Today I received an email from Prosper to notify me that they are entering a quiet period, as they register with the proper securities authorities for a secondary lending market. What is a secondary lending market? It is a market where you can buy and sell loans that have already been originated. This provides additional liquidity, as you are no longer bound to wait 36 months until maturity and you can sell loans before they complete the full term.
In a typical secondary market, the net present value of a loan depends on the expected future cash flows and a discount rate. The discount rate is the interest rate on the loan often with an additional risk premium. When interest rates fall, the net present value of existing loans will rise. This is because older loans were originated at higher rates and are more valuable. When interest rates rise, the net present value of existing loans falls since new loans can be originated at higher rates and provide greater cash flow.
I have a feeling that at least initially, the Prosper market will not behave like a typical secondary lending market. I think that either one of two things will happen:
- People that regret having tied up their money for 36 months will put their loans up for sale. In desperation they may be willing to accept very low prices for the loans. This will present a great opportunity for investors to purchase higher yielding loans.
- People will be greedy and attempt to sell their loans for much higher prices than they are worth. Investors will not bother buying them since they can just originate more attractive loans. It would be an illiquid market, very much like the broader credit markets are right now.
It will certainly be interesting to see exactly what happens. Perhaps neither will happen and the market will function in a relatively normal manner. I’m sure that Prosper will probably provide some tools to provide guidance to those selling loans to ensure some liquidity within the market. Prosper will want the market to be as liquid as possible, because they will very likely receive fees for sales within the secondary market.