Continued criticisms of p2p lending

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

Prosper, p2p lending online marketplace, is (really, we mean it?) back

It's been a long and arduous road (see here, here and here), but Prosper announced today that it is officially back, this time with the gold standard of proof: their statement with the SEC has been declared effective.
They are offering some innovative changes to the p2p landscape. From today's blog post by CEO Chris Larsen:

Trade Existing Notes
We’re also incredibly excited to introduce an Internet auction-priced trading platform for Prosper Notes. As many early Prosper lenders know, we’ve been working on this feature since we first launched in February 2006. We know that financial markets thrive on liquidity, which in P2P lending means lenders will have the opportunity to sell Prosper Notes any time regardless of the loan term. The note trading service is provided by Foliofn Investments, Inc., through their Folio Investing Note Trader platform.

Prosper Ratings
Other significant improvements include a new Prosper Rating system to make bidding easier and more rewarding. The new Prosper rating is built on Prosper’s huge database of approximately 28,000 loans. We have also introduced a minimum 640 credit score requirement for borrowers and a minimum bid floor for each Prosper rating to improve and optimize returns. Finally, to improve the ease of diversification, we’ve lowered the minimum bid amount to $25

Peer-to-peer lending may now be making its way to the mainstream. Federal Reserve Chairman Bernanke in a speech three weeks ago: “emerging technologies like peer-to-peer leading also show promise.”

Five things to ask yourself if you are interested in social lending

There is significant buzz around the concept of social lending these days. From the dramatic re-opening and prompt re-closing of Prosper Marketplace, to the calm (and dare I say bank-like?) steady returns of Pertuity Direct, mainstream borrowers and lenders across the spectrum are wondering whether social lending may be a legitimate pursuit. But who is it for? Is it an alternative reliable source of returns for investors? An option for borrowers who seem to have no other options? A platform to lend to the working poor around the globe? A risky, high-payoff avenue for lenders? A way to feel good about helping people reach goals that you support?

The truth is that social lending is an incredible diverse market space. If you’re thinking about entering the social lending sphere, ask yourselves these questions to know which platform may be right for you:

1. What originally drew you to social lending? I see three main classes of people interested in social lending: 1) Investors looking for an alternative return stream; 2) Idealists looking for a concrete, high-impact way to contribute to social good; and 3) Casual lenders intrigued by the possibility of cutting out the bank to earn returns and create a more transparent financial experience. You should know immediately which type you are—investor, idealist, or casual lender—and your options will narrow considerably based on these goals.
2. How much personal connection are you looking for? As the term “peer-to-peer lending” has evolved to the broader “social lending”, some sites are moving away from the direct p2p connection. Pertuity Direct, for example, has very consciously tried to move to the mainstream lending market by relegating the typical “borrower profile” to an optional community page. Instead, lenders buy into a pool of borrowers of a given asset class. This approach is excellent from an efficiency standpoint—no need to browse through profiles to try to create your own diversified portfolio—but the lenders looking for the feel-good sensation of getting to know your borrower will be disappointed. Lending Club offers the more traditional profile-browsing approach which gives you a direct connection to your borrowers. On Kiva and Microplace, you choose a microfinance institution who finds individual micro-entrepreneurs according to filters—in your chosen country, target demographic, etc.—whereas on LendforPeace, the entrepreneurs are all Palestinian. Through Virgin Money, you simply formalize deals with people you already know; no new relationships are gained, rather the site creates the framework to help prevent existing relationships from deteriorating when they are complicated by a financial bond. The latest entrant Unithrive connects Harvard alumni with current Harvard students – the possibility for a durable bond between individuals is there with both the financial and university connection.
3. How much risk are you willing to take? Initial challenges with high default rates when the p2p lending space was in its infancy led to many charges that borrowers on these platforms are an adversely-selected population and lending is risky business. The industry has made great strides since then and has instituted far more stringent borrower requirements, but the risk factor is still relevant. Pertuity Direct and Lending Club are the only two companies that are registered with the SEC, so if the government’s blessing matters to you, your options are quite limited. The international microfinance sites have very low default rates (1.7% on Kiva). Pooled lending, like on Pertuity Direct, achieves the highest rate of diversification, but if you’re willing to accept the risk, you can choose borrowers paying a higher interest rate based upon their profiles at Lending Club. Prosper is still shut down, but many early lenders were burned on the site – often due to their own lack of judgment, but an issue nonetheless.
4. Do you want to make money? At Kiva and LendforPeace, p2p microfinance sites, you earn no interest, but the sites offer a high-impact way for you to park additional money (as little as $25). At Microplace, you can earn up to 6% interest (although most investments fall more in the 1-3% range). At Pertuity Direct, the average interest rate is around 13.4% (minus fees). Lending Club claims a 9.05% average annual performance.
5. Are you interested in a particular cause? Many sites target very niche markets. If you are appalled by the usury of payday lending, check out alternative Yadyap (“payday” spelled backwards). Passionate about education financing? Look into People Capital or Unithrive. If you are looking to provide economic opportunities in Palestine, LendforPeace is your site. To help mainstream American families, Prosper and LendingClub are the best known.

The comeback party is over. Prosper shuts down again.

Today Prosper announced to the community that it is "voluntarily" shutting down again after less than 2 weeks open to California lenders. We profiled earlier from both a positive and negative perspective, the innovative Open Market Initiative that Prosper's debuted at its re-launch. Personally, I was skeptical about this new strategic direction, and with this decision, I'm really doubting Prosper's model.

Some official clearly found the state-by-state approach without full SEC blessing to be unacceptable. For social lending platforms, I would stick to Pertuity Direct and Lending Club, both SEC-approved, for now.

Here is the text on Prosper's website:

Prosper is Currently in a Quiet Period

We have been overwhelmed by the outcry from potential investors around the country who want to participate in peer-to-peer lending. Thank you for your support and your letters to us.

After much consideration we have decided to voluntarily shut down our operation in order to complete our SEC approval for a nationwide peer-to-peer lending platform. As a result, due to regulatory concerns, and in the interest of working toward getting our registration statement effective as soon as possible, we are discontinuing our California intrastate offering at this time.

If you're an existing lender, your current lender agreements will be unaffected; your existing loans will continue to be serviced; you'll be able to track and monitor your loans; and you'll be able to withdraw funds from your Prosper account.

If you are a borrower with an existing loan, you will continue with your current borrower agreement and be unaffected by the registration process.

We want to assure you that Prosper is looking forward to being able to offer a transparent, durable and participatory lending institution very soon.

As a result of this decision, we will not be accepting new lender or borrower registrations or loans, or new commitments from existing lenders effective immediately. Until this process is complete, we are required to be in a quiet period and will be unable to respond to press, blogger or other inquiries related to our SEC registration process, even though we would like to.

We sincerely apologize to the Prosper community members for this inconvenience or disappointment our decision may have caused. We want to thank those of you who demonstrated your support through your active participation whether by investing with us again or referring friends to our site.

Thank you in advance for your understanding, support and patience once more. We look forward to serving the needs of the community in the hopefully not too distant future.

Counterpoint: Prosper is Back…But is this innovation wise?

As we profiled yesterday, Prosper, the former industry leader of the p2p lending industry, continued to innovate and evolve during its forced “quiet period” in anticipation of its re-launch. In addition to offering traditional p2p loans, Prosper has now introduced its Open Market Initiative, which will allow other financial institutions to place their already funded loans on our site for auction. In his blog post, CEO Chris Larsen makes the argument that more opening up these loans to greater competition will lead to better rates.

That may be so, but I have a number of concerns about this model. First, I’m concerned about these lenders unloading their bad loans on the site. Prosper suffered some early challenges regarding poor repayment rates and I’m surprised to see them immediately target a less-than-prime space right at re-launch. Additionally, are retail investors really prepared to evaluate these loans effectively? Many of Prosper’s early lenders struggled to effectively diversify their p2p loan portfolio, explaining some of the initial losses reported. I see no reason to believe that they will be able to price more complicated small business, car, and consumer loans.

Finally, Prosper seems to be encouraging lenders to make financial decisions from the heart. From Mr. Larsen:

“...auto loans listed on the Open Market will show in which auto plant and city the car was made. That way fellow Americans who put a value on American jobs might make loans to cars made in Ohio, for example, at a better rate than loans to cars made in Germany.”

This structure introduces a level of transparency that we have not seen in loans before and it sounds great from a social entrepreneurship perspective. But is it wise from a personal financial decision-making perspective? Just as it may be dangerous to fund borrowers based on how they look (recall the recent study on how Prosper lenders gave more money to faces that looked “trustworthy”), it is risky to fund companies based on values. If your primary motive is gaining a healthy return, then whether you “like” the individuals or companies’ practices should be a non-factor. If your motive is to provide social value, then perhaps you would be better off funding a loan through Kiva.

I do agree with the sentiments of Mr. Larsen, however, that “the crisis is painful but is also a once in a lifetime opportunity to rewire finance in a way that is fundamentally more transparent, more participatory and more durable.” I’m glad to see Prosper back online and running. I’m really glad that it’s been able to start passing the onerous regulatory hurdles. Best of luck to the site in its second incarnation.

Prosper is Back...with an Innovative Vengeance!

Earlier this week, the sleeping beauty of P2P lending – Prosper – was brought back to life by the California state government. After the SEC asked Prosper to pause its lending operations for six months, California’s Department of Corporations decided on April 28th to allow the P2P lender to resume lending for all lenders located in California and borrowers throughout the nation.

And Prosper is coming back on the scene with a new model to add to it P2P lending platform.  The Open Market Initiative is an attempt to create a secondary markets for loans by allowing institutional lenders to sell their existing loans, such as car, consumer, and small-business loans to Prosper member-lenders in California.

The idea here is that this secondary market provides liquidity for the institutional investors as well as a diverse and patriotic investment option for local Prosper lenders. In his Welcome Back letter, founder Chris Larsen, explains how the social focus and dedication to transparency that serve as Prosper’s cornerstones have been applied to the Open Market Initiative.

"In addition, Open Market brings the same social lending possibilities to securitization that we have always seen in the Prosper Loans Marketplace. For example, auto loans listed on the Open Market will show in which auto plant and city the car was made. That way fellow Americans who put a value on American jobs might make loans to cars made in Ohio, for example, at a better rate than loans to cars made in Germany. This could never be done with traditional securitizations because investors never had that level of transparency."

While Prosper’s secondary market is not the first in P2P lending, (LendingClub gives members the option to trade notes amongst each other) it is certainly one of the most creative and extensive. However, as Mr. Larsen himself points out, “creative financing” does not carry a positive connotation nor a sense of patriotic pride these days.

An additional problem brought up in a recent Economist article is that the difficulty today with selling institutional investor’s loans is the pricing and not the liquidity. Thus, the extent to which Prosper’s creative secondary-market model is able to truly align incentives and truly scale remains to be seen.

Does appearance reflect creditworthiness on p2p lending sites?

Successful Prosper BorrowersA study conducted by Dr. Jefferson Duarte of Rice University sought to determine whether physiognomy-based prejudices about creditworthiness existed and, if they did, whether they were justified. To explore this issue, he used data provided by Prosper, a peer-to-peer lending hub, to determine whether analysis of a single photo provided by the borrower could help predict whether he received full funding of the loan and whether he would pay it back in time.

So do looks affect perceived creditworthiness? As the Economist profiles, the answer is yes. Even more interesting is that these perceptions correlated highly with the borrowers' actual credit ratings.

To explore the issue, the researchers paid assistants to analyze the pictures of thousands of aspiring borrowers on Prosper. The workers rated them, on a scale of one to five, on how trustworthy they seemed, and estimated the percentage probability that each individual would repay a $100 loan. They also made assessments of the borrowers' sex, race, age, attractiveness, family status, and obesity.

The researchers reached two main conclusions:

1. People flagged as untrustworthy by the assistants were less likely to be offered a loan. To have the same chance of getting one as those deemed most trustworthy they were required to pay an interest rate that was, on average, 1.82 percentage points higher, even when the effects of historical creditworthiness were statistically eliminated.
2. The assessments of trustworthiness, and of likelihood to repay a loan, made by the assistants correlated with potential borrowers’ credit ratings based on their credit history, even when the other variables, from beauty to race to obesity, were controlled for statistically.

So while Prosper is a relatively information-rich environment where potential lenders have access to complete financial profiles of borrowers including credit grades, income, employment, and assets, this study suggests that there is a substantial premium put on the subjective factor of perceived trustworthiness. For individuals who look untrustworthy, the "faceless bank" might be a better option after all.

An interesting aside offered by the researchers is that although attractiveness and trustworthiness are positively correlated, there is no evidence that attractiveness is related to the probability of a loan becoming fully funded. There are other physiology-based preferences at work.

And showing yet another emerging role for peer-to-peer platforms, the "assistants" used the researchers were in fact workers from the peer-to-peer market laborplace, Mechanical Turk (owned by Amazon). Peer-to-peer sites then provided both the source of data for the study as well as the independent evaluations and perceptions.

Looking to try out P2P Lending?

See the possibilities with our new P2P Lending Primer

Regulation troubles mean slowdown for some markets

Alternative markets are being tra markets and the government is going to treat them as such. The prediction market Tradesports is now permanently shut down due to gambling laws, p2p lending market Prosper will be off-line for months dealing with the SEC, and the viability of craftsmen on Etsy and many other direct seller-consumer markets is threatened by legislation soon coming into effect and more legislation to come. What does this all mean?

Perhaps most importantly, the previous sky-is-the-limit land of innovation in markets is retracting. It took them some time to get started, but government lawyers are hard at work writing cease-and-desist letters and new laws that may spell doom for smaller or newer entrepreneurs in this field. Ventures that survived by operating in gray areas slightly out of reach of the regulators will find that they can hide no longer.

Government involvement in a sphere that was a demonstration of nearly pure capitalism is both regrettable and necessary.  The consensus that regulatory and policy failure contributed towards the current financial crisis and allowed the likes of Bernard Madoff to flourish required the SEC to explore hidden markets and register all sellers of securities. Recent tainted milk and leaded toy scandals in China naturally lead the government to require higher product standards for children’s products and cosmetics. 

Unfortunately for Prosper and other p2p lenders, the SEC’s actions have the most profound and immediate impact upon them, as they need to shut down (Lending Club is still open) while they spend hundreds of thousands of dollars to go through the bureaucratic process of licensing with the SEC (this is a lot of work for an organization whose average loan in 2008 was $6,047).

For small sellers of cosmetics and other homemade items, January may prove to be their last month in business as they are the forced to prove the safety of their items as dictated by the Consumer Product Safety Improvement Act (CPSIA) and the FDA Globalization Act of 2008. Due to immoral practices of Chinese manufacturers, small businesses will now need to spend thousands of dollars a year in paperwork in order to prove that their $2 homemade soaps do not contain high lead concentrations. Paradoxically, the large toy corporations who practice the outsoucing that is so feared by some American consumers will be most able to comply with the new regulations while the small crafters who make items at home using organic wool will be out of luck. The reaction by the Etsy community makes clear that many crafters will simply be forced to close down shop.

It was probably only a matter of time from the beginning for Tradesports. Their entire business model was based upon skirting gambling laws through technical operation out of Ireland, although the majority of their trades knowingly took place in the U.S. It will be interesting to see whether its non-sports affiliated site Intrade (the more innovative and interesting market I would argue) will last.

As many of the best entrepreneurial teams pushed ahead over the past several years with their alternative, and often quite persuasive, ideas, many free market enthusiasts (like myself) found it hard not to get swept up in the excitement and see these as the undenaiable future. Expectations are now revised down from their initial irrational exuberance. These upstarts have a number of hoops yet to pass through, but their promise is still bright.

Is social lending a quaint concept?

An interesting factor common to many of the new alternative markets is the element of simplification: fewer steps per transaction, smaller dollar sums exchanged, and the reduced role of the middleman. To advocates, these characteristics are symbols of transparency, greater citizen engagement in the process, and a sustainable and informed approach to financial decisions. To others, the simplicity is a negative; the transactions are nearly medieval in their marketplace structure, the systems are inefficient, and there is no possibility of scale to make them true viable alternative financial constructs.

The origin of peer-to-peer lending is indeed older than medieval; Prosper’s website marks its advent as 300 AD in China. We have made vast progress since then in terms of efficiency and scale, and it is really only with the possibility of the internet and the growth of social networking that we find a renewal of this simple form of direct lending. Unexpectedly, the latest technological advances have enabled us to draw upon and revive ancient financial practices. Direct lending allows people who have otherwise been shut out of the complex credit market due to factors sometimes out of their control to turn to the old and trusted practice of asking the people around you to lend you a buck. Only now, the “people around you” are the millions on the internet.

Lending to a self-professed “entrepreneur” half way across the country (or world) is not quite the same as lending to your cousin, but these days, just knowing the destination of your money is a significant move towards transparency and accountability. But with this level of engagement in every single transaction you make, it’s true that the possibility of scale is lost. Evaluating potential borrowers on Prosper or Lending Club and then monitoring each loan you choose to make is a lot of work. The sums are small (maximum investment on Prosper is $25,000 and the default rates are high (on Prosper, 20%). Unless you are working with a small sum of money, alternative markets in their current form can only be utilized as an interesting and supplementary subset of any financial strategy.