. 

Please note that this is only a theory, and I have no intention of reading through reams of banking regulations to substantiate it.  But perhaps one of our members who has experience as a banker (not just playing one on the Internet) will chime in.
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ira01

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #1 on: December 23, 2007, 01:40:15 pm »

Very interesting post, as usual, Traveler.  You may well be right (I have absolutely no idea).  Besides the two possibilities you mention in your post, however -- wrongheadedness and your regulatory hypothesis -- there is also a third possibility, which is the one that Prosper has repeatedly asserted.  Namely, that it is working on obtaining its own national license, but the hurdles are high and many, so it takes a long time.  It is not irrational for Prosper to decide that it would rather be its own master by obtaining its own national license, rather than partnering with another, already licensed, entity like a bank. 
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mandmboysfan

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #2 on: December 23, 2007, 02:08:53 pm »

  Namely, that it is working on obtaining its own national license, but the hurdles are high and many, so it takes a long time.  It is not irrational for Prosper to decide that it would rather be its own master by obtaining its own national license, rather than partnering with another, already licensed, entity like a bank. 

To the best of my knowledge the only "national license" is a bank charter, which would present the problems the trav listed.  There is no such thing as a national license for finance companies.
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traveler505

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #3 on: December 23, 2007, 02:14:02 pm »

My understanding is the same as mandmboysfan's; "national license" is a misnomer.  The only way to be exempt from state-by-state regulation is to be a bank or credit union.  (The bank or CU doesn't even have to have a federal charter; state-chartered institutions share in the benefits of federal preemption.)

Is it possible that Prosper is in the process of opening a bank, or buying an existing one?  Theoretically, but I doubt that Prosper has enough spare venture capital sitting around to pull that off.  

A couple tidbits of history:

X.com (an early competitor of Paypal, which merged with Paypal's original owner, Confinity, in 2000) had built its P2P payments system around a partnership with a bank (First Western National Bank), but had also agreed to purchase the bank.  When X.com/Paypal reneged on the purchase agreement, it had to pay a $1 million termination fee plus reimburse the bank for another $1 million in losses.  If not purchasing the bank was that expensive, completing the purchase must have been considerably more costly.

And Paypal, prior to its 2001 IPO, attempted but failed to acquire federal trust bank status as a way to avoid state-by-state regulation.  
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ira01

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #4 on: December 23, 2007, 02:45:19 pm »

Interesting.  Then were all of Andrew's posts about how Prosper was dilligently working on this, but it was complicated, involved politics, yada yada yada, just pure bullshit (like his infamous "we'll find a way" to seize late blender's accounts to pay their own lenders)?
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Caladia

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #5 on: December 23, 2007, 03:18:08 pm »

Another thing to consider is that this whole business of partnering with banks was pioneered by Payday Loan places as a way to get around the laws.  As a result, it is seen as a somewhat unsavory thing to do. 

In a quick Google search, I found at least one legal challenge to the practice:  http://www.ago.state.co.us/press_detail.cfm?pressID=371 where the defendant, payday lender ACE Cash Express, lost and had to pay $1.3 million in restitution. 

So, it may be hard to find banks willing to partner up ("WebBank"?) and even when you do find one, you're still basically crossing your fingers and hoping not to get sued, which from what I understand is not Prosper's preferred way of doing business. 


 
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mandmboysfan

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #6 on: December 23, 2007, 03:19:47 pm »

Interesting.  Then were all of Andrew's posts about how Prosper was dilligently working on this, but it was complicated, involved politics, yada yada yada, just pure bullshit (like his infamous "we'll find a way" to seize late blender's accounts to pay their own lenders)?

I sure hope they were bullshit - the alternative is that nobody at prosper understood that what he was describing was not possible.
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Fred93

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #7 on: December 23, 2007, 03:29:15 pm »

"national license" is a misnomer.  The only way to be exempt from state-by-state regulation is to be a bank or credit union.  (The bank or CU doesn't even have to have a federal charter; state-chartered institutions share in the benefits of federal preemption.)

Nice to know we are so well protected by this maze of regulation.

bankomatic

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #8 on: December 23, 2007, 03:31:38 pm »

I would also add that partnering with a bank or a credit union means sharing the profit or else why would they partner. By going on their own prosper gets to keep all the profit. Also, anti usury law is set at < 6% in PA, what a joke, thanks for "protecting people".

traveler505

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #9 on: December 23, 2007, 03:43:23 pm »

Another thing to consider is that this whole business of partnering with banks was pioneered by Payday Loan places as a way to get around the laws.  As a result, it is seen as a somewhat unsavory thing to do. 

In a quick Google search, I found at least one legal challenge to the practice:  http://www.ago.state.co.us/press_detail.cfm?pressID=371 where the defendant, payday lender ACE Cash Express, lost and had to pay $1.3 million in restitution. 

So, it may be hard to find banks willing to partner up ("WebBank"?) and even when you do find one, you're still basically crossing your fingers and hoping not to get sued, which from what I understand is not Prosper's preferred way of doing business.   

I haven't looked at the Colorado statutes, but this outcome appears to be the result of specific language in the payday loans law, which enabled Colorado to regulates the bank's "agent" (the payday loan company) when it couldn't touch the bank itself. 

Quote
Importantly, the DDLA regulates not just the lender who funds the loan, but also the lender's agent who arranges the loan. The agent is included in the DDLA's definition of "lender". The Colorado Attorney General's Office contends that the agent, and all loans made through the agent, must comply fully with the DDLA.

If the language of the general lending laws (regulating both agent and principal) is the same, then it is possible that we lenders may be required to have Colorado lending licenses, on the theory that Prosper merely acts as out agent in funding loans which we have selected during the bidding process.  (The letter that Bama received from the Alabama AG suggested, and I think the statutes support this interpretation, that even though Prosper itself does not need an Alabama license because it has no physical presence there, any Prosper lender who lives in Alabama and makes more than a certain number of loans does.)
« Last Edit: December 23, 2007, 03:50:00 pm by traveler505 »
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traveler505

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #10 on: December 23, 2007, 03:47:01 pm »

I would also add that partnering with a bank or a credit union means sharing the profit or else why would they partner. By going on their own prosper gets to keep all the profit. Also, anti usury law is set at < 6% in PA, what a joke, thanks for "protecting people".

But eliminating state rate caps would significantly increase the number of loans funded, and the resulting increase in gross revenues would most likely exceed the share which would be paid to the bank or CU. 

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Mark12547

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #11 on: December 23, 2007, 04:08:39 pm »

Prosper's arrangement is rather novel: we bid, Prosper originates the loans, and then Prosper sells the loans to us (except for servicing). Our participation in the decision to make loans and at what rates (by virtue of our bids) may be part of why a bank license has been so hard to get.

Zopa, on the other hand, has loan officers that make the lending decisions, so they can be careful of the various state and federal laws, and the lenders are merely purchasers of CDs and giving some interest to help someone, but the lending decision is not left up to a bunch of amateurs, some of which think they can ignore the federal lending laws. Zopa, then, works more like a bank than a person-to-person lending site, making it a better fit for partnering with banks or credit unions.
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traveler505

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #12 on: December 23, 2007, 04:15:38 pm »

Prosper's arrangement is rather novel: we bid, Prosper originates the loans, and then Prosper sells the loans to us (except for servicing). Our participation in the decision to make loans and at what rates (by virtue of our bids) may be part of why a bank license has been so hard to get.

Zopa, on the other hand, has loan officers that make the lending decisions, so they can be careful of the various state and federal laws, and the lenders are merely purchasers of CDs and giving some interest to help someone, but the lending decision is not left up to a bunch of amateurs, some of which think they can ignore the federal lending laws. Zopa, then, works more like a bank than a person-to-person lending site, making it a better fit for partnering with banks or credit unions.

And LendingClub is halfway in-between, where interest rates are set by (one presumes, or at least hopes) professional loan officers, but the decision whether to fund or not is left to the amateurs. 

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nonattender

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #13 on: December 23, 2007, 07:55:41 pm »

Trav, et al,

I was always under the impression that going state by state was a first-mover/quicker-to-market strategy.  Not only that, but partnering with some other entity would doubtless require some sort of revenue sharing or other compensation to the partnering entity.  Nothing nefarious about that that I can see - especially as borrowers are free to accept, or not, the rates that the marketplace (prosper lenders) ultimately decide to offer them.

-t
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RussA

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Re: Why Does Prosper Do What It Does? (Part 1: State Rate Caps)
« Reply #14 on: December 23, 2007, 08:22:35 pm »

Trav,

I have researched this issue before and as close as I can get to a regulatory answer to your question is with how the loans are approved and originated.  Finance companies, such as WebBank are Industrial Loan Banks, and without getting into the differences between a Federally Charted Bank and an ILC here, you can read about them here:  http://www.fdic.gov/regulations/examinations/supervisory/insights/sisum04/industrial_loans.html  Notice: most are charted in Utah as is WebBank.

A key point in that webpage is the bullet stating “All ILC lending and activities must comply with Sections 23A and 23B of the Federal Reserve Act (restrictions on transactions with affiliates) and Federal Reserve Regulation O (loans to executive officers, directors, or principal shareholders).11”

The one item I found possibly pertinent to Prosper lending in Sections 23A and 23B FRA is with (3) in the first section. Linked here: http://www.federalreserve.gov/GeneralInfo/fract/sect23a.htm

My read of 23B (below) and other articles on it, is that the FDIC wants “soundness” in the underwriting process.  Read the “prohibited transactions” section.  I think this restates what I referenced to in 23A.  23A & 23B have long applied to banks, but due to concerns over ILCs (remember WalMart Bank) and their affiliates, all FDIC banks/financial institutions are now regulated by these rules.
http://www.federalreserve.gov/GeneralInfo/fract/sect23b.htm

There may be other reasons Prosper does not move forward on this, but I think there is a regulatory bump they cannot get over.

Edit to add 23B.
« Last Edit: December 23, 2007, 11:20:42 pm by RussA »
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