Transcapitalist

“The citrus are like children, they are very fragile, very thin and they need lots of attention and effort. But the olive tree is a tough thing, it survives by its own strength.”

Photo by Moises Saman for the New York TimesI was moved today by the NYT article on severed olive and orange trees in groves across Afghanistan and the commitment of the local farmers to re-grow them. The article paints a picture of the grove's successes and trials that reflect a broader Afghan picture - massive (and competing) investments by the Americans and the Soviets in the 1980s, followed by devastation during the Taliban years, and now, the seeds of rebirth funded by American military support.

Rebuilding the groves is a worthy undertaking - with the potential to employ tens of thousands of young Afghans, this is the type of investment that will reap benefits for years to come. But the approach seems too strangely reminiscent of that of the 1980s: an initial $1.8 million gift from the U.S. military Provincial Reconstruction Team (PRT) and the expectation of years of additional governrment money to come. Indeed,

Mr. Hakim estimates that he will need foreign support for at least five more years to get the farms on track to be fully productive again. The Agriculture Ministry has begun sending modest amounts of money, but is expected to increase the budget as millions of dollars in foreign donor funds become available.

The U.S. money to kick-start the project is understandable, but in a country where corruption is rampant, is funneling future funds through the Agriculture Ministry the way to reach Gul Abbas and farmers like him for this endeavor? When the initial projects were top-down designed by the Americans in the 1980s, there were no local champions with the expertise to guide them.  But now, there is Mr. Abbas, who possesses both the knowledge and the passion - can he be reached directly?

There are microfinance institutions (MFIs) operating in Afghanistan, coordinated by the Microfinance Investment and Support Facility, Afghanistan (MISFA), but none of platforms that enable you and I to contribute - such as Kiva and Microplace - work with Afghan partners. In the Kiva model - where individual faces and stories are presented to encourage donations to MFIs - the life and future of people like Mr. Abbas are compelling.

I would love to see an Afghanistan version of Lend For Peace, a platform to lend directly to entrepreneurs in the West Bank in the belief that creating economic opportunity will reduce social sorrow. Would Americans donate directly to Afghan entrepreneurs given the opportunity? Could this be seen as a small way for average Americans to contribute to building a nation and improving the chances that the military effort will be successful?

And for Mr. Abbas and others like him upon whom rests the future of a prosperous Afghanistan, access to loans, rather than handouts from the Americans and skimmed grants from the government, may offer a more sustainable way to build a market economy.

These days, it's easy to hate the banks. The government has managed them with bailouts and now special taxes, policies that you and I may agree or disagree with but likely have no impact upon. But there is a micro, market-based way to fight the problem: steal their business.

Traditional banks charge exorbitant rates for personal loans, as high as 29%. In the peer-to-peer marketplace, I can undercut the banks by funding loans at far more reasonable rates and still make a nice profit. My current expected returns? 13.59%. After kicking off my $1,000 p2p lending portfolio on Lending Club in early December, I've slowly built up my portfolio over the past few months, periodically adding $500 every couple of weeks until this week when I felt comfortable enough with the platform to drop in the final $2k. My portfolio at a glance:

Through these first few months, there are a few things I've learned....

Click to read more ...

The limitations of the current credit risk modeling approach – the FICO score – are manifold, but nowhere are they more glaring than the complete inability of FICO to evaluate young people. A system based entirely on prior payment history discriminates against youth who are just entering the financial world. For students seeking to continue their education, and needing loans to get there, the consequences are severe – automatically labeling as a credit risk may shut them out of the private loan market and prevent them from attaining higher degrees, regardless of their potential.

Around this striking weakness of the current education finance market is where People Capital, a p2p student loan platform, is seeking to innovate.

Click to read more ...

Since I wrote recently (and critically) of the recent negative articles about p2p lending, I thought it was time to put my money where my mouth was, so tonight I doubled my Lending Club investment portfolio.

Of the initial $1,000 that I invested last month, $250 didn't clear (because loans either fund fully or not at all so if a borrower fails to attract enough investors, the lenders who initially pledged retain their money), so I began backfilling that portfolio. Then I used their investing tool to screen by a few filters - less than 3 defaults in the past 2 years, approved by Lending Club - and create a customized "moderate risk" portfolio. I scanned the 50 proposed notes and eliminated those that seemed particularly egregious. Like last time, "egregious" to me meant poor grammar, failure to answer investor questions, and bad business ideas, such as this gem:

I help executives with 15+ years of experience start their own businesses as solo Entrepreneurs, or "Solopreneurs". After streamlining the setup process and creating an "incubator" that has most of the systems already setup for them, I am now ready to deliver this service via the web using an interactive website. (Emphasis added)

I then filled in the gaps with handselected loans that met my most stringent criteria - verified income, no defaults in the last 2 years - plus an effort to get loans that will clear more quickly - notes that end in less than 7 days. My expected return, accounting for expected defaults, is just shy of 12%.

My standards are rather lower than I thought they would be. I suspect that if I actually knew these people, I wouldn't lend to the majority of them. Maybe I'm being elitist. The questions asked by the lenders also seemed particularly invasive, "e.g., what steps are you taking to ensure that you will not end up in this financial hole again?" I thought about signing up as a borrower as well to see the experience, but now realize that I would prefer not to be so examined by strangers myself.

Still, I'm really excited about my Lending Club investments. I've begun to receive my first deposits and I look forward to continuing to grow the portflio.

A slew of articles criticizing the emerging p2p lending industry appeared this week, beginning with Mark Gimein's post at Slate's the Big Money, "You are Unlikely to Prosper". Felix Salmon soon after wrote "The Problem With Peer to Peer Lending" and then Techdirt followed with "Person to Person Lending Not Saving the Economy...Actually Looking Really, Really Bad".

The message of all of this coverage? That p2p lending is riskier than advertised, most lenders have lost money, adverse selection abounds, and really the whole venture is a failed innovation in finance. As usual in articles about p2p lending, the comments are full of testimonials from lenders about their terrible losses on Prosper.com and how p2p borrowers tend to be deadbeats.

If we were back in 2008, these criticisms would all be noteworthy. Prosper undeniably made terrible, risky gambles, produced misleading advertising, and failed to adequately screen borrowers in the early years. Investors are still reeling from those mistakes (see Fred93 who dropped $800K into the site), but why are we still focusing on earliest years and the losses incurred during the height of the credit crunch? This seemed like old news back in April.

By contrast, Lending Club (scarcely mentioned in these articles) launched with SEC approval, institutes stringent borrower requirements, and has a happy lender community (no hate blogs that I've found yet). Gartner predicts that p2p lending will increase by 66% over the next three years. It's 2010. Let's look forward and let the new crop of p2p lending companies learn from Prosper's early mistakes and do better.

Note: The best discussion forum to get a sense of p2p lender frustration is prospers.org.

Flickr credit: amalthy

The new House financial reform bill has been described as a positive development for the p2p lending community and welcomed by industry leaders such as Prosper CEO Chris Larsen. The reason is the move of transfer of regulatory authority from the SEC to a new entity, the Consumer Financial Protection Agency (CFPA). Getting out of the clutches of the SEC probably is good news; so many nascent p2p marketplaces that initially seemed so promising, from Yadyap to People Capital  to Zopa, have either stalled or shuttered US operations in face of overwhelming regulatory requirements. Even those that survived – Prosper, Lending Club, and Pertuity Direct — were set back considerably at the time.

Yet, I’m concerned about a new entity receiving such broad sweeping power in the name of consumers and what it means for the p2p community. The Consumer Product Safety Commission, for example, has not looked with particularly friendly eyes upon the “innovation” of direct selling of handmade children’s items (rather than relying on mass production in China) and threatens to significantly curtail the operations of small sellers on Etsy. It is a sad day when the interest of big business overrides the best interests of the consumers in the name of protecting them.

Here’s to hoping that the CFPA, if it is in fact created (still a great uncertainty), will recognize the benefit of alternative credit models to consumers, rather than restricting access in fear of innovation and newness and of course, the lack of a massive lobbying effort to speak for the consumers who can now access loans at reasonable rates and the lenders who can make sound investments.

Since the closing of Pertuity Direct, I made my first move back into the domestic p2p lending market this weekend, opening a Lending Club account with a friend. Our goal is to earn a healthy and stable return of around 10% with minimum monitoring required and full transparency of the status of our investments at all times.

My approach was first to use LendingMatch, their automated tool, to give me a decent, diversified base portfolio. [On a design note, the user interface of LendingMatch is extraordinary; it ranks up there with Etsy as among the most fun and intuitive browsing and selecting tools]

I selected three filters:

1. $1,000 total investment
2. Target return (after accounting for expected default and the service fee) of 11%
3. No delinquencies in previous 2 years

There were certain other filters that I wanted to choose—notes that were both approved by the Lending Club credit team and where the individuals had their income verified—but they too restricted the portfolio, bringing me down to only a handful of notes, so I let them go.

This search gave me 32 notes to compare. I went through them individually to eliminate certain notes that failed in certain less scientific ways:

1. Inability to spell (especially in the case of the two word loan title, e.g. “Debt Consoalidaton”)
2. Bad business ideas (e.g., fixing up and flipping houses in a depressed housing market)
3. Failure to adequately answer questions asked by other lenders

At this point, my portfolio was a bit more aggressive than expected. Lending Club rates their notes from A (less risky) to G (more risky) and I had no A or B loans and an excessive number of F and G loans. I filled in with more A and B loans, filtering for verified income, which obviously brought my expected return down a bit, but I was more comfortable with the final result, summarized here:

The historical default for this blend is about 3.5%, plus the fee of about 0.7%, so my final expected rate of return is between 10 and 11%. My plan is to continue to expand this portfolio to $5,000. I was actually prepared to invest all that at once, but there are simply not enough notes on the site to create my desired portfolio at that scale. Rob at Lending Club indicated to me last month that the company is focusing on attracting additional borrowers. Now I fully understand why a sufficient number of borrowers is so crucial to taking p2p lending mainstream; while it remains hard to invest a significant amount of money, Lending Club’s reach is limited.

The company’s customer service remains stellar. When I experienced a technical issue, I Twitter DMed @RobGarciaSJ, their Senior Product Strategist, who wrote back nearly immediately.  A colleague who is also looking at opening an account shared with me several e-mail exchanges he had with one of their VPs, all answered in great detail within a few hours. Through those emails I learned that Lending Club is allowing accounts to be opened on behalf of dependents. My colleague is looking for a way for his kids’ savings accounts to earn more than 0.5% interest and thinks Lending Club may be a good option.

I’m looking forward to expanding my Lending Club portfolio as the company grows and tracking how it is going here. With expectations of a 10% return, warnings of “if it sounds too good to be true, it is” ring in my ears, but I remain optimistic that p2p lending is simply offering a simpler, better investment opportunity. It’s one I’m willing to bet on.

A savvy, young real estate investor of mine asked me recently about p2p lending:

"What is this peer-to-peer lending about? Is it true that anyone can lend to strangers on a website without anyone who actually knows anything about investing helping them? They must be getting screwed. Investing is hard. Not everyone should be doing it themselves.”

It's a similar argument to that made by many critics of microfinance recently: that the poor aren't knowledgeable enough to make use of access to financial services wisely. As with naive p2p lenders who far from earning a return, may end up holding useless paper of defaulted loans, naive microfinance borrowers  may end up far from improving their lives in the worse shape of over-indebtedness.

These concerns certainly are valid. Not everyone is a savvy lender with knowledge of investing principles and not everyone is a born entrepreneur or businessmen who can reasonably project future income based on new debt. But there are some common principles that both p2p lending companies and microfinance institutions can (and often do) embrace to alleviate these concerns and make them both accessible and fair.

• Simplicity. P2P lending is remarkably straightforward: You (the lender) select the return you want and the risk you can accept, choose borrowers that fit that profile, and agree to lend them money. You then collect a proportion of their monthly interest. This is a process that most people can understand without credentials as a finance genius and creator of synthetic CDOs. And because more people can understand it, more people can reasonably be expected to enter the market and make rational decisions. I’m a believer in not investing what you don’t understand, but a smart person can get p2p lending.

• Transparency. As a P2P lender, your money changes passes from you through one middleman (the lending institution) to the borrower. There are no mysterious detours. You won't be told that your loans will be repackaged into something newer and better that you no longer recognize. To the unsavvy investor, this is paramount -- I can track where my money is at all times. In microfinance, the transparency comes with clear terms and rates. Adjustable rates and balloon payments don’t exist in the legitimate microfinance world. First time borrowers can enter into these agreements with full knowledge of what their repayment commitment will be throughout the course of their loan.

• Quality. When markets are open and quality is poor, disaster awaits. Unsophisticated, early investors on Prosper lended money to very high risk borrowers and were soon burned. P2P lending companies learned quickly from this mess that they needed to focus on finding quality borrowers. In fact, Lending Club now claims that among their biggest challenges is finding enough good borrowers, not lenders. Similarly, many microfinance institutions have embraced a certification/rating mechanism to signal high quality partner institutions that embrace client protection. This is a market mechanism to determine quality (like Moody's, minus the conflict of interest) of the providers and minimize negative effects on the poor borrowers.

I agree that there are risks to democratizing finance. Cutting out expert financial advisors to investors and providing access to capital to poor borrowers can lead to dangerous outcomes if the opening comes without caution. My friend worries about what will happen to amateurs making investment decisions without the help of an expert. The Wall Street Journal and others worry about what will happen to the poor who become overindebted because of newfound access to financial markets. I argue that people can generally make good decisions for themselves if the right prerequisites and protections are in place. P2P lending companies and microfinance institutions offer that chance.

Lawrence Lessig's article "Against Transparency" in The New Republic has sparked a lot of debate about the perils of going down the road of "naked transparency".  Lessig fears open data for government may end in citizen cynicism and withdrawal from the political process. Rather than being actually against transparency, he makes clear in his follow-on article and this interview that his real concern is that people will see transparency as the sole answer rather than the necessary combination of transparency + meaningful campaign finance reform.

I agree that transparency is not a panacea, but I believe he overstates the "perils" of open data. Take a look at the Sunlight Foundation's display of health care lobbyist contributions to Senator Max Baucus, author of the current main health care reform bill being debated in Congress. Will citizens reach "unwarranted conclusions" upon seeing the nearly half a million dollars Senator Baucus received from these lobbyists while he was shaping health care reform? It's a scandal that such a revelation does not lead his career to "be destroyed".

Of course, Prof. Lessig is in support of such thoughtful analyses and he is right to bring up the broader reform issues.  I believe we need more of the kind of transparency and analysis that the Sunlight Foundation has fostered, but the cynicism question raises an important point. One can imagine a scenario in which people are participating in a process that is ultimately good while ignorant of some of its messier internal mechanics. Should that process be made transparent at the risk of alienating the participants or is ignorance really bliss?

Take the case of Kiva. Yesterday the Harvard Businesss Review pointed out that the peer-to-peer lending platform tells a story that is not entirely true. A large part of Kiva's appeal for lenders is the implicit promise that your money goes directly to the needy entrepreneur of your choosing. In reality, the $25 that you donate on Kiva to Ndidi Bienose, for example, is routed through his sponsoring NGO, Lift Above Poverty Organization (LAPO). LAPO collects all lender money and in turn distributes it to their entrepreneurs. This is one reason for the unexpectedly high repayment rates of Kiva (~98%) -- individual losses can be easily disguised within a group under an NGO. Microplace uses the same model, but has always been straightforward about it.  Kiva, however, has been vastly more successful because of their more appealing, albeit untrue, story.

This unplanned transparency could turn into an example of what Lessig fears: that the exposing of the behind the scenes action will turn previously happy do-good Kiva lenders into cynics who now see P2P micro-lending as just as corrupt/misleading as the more traditional forms of aid that it hoped to supplant. Due to the attention problem that Lessig identifies, lenders will not take the time to learn that the end result of Kiva's and Microplace's approach is actually more effective and more efficient than direct peer-to-peer lending.

It's too soon to tell whether some Kiva lenders will be turned off enough by the revelation to stop participating, but I'm optimistic that the real Kiva story can be told effectively.  There is a powerful fact that Kiva can stand behind : Lending through a field partner is more reliable than direct lending and smooths the process for the benefit of the entrepreneur that the lender is hoping to help. The bottom line of Kiva remains the same -- to alleviate poverty through microloans -- and in the end, your money still goes to Ndidi Bienose. In Seth Godin's parlance, the P2P story is still authentic, even if it is not entirely true.

So is the new transparency in Kiva a good thing? A few lenders may be lost, yes, but the ones who remain will have full knowledge of the process and will no longer be duped. The strongest and most engaged communities are built on honesty. The same is true of government.

Flickr credit: bgblogging via Creative Commons, where I get all my photos and a concept for which I thank Lawrence Lessig for pioneeering