New here? You may want to subscribe to the RSS feed or browse the site map. Thanks!

If you have been reading my recent posts at Personal Loan Portfolio, you know that I am in the process of formating a P2P lending strategy. However, lending does not seem to be a good business to be in recently. Countrywide, one of the nation’s largest mortgage lenders, is hemorrhaging jobs and money due to poor lending practices. Countrywide is not alone — see the recent financial results at Morgan Stanley , Citibank, and Merrill Lynch which have all been negatively impacted by their mortgage backed securities investments. These recent results make for a frightening lending environment.

Today, MSNBC is reporting that mortgage foreclosures rose 30% in the third quarter of 2007 over the second quarter. The level is double the third quarter 2006. That makes the overall US foreclosure rate one out of every 196 households. How does this rise in foreclosures impact your Prosper lending strategy?

First, why the increase in foreclosures? Too many borrowers bought more house than they could afford by taking out an adjustable rate mortgage (ARM). ARMs give the borrower a lower introductory mortgage rate on the assumption that the borrower will 1) sell the house before the rate adjusts upwards or not long after the rate change, 2) the borrower will earn more money in the future and thus be able to take on the additional payment or 3) refinance at a lower rate or under better terms in the future. Too often, I believe that the reason that borrowers took on ARMs was that they simply did not understand the interest change.

An upward rate adjustment of only 2% could add over $600 per month on a $500K mortgage payment[1] — but the story is even worse if the borrower had received a special introductory rate. Add to the picture rising gasoline prices, rising home owner’s insurance rates, and inflation. This makes the foreclosure rate very understandable in the markets that had high price home appreciation, especially considering that many people can no longer sell their house at a profit in the slow moving and declining market. According to BankRate.com, a borrower has a 1 in 3 chance of losing their home if they took out an ARM and had an initial interest rate of less than 4%. Unfortunately, foreclosure even impacts those who borrowed wisely according to the Center for Responsible Lending:

The center’s property value analysis was based on academic research indicating that a foreclosure lowers the price of neighboring properties by 0.9 percent on average. That impact was higher in poor neighborhoods, where prices dropped 1.4 percent on average.

So how does this effect a Prosper or other P2P lending strategy? Just like real estate, Prosper lending is not only about the overall national economic situation but also the local economic conditions. The previously mentioned MSNBC article, states the highest rates of foreclosures are in particular states:

[T]he highest concentrations were a handful of housing markets; California Arizona, Florida, Nevada, Ohio, Texas and Michigan made up more than half of the total.

To be more specific, the foreclosures are concentrated in specific cities. Another MSNBC article lists the cities with the highest foreclosure rates. For example, Stockton, California had a foreclosure rate of 1 out of every 31 households! Below are many of the top foreclosure markets with a longer list in the article. I would avoid lending in any of these top foreclosure markets because a lender could essentially truthfully tell you that his or her debt to income ratio is currently a reasonable value, but possibly the borrower knows that the rate is changing in the near future and will significantly change the equation. The borrower could be using your loan on a prayer to keep their house in the near future, but with no long term real hope of recovery. I will be avoiding loans to borrowers in any of the following metropolitan markets.

[1] The monthly payment on a $500K mortgage at 4% interest is $2,387. The monthly payment on a $50K loan at 6% interest is 2,997. A difference of $610 per month.