Thursday, June 19, 2008

Caught in the Crunch? Try Peer to Peer Lending

It is no secret that the demise of the housing boom and seizures in the debt markets have led to a constriction of credit leaving many cash strapped borrowers scrambling for funds. The ongoing de-leveraging of bank balance sheets combined with the lack of liquidity for securitized debt has forced banks to limit loans to only the most trustworthy borrowers. An alternative that has emerged in the past few years is “peer to peer” lending. This can be generally defined as an individual or collective group lending to another individual. One of the pioneers in this fledgling industry is Prosper.

Prosper is a web site founded by the former CEO and founder of E-Loan that facilitates personal loans of up to $25,000 negotiated between potential borrowers and lenders. The lenders bid on a portion of a loan, with a minimum bid of $50, in a Dutch auction format where the clearing rate on the funded loan is the highest reserve rate of the winning bidders. Thus, hundreds of lenders could jointly fund a loan to a single borrower. Borrowers are evaluated based on credit statistics provided and verified by Prosper, but only summary level data is displayed as opposed to a full credit report. A wide range of borrowers request loans for business investment, loan consolidation, real estate improvement, or other expenses. All of the loans are unsecured personal loans so lenders have no collateral and limited recourse in the event of default.

I have been a lender on Prosper since spring 2007 and have reviewed loan performance extensively. Lenders must be cognizant of the potential for adverse selection as borrowers will most likely exhaust all conventional sources of funds prior to resorting to Prosper. The limited credit reporting does not allow lenders to delve into payment histories, credit usage, and debt distribution across loan types. Therefore, one is making credit decisions based on a Prosper credit rating, summary credit data, and the borrower’s self description. It is possible to identify viable loan options, but it requires significant investigation and review. Thus far, I have completed 14 loans with two paying off early. Of the remaining twelve, two have been over 30 days late at least once and one is habitually late, but it always cures. I have earned an annualized return of more than 14%, but a single default could quickly wipe out all returns to date (View My Loan Portfolio). In fact, most lenders with seasoned loans have very low or negative returns. Focus on higher credit quality borrowers with no public records and no recent late payments. Lending on Prosper presents an asymmetric return proposition with the upside limited to the stated interest rate (after Prosper’s servicing fees) while the downside is only limited by the remaining outstanding principal.

If you are a borrower, it is essential that you provide an in depth and accurate description for why you are borrowing the money, how you intend to repay the loan, and your current financial situation. Any lender that thoroughly vets borrowers will quickly see through poor applications and you will not get funded. Frequently, loans by self employed borrowers or those with difficult to verify details are cancelled by Prosper after fully funding. This is a frustrating phenomenon for both the borrower and the lender as significant time and resources have been invested. If your income, employment history, or other details lack reasonable corroboration, it is better to understate these characteristics in order to facilitate the funding of your loan. It is also advisable to set your initial loan rate as high as possible. If you are a qualified borrower, your loan will quickly be funded and your rate will be bid down. Once lenders have invested the time to research your loan, they will be more hesitant to walk away a loser. The sunk costs of researching your loan application combined with an intrinsic desire not to lose leads most bidders to experience escalating commitment resulting in lower borrowing costs. Rates that average 8-10% for high quality borrowers and more than 30% for high risk borrowers are common.

Peer to peer lending possesses the promise of revolutionizing the lending industry. Until the credit summary provides a more complete picture and the borrower proffered details are vetted in advance, the full promise of peer to peer lending will fail to be realized. Peer to peer lending is a growing industry that is must continue to innovate and refine the process in order to realize its potential. In the mean time, borrowers and lenders alike may mutually agree to terms that provide much needed liquidity in the credit markets.

NOTE: This is not to be construed as financial advice, investment guidance, or a recommendation. I have previously loaned funds on Prosper, but I am currently evaluating the potential investment returns that can be realized. The insufficient loan and payment history makes comparison and evaluation on a broad scale difficult. Returns will likely differ from that which I have achieved thus far (most likely lower) and my returns could change at any time with defaults. Please do your own homework prior to making any lending decisions, and consider talking to a financial planner or debt counselor prior to borrowing additional funds on Prosper.