Upton Sinclair, petty capitalism, and intrusive thoughts

“It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”

I’ve been thinking about that line from Upton Sinclair’s campaign memoir “I, Candidate for Governor,” on and off for the last year, and I’ve come to believe it gets one thing very right and one thing very wrong.

Cultures are very good at reproducing themselves

It’s currently fashionable to claim that Americans are in a maelstrom of loneliness, but what I’m continually struck by is the astonishing plethora of civic organizations you can see on every streetcorner. You may suspect that the Elks, Eagles, Pachyderms, and Masons are aging and insignificant because you happen to not enjoy spending time with them, but whenever I visit small and medium-sized towns they’re the first places I see teeming with activity. I’ve gone to bingo at the VFW, sung the Montana state anthem at a Kiwanis meeting (“Montana, I love you!”), and danced lacklusterally in ballrooms at the Elks Club.

If you don’t like those examples, let me suggest you look at the stately manors lining the most valuable real estate in the most successful cities in America: note they all seem to have Greek letters outside, because they’re owned and occupied by the members of fraternal organizations that have managed to survive not by stringing along aging members into senescence or renting out their ceremonial halls for funerals, but by recruiting brand new troops of 18-year-olds each and every academic year.

These cultures adapt and shift over places and times, but the reason they perpetuate isn’t because of their adaptability, it’s because of the urgency of their internal logic. And, in fact, most human activities take this form.

The culture of petty capitalists is determined by the nature of petty capitalisms

If you have ever known someone before and after they acquire a rental property, you’re no doubt familiar with the sudden change in personality they undergo. Suddenly obsessed with trash pickup schedules, noise ordinances, and lawn maintenance, the simple act of holding a deed transforms your laid-back friend into the most annoying landlord you’ve ever met, overnight.

The same pattern repeats everywhere. Anyone who has bet money on the Superbowl can transform before your eyes into a specialist in NFL rules mechanics. Any piker who busts a hand in blackjack will suddenly be able to explain why the player to their right screwed them by making the wrong play and, really, that two of hearts should have been theirs, if you think about it.

I recently read an anecdote [I thought this anecdote was from Gay Talese’s memoir “Bartleby and Me” but I can’t find it there, so consider this hearsay instead] of a door-to-door furniture salesman from the 40’s or 50’s who explained to the reporter that the only thing worse than a customer who couldn’t make their installment payments was one who paid off their furniture early. After all, a late payment just added to their total interest, most of which went to the salesman as commission, but an early repayment meant cutting short the entire future stream of income from the exhausting work of closing a door-to-door furniture sale on installment.

What all these examples have in common is that they take an outcome you might otherwise be neutral towards (landlords versus tenants, Texas versus New England, furniture debtors versus furniture creditors) and, purely through the mechanism of self-interest, make you emotionally and morally invested in one side over the other.

This is a mistake, but it’s a very easy mistake to make, so one shouldn’t feel too bad about it, but rather strive to do better.

Prosper and the strange case of “prepayment risk”

If you’ve ever heard of “prepayment risk,” it was probably in the context of mortgage loans. Lenders financing long-term, fixed-rate loans live in the same terror as our door-to-door furniture salesman: if a loan can be repaid at any time, then it’s impossible to predict the loan’s future stream of income. If short-term rates rise, then the lender is stuck collecting below-market interest on their capital. But if rates fall, then the borrower can refinance the loan at a lower rate and force the lender to reinvest their capital at a similarly lower rate.

Since ordinary people borrow money to buy houses, rather than lend money to others to buy houses, most people understand that this is a feature, rather than a bug, of our housing finance system. Since financiers cannot live in houses, but people can, people should be free to refinance their loans as often as it’s advantageous while rates are falling in order to more easily afford shelter, but not be forced to refinance their loans when rates rise, since that would make their shelter less, rather than more, affordable.

What I was not expecting from investing in peer-to-peer loans with Prosper is the way it so closely mirrors the experience of a mortgage lender and the similarly intrusive thoughts it generates.

From a lender’s perspective, prepayment risk is the dominant risk on the Prosper platform. This should surprise you. After all, Prosper makes extremely risky loans. Here’s one offering a yield of 29.25% on a 5-year loan:

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This loan will probably not be repaid in full and on time, which Prosper itself explicitly acknowledges (the historical return on such notes is shown as 2.62% - 13.18%). If you had some way of only picking the 29.25% loans that would be repaid in full and on time over 5 years, you’d make a killing only investing in those notes. But you don’t, so some of the loans you pick will default and the more loans you buy, the closer your actual returns will get to the overall return of similarly-risky notes.

Prepayment risk is the flip side of default risk, because Prosper also makes extremely safe loans, and people with good credit and steady income have much cheaper alternatives for credit than unsecured Prosper loans. In the same way that people who just-barely qualify for Prosper loans can quickly slip into default, people who easily qualify for Prosper loans can quickly find more favorable terms from other lenders.

Since I started investing with Prosper again in January, 2023, 37 of my loans have been paid in full, compared to 488 in current repayment, 5 with late payments, and one charge-off. In other words, while investing in highly-rated loans, prepayments are a vastly more frequent occurence than settlements, bankruptcies, and charge-offs.

Why do Prosper lenders hate prepayments so much?

There’s something intrinsically funny trying to explain why Prosper lenders hate prepayments. Here’s a typical example of a prepayment. The loan was originally for 4 years at a 14% yield:

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The borrower made their first two payments on-time, then repaid the remaining interest and principal balance:

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I made a total of $0.72 ($0.77 in interest less $0.05 in Prosper’s “service fees”) on a $25 loan, a mere 2.88% total return, far from my promised 14% yield. But I made it in 2.5 months (October 23 to January 7), not 4 years, which through a little exponential arithmetic gives me an annualized return of 14.6% (this is not to be taken too literally; on small amounts over short periods each penny and each day shows up as a big difference in annualized yields).

There are essentially three reasons that I think Prosper lenders spend so much time fuming over prepayments. First is a sense of powerlessness. Prosper determines the eligibility of borrowers and the repayment term and interest rate they’ll pay. Lenders have to accept or reject the loan terms agreed on by Prosper and the borrower. Since the lender is subject to the whims of the Prosper lending algorithm, lenders have a sense that borrowers should be too. If a lender is willing to surrender access to their money for a full 5 years, why shouldn’t the borrower be locked into the same repayment period?

Second is a sense of scarcity. Once Prosper has determined the loans that are available, it feels to lenders like they’re doing valuable work sorting through those loans to determine the most qualified borrowers and most favorable repayment terms. Prosper invites this mania by listing obviously meaningless information like the borrower’s state of residence and information about their residency, credit history, income, and employment. The provision of this information mechanically instills in the lender the conceit that they can apply some novel combination of metrics to select the loans most likely to be repaid on time and in full, but not a moment sooner. If you’re carefully hand-picking loans and one of them gets repaid after just a few weeks or months, then you’ve not only lost that dedicated stream of interest revenue but you’ve also wasted all the time you spend hand-picking that loan.

And finally, there is a perfectly accurate sense that Prosper gets paid first, because they do: their loan origination fee (“1%-9.99%, depending on Prosper Rating”) is subtracted from loan proceeds before they’re distributed to borrowers. This means Prosper gets paid generously to process the churn from quickly-repaid, high-quality loans: the same $25 loan that netted me the $0.72 in interest over 2.5 months generated roughly $2.55 in revenue for Prosper (a 1% origination fee and $0.05 in servicing fees).

Of course, Prosper incurred expenses managing the loan, and I didn’t.

You cannot keep the intrusive thoughts out but you don’t have to agree with them

Hopefully I’ve given enough examples in this post that you recognize yourself or someone you know in at least one of them. The fact is, people succumb to moralizing when they are personally financially involved in a way they never would about identical financial transactions they don’t have a stake in. Once you become a realtor you are compelled to believe that a 3% buyer’s fee was handed down to Moses on Mount Sinai. Once you become a New York City apartment broker (a profession that everyone agrees does not and should not exist anywhere else) you are instantly convinced that one month’s rent is the correct and natural broker’s fee.

What I am here to tell you is that you cannot resist thinking those thoughts, but you do not have to agree with them. We all know that there are good people, who resist the intrusive thoughts of their profession and adhere to a moral code independent of their income source. We all know there are normal people who are just trying to get by in whatever profession they happened to land in. And we all know there are bad people, who succumb instantly to the imperatives of their profession.

So, when you feel those imperatives, do you resist them, go along with them, or succumb to them? Do you think homeowners have special insight into the unfairness of property taxes just because you happen to be a homeowner? Do you think employers have special insight into the unfairness of the minimum wage just because you happen to be an employer forced to pay the minimum wage? You can’t keep from thinking such thoughts, but you are not forced to agree with them when they intrude on you unbidden.