Dispatches from the Frozen North

Sun - April 27, 2008 02:32 PM in

The Magic Year

It's always dangerous to extrapolate current trends far into the future, but I've been doing it anyway for solar energy. I got my hands on a data set of the average price of photovoltaic modules over the past 25+ years (in constant 2006 dollars), thanks to Robert Margolis at NREL.

Keeping in mind that the data shows the prices of the PV modules only (not installation), the trend is remarkable: on average, the real price per watt of photovoltaic modules over the past 25 years has tracked almost perfectly to a curve which drops by half every 10.5 years (or about 6% per year). There are a few blips here and there--corresponding to supply and demand fluctuations--but the simple 6% annual drop in prices explains 96% of the variation in PV module cost over two and a half decades.

Given recent advances in photovoltaic technology, there's no reason to believe the trend won't continue for a while longer. It may even accelerate at some point.

At this point, it's natural to ask when solar panels will be cheaper than power from the electric company. You have to make some assumptions about the long term interest rate, how long the modules will last, and the relative cost of installation, and I came up with the answer that solar and grid power will be at parity somewhere between 2020 and 2025.

That's not the whole story, though, since it's reasonable to assume that the cost of electricity will increase faster than inflation for the foreseeable future. That means that while the cost of solar power is going down every year, the savings will go up--and the savings will continue to increase even after the solar panels are bought and paid for.

So in reality, it makes financial sense to install a photovoltaic system while it's still somewhat more expensive than grid power, since over the life of the system the savings will continue to increase. The Magic Year--the year when a brand-new photovoltaic system will pay for itself over its lifetime--depends on the assumptions you use about the inflation rate for electricity, the real interest rate, the life of the system, and so forth.

The Magic Year is 2015
The Magic Year is 2015 using these assumptions:

* The installed price of a photovoltaic system will be twice the price of the modules alone
* The price of the modules will continue to follow the historical curve
* Grid power today costs $0.10/kWh (about the price I'm paying now)
* The real inflation rate for grid power will be 3% (i.e. grid power will increase on average by 3% more than the inflation rate)
* The long-term real interest rate will be 3.5% (i.e. the interest rate will be 3.5 percentage points above the inflation rate)
* One watt of PV capacity will generate one kilowatt-hour of electricity per year (about the factor for Minnesota)
* The system will last 30 years
* After 30 years, the photovoltaic system will have no residual value (i.e. it will need to be completely replaced)

I used a Net Present Value (NPV) calculation, the standard way to figure the current value of future cash flow or savings. If the NPV is negative, then the system costs more to install than it saves over its lifetime; conversely, a positive NPV means the system pays for itself. The breakeven point (NPV = 0) is the Magic Year.

Your Magic Year may be different than mine. For example, in the California desert where grid power is more expensive and a photovoltaic system produces more power over a year, the Magic Year could be as early as 2007 (using the same interest rate and inflation assumptions). In Seattle, where hydro power is still cheap and it's cloudy all the time, the Magic Year could be 2025 or later.

Saving for the Magic Year
There are a lot of assumptions and an uncomfortable amount of extrapolation which go into calculating the Magic Year, but it seems reasonable to assume that 2015 will be the year to install a photovoltaic system here in Minnesota (give or take a couple years). She Who Puts Up With Me and I have decided to run with this assumption, and start putting aside some money every month with the idea of saving enough by 2015 to install a PV system big enough to bring our net electrical consumption to zero. We're also putting aside enough to pay for a major upgrade of our heating and air conditioning system at the same time--which might include switching to a geothermal heat pump.

In the meanwhile, we'll keep burning firewood in the winter--the stove has now paid for itself with gas savings--and doing smaller energy upgrades along the way like windows and lighting. 2015 is only seven years away, and by then we hope to have our net home energy use down to zero.

Posted at 02:32 PM | Permalink | |

Mon - April 7, 2008 02:10 PM in

Inscribed on Charlton Heston's Tombstone

Okay, you can take my gun now.

Posted at 02:10 PM | Permalink | |

Tue - March 11, 2008 05:05 PM in

50! *

Spring is finally here--after months of nearly-continuous days below freezing, the temperature shot up to 50 degrees today. Thank the intense sunlight (we're now getting as much sun each day as we did at the end of September) and favorable westerly winds.

To be precise, our home weather station recorded a high of 49.7, which while it isn't precisely 50, it is close enough if you round to the nearest degree. Hence the asterisk.

When it's 50 outside and bright sunshine, the house stays at a comfortable temperature all by itself: I let the stove go out, despite the fact that I'm home this afternoon (with a cold). I can practically see the snow disappearing before my eyes, and the highs are forecast to stay above 40 for pretty much the rest of the week. By this weekend, the snow cover which has persisted since early December may be completely gone.

I love all the seasons in Minnesota, but Spring is easily my favorite, followed closely by Fall. I love those moments when we pass through Perfect while going from one extreme to the other.

Posted at 05:05 PM | Permalink | |

Thu - March 6, 2008 09:20 AM in

Blood in the water on Wall Street

The stock market opened down big this morning (30 minutes into trading, the S&P 500 is down well over 1% with no bottom in sight). The news in the Wall Street Journal is alarming: the private equity fund Carlyle Capital failed to meet a margin call last night.

A margin call is the second worst thing which can happen to any investor. It means that the investor borrowed money against its portfolio, and the bank or brokerage is demanding more collateral for the loan because the value of the portfolio dropped too much. The usual response is to add more cash to pump up the portfolio value and reduce the loan amount.

Normally when an investor gets a margin call, there's only a matter of hours to put up enough collateral (or "meet the margin call"). If the problem isn't fixed by the start of trading the next day, the bank or broker will force the investor to start selling part of the portfolio to pay back enough of the loan to satisfy the collateral requirements.

This forced selling is the worst thing which can happen to an investor.

That a private equity fund as prominent as Carlyle Group would fail to meet a margin call is nothing short of astonishing. Aside from the fact that they should have been smarter than to get themselves in this situation in the first place, this was the group all the conspiracy nuts liked to weave their dark theories around, because of the number of prominent politicians (including ex-Presidents) associated with the fund.

There's an old saying among stock traders that you should buy when there's blood in the water. In other words, when a big player is wounded or dying, the forced selling will push prices to an irrational place and that's the time to step in and buy.

This morning there's blood in the water. Too bad I'm already invested.

Posted at 09:20 AM | Permalink | |

Fri - February 22, 2008 11:07 AM in

Economic outlook

The majority of pundits lately have been thinking deeply about the economy, at least when they're not obsessed with the scandal du jour in the presidential contest.

I'm not a pundit, but I occasionally pretend to be one on the Internet, and I've been thinking about the economy lately. Here's my conclusions:

First, we are probably in a recession. When the dust settles, we'll probably decide that the recession began sometime between November and January.

Second, I think we're probably close to the bottom right now (but we won't know that for a good six months or more). I base this on these observations:

1) The stock market has been basically flat for a month now, neither moving significantly up or down. We may have actually set the bottom in January, though we haven't moved enough up to be sure that there won't be another bottom in the near future.

2) The Fed is pumping huge amounts of liquidity into the economy, and that money is going to have to go somewhere. Near-term it seems to be going into super-safe investments like government bonds (and especially inflation-protected bonds), but before long investors will start looking for more return, and that means investing money in real businesses and people.

3) Media reports are uniformly and overwhelmingly focused on the negative, and not the positive news--and there is positive news out there, it's just hard to find. I take this as a sign that the mood can't get much worse from here.

Third, just as in the past couple economic slowdowns, all the money the Fed is pumping into the economy right now is likely to lead to a new bubble somewhere in a couple years. Don't believe me? Look at the pattern: the 1992 recession was arrested by easy money from the Fed, which contributed to the dot-com bubble. The 2002 recession was also marked by easy money from the Fed, and that helped pump up the real estate bubble.

This isn't necessarily a bad thing. Financial bubbles (despite the problems when they burst) have a number of desirable side-effects, not the least of which is driving a period of strong economic growth. Bubbles also tend to create massive investment in infrastructure which--even if uneconomical when built--lay the groundwork for future innovations and benefits. For example, a massive amount of fiber-optic capacity was built in the late 90's, far more than would be needed at the time. But the telecoms which lost their shirts on that fiber also created the conditions for cheap bandwidth today and made companies like YouTube possible.

For the most part, the excess housing built this decade won't disappear, and (as long as the population continues to grow) there will be families willing to buy or rent the homes for the right price.

What's The New Bubble?
If you think there's going to be a new financial bubble forming in the next few years, it's very useful to know where the bubble might form. Good candidates are industries or sectors where:

1) Fundamentals have changed significantly for the better recently, and are likely to remain favorable. This could be due to new technology, market conditions, or other circumstances.

2) Returns have been good.

3) There's an element of sexiness or the exotic to pique investors' interest.

The most obvious place is alternative energy: if you believe that oil is likely to remain around $100/barrel or higher for the indefinite future--and this seems a reasonable assumption--then the fundamentals for renewable energy are strong. Combine that with improving technology and dropping prices for renewable sources like wind and solar, and the sexiness of "green energy," and it looks almost irresistible.

What's more, if you believe that renewable energy will ultimately have to replace nearly all our fossil fuel consumption, there's enough demand for renewables to sustain industry-wide growth of 25% to 50% per year for decades.

First Draft of a Renewable Energy Portfolio
To test this investment thesis, I took a stab at building a model portfolio over the weekend. I started with a comprehensive list of alternative-energy related companies (which was hundreds) and applied these criteria:

1) The stock has to be listed on the NYSE or NASDAQ. No pink sheet stocks or bulletin board stocks; any company with serious prospects will have the resources to get listed on a "real" exchange. Also, no foreign exchanges, since those are harder for Americans to buy, and I'm not familiar with the foreign accounting and trading rules.

2) The company has to be primarily focused on alternative energy. This excludes companies like GE, which makes a lot of wind turbines, but makes most of its money elsewhere.

3) No biofuels, because I'm not convinced that biofuels make economic or environmental sense in the absence of government supports.

This left me with 14 companies, all but one of which make solar panels (the other company is a tiny manufacturer of wave power systems).

Also, because this is a hyper-growth industry, I weighted the model portfolio by revenue growth in dollars from 2006 to 2007. That eliminated two companies which actually shrank (one due to an accounting change which I didn't want to bother researching). I also applied a cap of 15% of the portfolio value to individual companies, to keep it from being too heavily weighted towards a couple big Chinese companies.

Of the twelve remaining companies, about 60% of the portfolio wound up in four big Chinese manufacturers of conventional (polysilicon) solar panels, and First Solar, the upstart thin film manufacturer, was another 13.5%.

Unfortunately, this has been a really bad week for my model solar portfolio: all but two of the companies are down for the week, and the portfolio as a whole is down 15%. Apparently one of the big Chinese companies lowered its forecasts because of cost and availability problems with polysilicon, and that pulled down the entire industry (even the companies not using polysilicon).

Volatility is to be expected in this sort of concentrated, speculative portfolio, but I'm really glad I didn't invest any actual dollars in it this week.

Posted at 11:07 AM | Permalink | |

10:08 AM in

Ten Business Lessons

Rob at Businesspundit is signing off today, and he ends with a list of ten lessons he's learned about business after ten years of entrepreneurship.

I don't normally link to Businesspundit (mainly because he's loaded up the site with zillions of craptacular advertisements, widgets, and other blog-flotsam), but this article is excellent and worth reading for anyone thinking about starting a business.

There's an eleventh lesson not mentioned, however: every entrepreneur will have to learn these lessons for himself. We're a stubborn lot by nature, and there's no substitute for getting burned a few times.

Posted at 10:08 AM | Permalink | |

Sun - February 10, 2008 12:47 PM in

Biofuels are not the answer

I've been gradually becoming less and less excited about the potential for biofuels (ethanol, biodiesel, etc.) to replace fossil fuels, and I've now come all the way around to the opposite opinion of what I used to believe.

I'm now convinced that biofuels are not the answer, either to global warming or our limited reserves of liquid fossil fuels.

Conversion Efficiency
Biofuels are a way of storing the energy from sunlight in (usually) liquid form, suitable for powering vehicles, heating homes, and similar purposes. The problem is that when you measure the net energy content of the resulting fuel (after subtracting the energy required to process it, such as planting, harvesting, fermentation, distillation, etc.), you find that the ethanol, biodiesel, etc. contains almost a laughably small percentage of the original energy of the sunlight which fell on the field. We're talking about hundredths of a percent or less--with some scientists arguing that some fuels (like corn ethanol) actually contain less energy than what it took to process the plants into fuel.

While there's plenty of sunlight available--in theory, just the sunlight hitting Nevada is orders of magnitude larger than what's needed to meet global energy demand--there is a limited amount of arable land on the planet, and much of that is already farmed for food. Given how inefficient biofuels are at capturing solar energy, growing enough biofuel to meet demand will exhaust the available supply of land suitable to current farming practices and fuel crops.

This also sets up an unhealthy competition between growing food and growing fuel, one in which the energy demands of wealthy countries could lead directly to famine in poorer places.

Of course, new technologies could change this calculus. There's plenty of "land" available in the middle of the Pacific ocean, and a (hypothetical, as-yet-to-be-invented) process for farming massive floating algae beds could be an economical way to grow biofuels without competing against land currently used for food.

As things stand right now, however, existing biofuel technology simply won't be sufficient.

Solar Power
Once you realize that biofuels are nothing more than a grossly inefficient form of solar power, however, the answer to a big part of the problem becomes obvious. Existing solar-electric (either photovoltaic or solar-thermal) technology is reasonably efficient, and even starting to come within shouting distance of coal-based electricity in cost. The conversion is efficient enough that our current energy needs can be met with a reasonable amount of collector area, and as a bonus, the best sites for solar collectors are often unsuitable for crops so there would be no food vs. energy competition.

The problem is that the most efficient processes we have for capturing solar power today all convert the solar power into electricity. Electricity is the best choice for many energy uses, but is hard to store (in a compact and lightweight form) for powering a vehicle. You need either an efficient way to convert solar power into liquid fuel, or a better battery.

Battery technology is slowly improving, and commercially available electric cars today can go about 20 miles on a charge. That's enough for a lot of people's daily commute, but doesn't even come close to sufficient for long-haul trucking. The idea that we might someday have battery-powered airliners is almost laughable, given the limited weight available for fuel on an airplane.

Direct conversion of sunlight into liquid fuel is pretty much a pipe dream at this point. There has been some interesting progress in conversion of sunlight into hydrogen gas, but hydrogen (despite the hype) is a poor vehicle fuel: it's hard to handle, and takes up too much weight and space for the necessary pressure tanks.

Transition Plans
Existing products and technology show a likely path for weaning ourselves from fossil fuels. First will come longer range electric vehicles and plug-in hybrids. Shorter trips (which account for a disproportionate share of fuel consumption) will become mostly all-electric, though petroleum will still be used to fuel long trips. A commercially available car capable of going 60 miles on electricity alone seems possible within five years, and for most people that will result in daily gasoline usage close to zero.

More and more of the electricity from the power grid will come from renewable sources, especially wind and solar, now that those are close to or less than the cost of fossil fuels for peak generating capacity. Since those sources are somewhat unreliable, you may get a discount from the power company for not charging your electric car on days when there is less solar or wind power available.

That alone will dramatically reduce our need for fossil fuels, and requires no new technology.

Replacing liquid fuels for long-distance travel (trucks and airplanes) is harder to foresee. It may be that biofuel is necessary for those applications, but at least it will represent much less impact than trying to run our entire transportation infrastructure on biofuel. Better, though, would be a reasonably efficient process for converting sunlight to liquid fuel (maybe with hydrogen as an intermediate step)--but I'm not aware of any promising technology, or even serious research, in that direction.

Biofuel Niches
I don't think biofuels are a sustainable way to replace all our liquid fuel needs: the majority of the burden has to come from solar power and electricity.

There are some niches where it makes sense, though. Long-distance transportation is one of those. Waste biomass conversion (i.e. taking biomass which would otherwise just be landfilled, such as downed trees, agricultural waste, etc., and either burning it for heat or converting it to liquid fuel) is also sensible, though there isn't enough waste biomass around to make a big dent in our fossil fuel use.

But fueling your Hummer with biodiesel is not the way to save the planet.

Posted at 12:47 PM | Permalink | |

Sun - February 3, 2008 11:29 AM in

Really Frozen North

2007-2008 is the first Real Winter(tm) we've gotten in the Frozen North in a few years. A reasonable amount of snow, subzero temperatures, the whole nine yards.

Plus a new feature this year: the Temperature Roller Coaster. Most years, when we go into the deep freeze, we get a week or maybe ten days of consistently subzero temperatures, barely struggling into positive territory in the mid-afternoon if at all. This time around, we're getting short little bursts of bitterly cold temperature, followed by a warmup a day or two later, and then another plunge a few days to a week or two after that.

This week was especially remarkable, as shown in the graph:

Over a 36-hour period, we went from +45 degrees to -15 degrees, a 60-degree swing. In the temperature plot you can almost see the exact minute the arctic cold front passed our house.

The weather service likes to measure these things in nice 24-hour chunks, and on that basis this was apparently the biggest drop in decades. It was a little surreal to be walking around outside with no jacket on Monday, then all bundled up and worried about the car starting on Tuesday.

Welcome to Minnesota.

This week, they're forecasting a snowstorm on Monday, and more moderate temperatures (nothing below zero). We're past the midpoint of winter, there's noticeably more daylight now than back in late December, and it will get harder and harder for those arctic airmasses to compete against the warmer air coming from the Gulf of Mexico.

We've also now completely consumed the five cords or so of firewood I'd stockpiled in the garage, so I'm now starting to move wood in from the outside piles. The wood in the garage lasted until February, almost exactly as long as I'd predicted. The supply is looking good, though I'm spending a fair amount of time picking through the piles to find the best wood to burn while it's still relatively cold out. The lighter wood (mostly cottonwood) is best for burning in the spring, when we don't need to keep the stove going all the time. It just burns too fast for the middle of winter. The biggest problem is that I've still got something like eight cords of cottonwood, most of it in large unsplit pieces. That's almost half a season's worth of wood, which is good, but there's so much of it that I'll be spending a lot of time splitting, stacking, and moving it.

On the other hand, it was all free. Beggars can't be choosers.

Posted at 11:29 AM | Permalink | |

Wed - December 26, 2007 12:44 PM in

December Gas Usage

The month of December was cold in the Frozen North, and we saved about $220 on our natural gas bill through the wood burning stove.

This bill marks almost exactly two years since we got the wood stove installed, and we're closing in on paying for it through fuel savings. To date we've saved about $2,600, and kept something like 25 tons of carbon dioxide out of the atmosphere.

The stove is starting to show some wear, though: a piece of fiberboard in a baffle in the firebox is disintegrating, and needs to be replaced (about sixty bucks for the part, and probably ten minutes to install). This is apparently expected to need replacement from time to time, since the manufacturer excludes it from the warranty.

Posted at 12:44 PM | Permalink | |

12:38 PM in

New Weather Page

I've had some annoyances with the old software I was using to upload the current weather to Weather Underground, so I've switched to a different software package and a new weather page right here on the blog.

The current weather at the Frozen North is here. The page will update every five minutes, and I'm going to add some history graphs when I get the chance. One benefit of the new page is that I can now display the temperature and humidity inside the house, which Weather Underground wouldn't support.

I'm still trying to find a fix for one significant bug, that the USB driver for the interface to the weather station crashes with some regularity. The symptom on the weather page is that the current conditions are all blank, and fixing it requires either unplugging the USB cord to the weather station, or rebooting the computer.

For now, I've got the computer set to reboot overnight, but I'd really like to find a more permanent fix. If anyone knows about fixing a flaky Silicon Labs USB driver on Mac OS X, let me know. I've already done the obvious stuff like making sure I have the most current drivers, and I'm not the only person to report the problem.

Posted at 12:38 PM | Permalink | |

Wed - December 19, 2007 04:29 PM in

Solar Installation Costs

Startup Nanosolar made a splash this week announcing that they're starting to manufacture photovoltaic panels for under $1/watt, and this has highlighted the rapidly dropping cost of solar-electric power.

This is an important milestone, of course, but it's a little premature to get all excited about going solar quite yet.

It's important to note that the $1/watt quoted in the press release is a manufacturing cost, not the retail price. Solar modules are generally in short supply, and odds are Nanosolar is charging a market price for its panels, or no less than slightly under the market price. For big megawatt-level installations, the market price is probably in the $2-$3/watt range right now. Ordinary humans like you and me still have to pay upwards of $5/watt, maybe as much as $7 for the stuff which is actually in stock at a real distributor.

If Nanosolar's manufacturing cost really is under $1/watt, however, their business is insanely profitable for the moment. That will give them the financial ability to quickly build new plants, ramp production, and help make the solar panels more available and much less expensive. So the gap between manufacturing and market price will narrow with time.

The more important problem, which won't go away with time, is the installation cost. From what I've seen, it costs around $2-$3/watt to install a residential-scale photovoltaic system. That's what it costs to buy wires, inverters, mounting brackets and other miscellaneous gunk, and then hire guys to crawl around on the roof bolting stuff together. Unlike the cost of the panels themselves, the installation cost isn't going to drop precipitously when a new factory comes online or someone invents a breakthrough process. Instead, you have to figure some clever way to nail more panels to a roof (safely!) with fewer hours of skilled labor.

Right now, for mere mortals, the total cost of a PV system looks to be in the $7 to $10/watt range, before any rebates or tax incentives. Here in Minnesota, solar becomes less expensive than the power company when the installed cost of solar drops to around $1.75/watt (assuming 6% interest and a 30-year system life). Solar becomes a no-brainer when the installed cost drops under $1/watt, allowing you to pay off the system (with interest) in around ten years from the savings in electricity.

It's pretty obvious that if the installation cost of a PV system is $2-$3/watt, you're never going to hit the $1.75/watt threshold even if the panels themselves are free. In fact, as the price of the solar panels drops, the system price will become more and more dominated by the labor and hardware to install them.

So is there hope that photoelectric power will ever be cheaper than grid power?

Yes. For starters, right now there are very few contractors with experience in solar power, making that a skill which is in very high demand. I expect that the installation price will drop over time, as more companies develop the skills and experience necessary to perform this work.

I also expect that as the cost of the panels keeps dropping, it will become more and more obvious that installation is a bottleneck. This will lead to the development of simpler installation systems: things like self-sealing roof anchors (to avoid having to install flashing around bolts), plug-together wiring systems, click-together mounting brackets, and so forth.

If the average Minnesota home uses about 5,000 kWh/year, and that requires installing about 5,000 watts of solar capacity (round numbers for the sake of simplicity), we hit the no-brainer threshold when the total system costs less than $5,000. If we're a few years in the future and the panels are down to $0.50/watt (contractor's price), that leaves about $2,500 to install a system with 25-30 panels, or 20-40 hours of labor. With a clever mounting and wiring system, it seems quite possible: 10-20 hours to install brackets and mounting hardware, then a few minutes to click each panel in place.

So cheap photovoltaic is coming. Just not as fast as the press releases might have you believe.

Posted at 04:29 PM | Permalink | |

Sun - November 25, 2007 08:30 AM in

November Gas Usage

We got our November gas bill, and this month we saved about a hundred bucks through wood heat (details here). We're getting close to having saved the cost of the stove, which was a bit under $3,000 including installation. Not bad for less than two full seasons.

This is the time of year when we're starting to burn firewood in earnest, but haven't yet had to turn on the main furnace. The house stays reasonably warm (depending on how much sun we get) just with the wood stove, but we're consuming fuel at a healthy clip. I'm pretty sure we've got enough good, dry firewood to last the season, but I won't know for sure until we get a lot closer to spring. The woodpiles are disappearing alarmingly fast, so I hope I've estimated correctly in how much wood we'll need and how much I collected.

So far, we've completely consumed one small stack of wood, about 1-2 cords which were on the patio. I had been expecting this to last until sometime around the end of November, and I was pretty close: we used the last of it on Thanksgiving. Next up is the approximately six cords stacked in the garage, which I estimate will last us until sometime in the last half of February. The garage wood is the best stuff, with a lot of nicely seasoned oak and maple.

Then there's another 2-4 cords stacked under a spruce tree next to the garage, which should get us to the end of the wood burning season. I've also got several more cords under a different spruce tree, but that wood mostly still needs to dry for another season before its ready to burn. Some of it is quite green, having just been cut this fall, and some of it is cottonwood, which isn't very good firewood until very dry. There's probably four cords of cottonwood waiting to be split (equivalent to just two cords of oak), but I'm waiting to split it until it freezes and gets brittle.

The bottom line is that this year, for the first year, I think we really have enough well-seasoned firewood to last the whole winter, and a good start on the following winter. I made an effort this summer to try to collect two years' worth of firewood, so that we'll have a plentiful supply of dry wood. I didn't quite get two winters worth, but I did get maybe one and a half.

Posted at 08:30 AM | Permalink | |

Sat - November 24, 2007 03:56 PM in

Taking the Plunge with Prosper.com

I was intrigued enough by the research I did for my article a couple weeks ago that I decided to open a small lending account at Prosper.com, the peer-to-peer lending company. It's been an interesting experience so far, and I'm still learning a lot.

In no particular order, here are some of the things I've discovered so far:

* On average, Prosper.com lenders tend to charge too little interest on the riskier loans: the interest rate isn't high enough to compensate for the higher risk of default (and often isn't high enough to make the expected return match the lower risk loans). For example, if lenders expect 8% interest on a low-risk loan with a 0.5% expected net default rate (i.e. on average lenders lose 0.5% of their principal to defaults on loans of that class), then on a loan with a 5% expected net default rate the lenders should charge significantly more than the 12.5% interest which would make the return the same as the low-risk loan. But that's not what happens on average on Prosper.com; instead lenders are asking less (sometimes a lot less) interest on those risky loans than you would expect. This means that if you're a high-risk borrower, Prosper.com is a great deal for you if you can get your loan funded.

* That said, there is a surprisingly wide range of interest being charged on similarly risky loans: I've observed as much as six percentage points difference in the rate charged for loans which (as near as I could tell) were about equally risky. So, if you're a borrower on Prosper.com, sometimes you win the interest rate lottery and sometimes you lose.

* The name of the game in lending is minimizing default. You only earn 7% to 25% interest on your loan, but if the borrower doesn't pay you can lose 100%. A single bad loan can destroy your performance, unless you've got at least a hundred or so different loans in your portfolio (this implies, by the way, that you need to invest a minimum of $5,000 to $10,000 in Prosper.com if you're going to be serious about it, since the minimum slice each lender can have of a single loan is $50). Any loan can default, but some are more likely than others, and it's best to stick to the very highest rated loans.

* It can take a long time to put money to work. A week to transfer funds into Prosper, several days to go through the bidding process, and then up to a week to actually originate the loan. You earn no interest until the loan originates. Sometimes a borrower doesn't check out (happened to me once already), so you have to start the process all over. Assume you'll be earning no interest for 2-3 weeks while trying to invest your money.

* Standing Orders are your friend. Standing Orders are a mechanism which lets you specify specific lending criteria and an interest rate, and any time a matching loan is available it automatically bids on it. This is handy because it takes the emotion out of bidding, and lets you automatically set criteria which result in an acceptable return for your risk. Too many Prosper.com lenders bid on the emotion, which is why some loans get charged too little interest, and others pay a lot more.

* Keep your expectations modest, and you probably won't be disappointed. The majority of Prosper.com lenders with 20 or more loans (i.e. a minimum of $1,000 invested) appear to be earning between 5% and 7% after taking defaults into account. That might not sound spectacular, but it's significantly more interest than a 3-year CD will pay right now. I suspect (but can't prove) that it may be possible to systematically earn 12% to 14% after defaults, by setting up a careful program of Standing Orders which only bid on loans which pay enough interest to more than compensate for the additional risk.

* Only bid on loans which expire soon. There's no point in tying up your money for the entire ten days it takes some loans to get bid. Set up your Standing Order to bid on matching loans which end the earliest.

* Most borrowers are honest, but borrowers can (and have) lied about anything and everything on their loan descriptions. The only thing which can be trusted is the credit report, since it comes from a neutral third party. Therefore, don't ever bid on a loan because of something the borrower says (though it's OK to not bid because of something the borrower says). Most interest rates get bid too low because something the borrower wrote inspires sympathy, trust, etc....don't get caught in that trap. By the way, this is one reason why Standing Orders are so useful: they're strictly "by the numbers."

* As I wrote before, at this stage Prosper.com should be treated like online poker, not a serious investment. Assume you could lose everything, because if the company goes under you just might. On the other hand, if you can afford the loss, it can be entertaining, educational, and sometimes profitable if you're sufficiently disciplined.

Posted at 03:56 PM | Permalink | |

Wed - November 7, 2007 01:09 PM in

Aviation Denial of Service Attack

You may have heard about the Swedish guy who told the FBI his son-in-law was a terrorist in order to prevent a business trip to the Untied States. A blog entry at Discourse.net raises an interesting point: we've now become so paranoid about air travel and border crossings that anyone (and I mean anyone) can have someone arrested, hassled, and denied entry or deported. It doesn't matter how credible the threat is, our security apparatus has determined that any threat has to be treated as true.

This effectively gives Those Who Wish To Do Others Harm a powerful weapon, effectively a simple denial-of-service attack against air travel (and probably train and bus travel, for that matter). Even better, this attack can be carried out anonymously, even from the safety of a village in a third-world country.

But I don't think Michael at Discourse thought this through entirely. It's easy to see that this could become a crippling attack against our entire aviation infrastructure. If an enemy's goal is to disrupt rather than actually kill, it can be extremely effective, cost nothing, and present little or no risk to the attackers' lives or even liberty.

Consider these attack scenarios:

1) An e-mail is sent to the TSA claiming that a terrorist will be checking a suitcase packed with 50 lbs of high explosive onto a flight departing LaGuardia airport at 10 AM on a specified date. The bomb is set to detonate in or near the baggage screening area, killing people and severely damaging part of the terminal building. The threat contains enough details to be considered credible, but not enough to pin it to an exact passenger or flight. The threat might even contain previously unknown but confirmable details about some terrorist organization (to better establish the legitimacy of the sender).

Likely impact: Some or all of LaGuardia airport is shut down for several hours, canceling hundreds of flights and delaying hundreds more, causing airlines, the TSA, and passengers substantial financial losses. Since delays at LaGuardia tend to ripple across the entire flight schedule of several airlines, many flights are canceled or delayed which go nowhere near New York.

2) Now suppose that the threat claims that this will be a coordinated attack on several of the largest hub airports in the U.S.: LaGuardia, Logan, O'Hare, Minneapolis, Denver, San Francisco, Los Angeles, etc. Since a coordinated exploding suitcase attack is well within the means of even a small terrorist organization, this doesn't diminish the credibility of the threat much.

Likely Impact: Total disruption of the national air system for most (possibly all) of the day. Depending on how credible the terrorists make the threat, a one-day grounding of all commercial flights isn't out of the question.

3) A terrorist network uses a communication channel which they know is compromised to implicate targeted individuals (for example, prominent businessmen, key opponents) as part of a sleeper cell or other plot. This kind of disinformation campaign was actually used in WWII very successfully against the axis countries, and can be extremely effective if the covert listener doesn't know that the enemy knows about its listening. (Disinformation in a compromised channel can also be used to deliver the threats for attacks #1 or #2.)

Likely impact: Targeted individuals will find it difficult or impossible to travel to/within the United States, and may even be arrested (and possibly tortured these days).

4) Simultaneously in several airports around the country, someone rushes past security screening. This usually causes the airport to shut down for a time until the individual is arrested (and with simultaneous incidents it may trigger a more thorough security sweep and further disruption). This is not zero-risk for the attackers, since they are likely to be arrested and tried, and there's an outside chance of being shot, but it's still a lot better odds than a suicide attack.

Likely impact: Major disruption of the national air system for several hours at least. The coordinated attack could lead to a complete shutdown until the authorities decide there's no larger plot.

The bottom line is that it's now very easy for anyone to create major headaches for anyone else trying to travel in the U.S., and the authorities seem to care little that their overzealousness can cause big problems for a few people here and there. Worse, a highly credible threat could lead to a service disruption which might be more expensive and deadly(*) than an actual terrorist attack.

(*) Disrupting air service might actually be deadly when you consider things like (1) people who decide to drive instead of fly, since driving is something like ten times as dangerous per mile; (2) disruption in life-saving medical treatments, like patients traveling to a distant hospital and organs traveling to distant patients; and (3) the combination of paranoid security personnel with angry mobs of passengers possibly leading to someone accidentally getting shot.

Posted at 01:09 PM | Permalink | |

Mon - November 5, 2007 01:33 PM in

Prosper.com

"Personal lending" startup Prosper.com must have recently hired a new PR firm, since it's been all over the place lately. I think I've heard or read three or four radio segments and articles about the company in the past week alone.

The idea is pretty simple: think of it as Ebay for lending. People who want to borrow money (up to $25,000) post a plea online, Prosper.com assigns them a risk rating (based on their credit score), and individual lenders can "bid" to fill some or all of the loan at a given interest rate. If enough lenders are interested, the loan gets made; and if the loan is oversubscribed, then the interest rate gets pushed down. Loans are all fixed interest rate unsecured three-year loans.

It's an idea with a lot of appeal, especially borrowers sick of paying 30% or more for credit card debt, and individuals looking for a better return than the 5% or so currently offered by CDs and other short term debt. Even the safest (lowest yielding) loans on Prosper.com are paying over 10% to the lenders, and the higher risk loans are offering well over 20% interest.

That's before fees and defaults, of course, and there's the rub. Prosper.com takes a 1% fee for all but the highest rated loans, and if the borrower defaults then the lender might not get anything. So the actual return has to be adjusted for fees and defaults.

Fortunately (and to their credit), Prosper.com makes a handy performance calculator tool available, which calculates the ROI for a basket of loans based on criteria you specify, including rating, origination date, and about a hundred other factors. So you can get some sense for the actual returns corrected for fees and default histories (though the calculation could be proven completely wrong if the economy changes and default rates go up or down significantly). And, according to the performance calculator, even after correcting for defaults and fees the returns still look attractive: over 9% for the highest rated loans.

But there's a couple of gotchas and oddities.

Gotcha #1
Looking at the default return calculator, it only includes loans originated between 6/1/06 and 10/6/07, and those where the borrower had no current delinquencies and no more than two recent credit inquiries at the time of the loan.

In other words, the "headline" return isn't the real return for all Prosper.com loans. Playing around with the tool somewhat, I found that including all loans in the performance calculation causes the return to plummet: even then highest rated borrowers only returned a little more than a money market fund, and the lower grades had substantially negative returns. In other words, even the high (20% and up) interest rates charged on those risky loans weren't enough to make up for the very high rate of default.

Worse, in the June-September 2007 quarter, only about half the loans originated at Prosper.com met the "no defaults and two or fewer credit inquiries" test. The rate of return published on the web page is seriously misleading, since it excludes the riskiest half of loans. Someone not paying attention could very easily miss that detail and wind up making much riskier loans than expected.

I presume that the default and credit inquiry information is available to lenders (I don't know for sure since I haven't created an account to see for myself), so clearly lending to people who have current defaults or more than a couple credit inquiries is extremely risky, whatever Prosper.com's rating might be, but this is also an avoidable mistake.

Gotcha #2
There's only a limited amount of data in the loan history, since Prosper.com didn't start making loans until 2006. On a three year loan, that means that not even the oldest loans have gone to maturity (though some have been paid off early), so the reported default rate will be lower than the actual default rate for the full life of the loan. In fact, the preset time frame in the ROI tool excludes the first six months of Propser.com's history--looking just at that initial six months shows an ROI a couple points lower.

In other words, if you want to know the actual historical return on Prosper.com's loans, the answer is "nobody knows because none of these loans has gone to maturity yet." It is a fair bet is that the actual return will be at least somewhat lower than reported by the performance calculator.

Oddity
It's also weird that the default-adjusted return for riskier loans is actually lower than for the less risky loans. Normally you would expect the riskier loans to return more, even after adjusting for the default risk, since lenders will demand more interest in exchange for the increased risk. But that's not the case.

This suggests to me that at least some of the lenders on Prosper.com aren't doing their homework, and get seduced by the very high interest rates offered on the riskiest loans. Because the interest rate is so high, at least some people aren't properly calculating the default-adjusted return.

Gotcha #3
If you really want to delve deeply into the expected return on a Prosper.com loan, there's no way to get enough historical data to make a meaningful calculation, and it isn't clear exactly how Prosper.com does the calculation.

For example, it's very important to know not just whether a loan defaults, but when. It makes a big difference if a loan defaults in the second month instead of the twentieth. In the latter case, the lender has already recovered over half the capital. It's also important to know what fraction of loans in default ultimately are repaid or written off.

It's also important to know when loans are repaid early, to get a handle on "prepayment risk." How could early payment of the loan be a risk? Simple: there's no guarantee that you can reinvest the money at the same interest rate, and the borrower gets to choose whether and when to repay early. If interest rates drop, many borrowers will refinance (which Prosper.com makes easy), and the lender is suddenly no longer getting the 10% interest he expected to get. On the other hand, if interest rates go up, the borrower has locked in a low rate, and the lender doesn't have the ability to make new loans at the higher interest rate.

In other words, borrowers get the ability to reset their interest rates by prepaying and refinancing, but lenders have no such option. This will always work to the lender's disadvantage.

When to Invest Through Prosper.com
Given all this, I don't think Prosper.com is likely to be a good investment for most people. Lending money is a complex business, and there are a lot of subtle details which can impact your return. Even for big, sophisticated banks lending money to individuals isn't a great business to be in: despite the absurd interest rates, credit card companies make most of their money on fees, not interest. There are some people who might find this model rewarding, however:

1) People willing to do their homework and be extremely smart and careful about the loans they make.

2) People who derive nonfinancial rewards from Prosper.com (for example, the satisfaction of helping someone in need, or the gamelike aspects of the site).

For the most part, however, the extra financial return you might earn through Prosper.com will not come anywhere close to paying for the time and effort to manage their loan portfolio.

And there's also the question of what happens if Prosper.com goes bust: the company has been backed by $40 million or so in VC money, and with that kind of investment the investors are probably looking for the company to have $50 to $100 million/year in revenue in fairly short order. That implies originating several billion dollars/year in loans, and right now they're a couple orders of magnitude shy of that number. It's not clear to me that there's anywhere close to the required level of demand, and if the VCs pull the plug, where does that leave the lenders? Only Prosper.com is allowed to service the loans, and it's not clear that any other financial institution would be interested in taking on that job.

So for now, I'd view lending through Prosper.com as a stodgier version of online poker: do it for the entertainment value, don't expect to actually make any money in the long run, and be mentally prepared to lose everything in the worst case scenario.

Posted at 01:33 PM | Permalink | |

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