Online person-to-person lending seemed like a terrific concept. People with a bit of available cash could have the opportunity to loan their money to folks who needed it. Without the expensive branches and staffs of brick-and-mortar banks, an online intermediary could keep its costs low. In theory, that would result in higher-than-bank-interest returns for the folks who could lend cash and lower-than-bank-interest costs for the people who needed to borrow it.

If it worked, it would have been a tremendous win for all involved. It's too bad that online-lending pioneer Prosper.com botched the execution of that concept. Sure, any start-up will have growing pains. It's how a company responds and adapts to those pains that really matters.

On that count, Prosper has earned an F.

Perjury or fraud?
The most egregious misstep by the company happened in May of this year. In a filing in United States bankruptcy court, Prosper denied it directly loaned money to either a man who was declaring bankruptcy or to his wife, whom he accused of stealing his identity. Instead, Prosper claimed that it was acting as the authorized agent of individual lenders who loaned the money.

That may seem straightforward, but it's actually directly contrary to the contract that Prosper had with the people who bought the loans it originated. Prosper may call those folks "lenders," but as the contract states, Prosper was the lender and the people it called lenders were really loan purchasers.

So was Prosper misrepresenting itself to the bankruptcy court, or did it execute phony contracts with the people who purchased loans through its service? Either way, if you were looking to get into the money-lending business, you might think twice about whether that's the kind of company you should want to do business with -- especially since you need to give it personal information like:

  • your name,
  • your Social Security number,
  • your bank account information, and
  • your home address.

Why it really matters
In this particular case, whether it was truly identity theft is tough to discern. If it was, Prosper would be on the hook to buy back the loan through its identity-theft guarantee. That's important to the people who bought the loan from Prosper, but it's truly a secondary concern to the real problem unveiled by Prosper's statement to the court.

The real problem is this: Only Prosper knows the true identity of and has the ability to directly verify any claims (such as income) made by anyone looking to borrow money on its site. With Prosper as the original creditor on its older loans (WebBank originates the newer ones), it has rights to attempt to collect under the Fair Debt Collection Practices Act. By its agreement with its loan buyers, in fact, Prosper does administer collections on loans that go sour.

And far too many of those loans are going sour -- fast. Fully 18.5% of all dollars loaned on Prosper between its inception and the end of June 2008 have gone delinquent. Some individual months look substantially worse: More than 35% of the dollars loaned in February 2007 are in some stage of evaporating.

Customers are not amused
Prosper.com member Fred93, who has apparently invested more than $800,000 in Prosper loans, has repeatedly called into question the efficacy of Prosper's collections. Likewise, Prosper.com member ira01, who has also reportedly invested a decent chunk of change, has posted to a discussion forum about several areas in which he says the company is not living up to customer expectations. They include:

  • Misleading advertising
  • The (now defunct) process for selling off non-performing loans
  • Poor identity and income verification
  • Erasing the old discussion forums where borrowers and loan purchasers could interact

With Prosper now denying in court that it even made a particular loan, the problems that customers like Fred93 and ira01 raise take on an even sharper focus. Issues that may once have been excused as start-up pains can't be so easily overlooked. While some loan buyers trust Prosper as if it were their fiduciary, Prosper's statements before the court seem to confirm that it does not act with full fiduciary care of its loan buyers' money.

A better way to loan money
A standard Prosper loan lasts three years. If you have money to loan and that you won't need for three years, an FDIC-insured bank CD is certainly a safer option than buying a Prosper loan. And given the tremendous rates of non-payment on Prosper loans, you just might see a higher return in any of these CDs:

Bank

3-year CD Rate

Discover (NYSE:DFS) Bank

4.70%

GMAC (NYSE:GJM)

4.40%

M&T Bancorp (NYSE:MTB)

4.40%

Intervest (NASDAQ:IBCA)

4.36%

California First National Bancorp (NASDAQ:CFNB)

4.22%

Capital One (NYSE:COF)

4.07%

Washington Mutual (NYSE:WM)

3.93%

There may still be a future in online person-to-person lending, but I wouldn't invest another dime in Prosper.com.

The author would like to thank Fred93, ira01, and the other sleuths at http://www.prospers.org for all their hard work uncovering the data that went into this article. At the time of publication, Fool contributor Chuck Saletta owned shares of Discover and Washington Mutual. Discover is an Inside Value selection. The Fool has a disclosure policy.