Tuesday, June 26, 2007

eBay + MySpace + ? = Peer to peer lending

Brad Slavin has written an informative 15-page paper reviewing the peer to peer (P2P) lending industry (pdf) with a focus on Prosper and Zopa. His outlook is very optimistic. I've extracted a few of the highlights from his article. Quotes are in italics.

"The timing is right for sites like Zopa and Prosper, which are part of a broader wave of sites aimed at fostering online communities. These companies are challenging the status quo using an online loan marketplace with a social computing twist. These online lending communities can be considered as a combination of eBay and MySpace.com — a place where consumers come together to loan and borrow money from each other."

It looks like Brad is not the only one that has an optimistic outlook. Prosper just secured an additional $20 million in venture capital and Facebook's Lending Club is off to a great start. He thinks the current conditions are just right for peer to peer lending.

"...an increase in individual debt, a low return on savings, and increasing asset prices are also changing consumers' borrowing and lending behavior thereby creating a favorable environment for alternative investment platforms such as peer-to-peer online lending exchanges. The success of these web based P2P lending communities can be gauged by the strong growth in their members and loan volume. Zopa has attracted 87,000 members and Prosper currently boast of approximately 100,000 members."

Although he published the article yesterday, Brad must have pulled his stats some time ago. Prosper currently has over 310,000 registered members. Later in the article he mentions that Prosper has loaned $24 million. The figure is now $71 million. Even though his stats are dated that just further reinforces his point that the peer to peer lending industry is in a period of rapid growth. He mentions some of Zopa's awards:

"Zopa won "Internet Innovation of the Year" at the 2006 CNet Technology awards and was named by American magazine Business 2.0 as one of the eleven most disruptive companies in the world."

He did not mention similar accolades that Prosper has won including the #1 website of the year in 2006 by Time Magazine.

Brad talks about the success of other online communities and user generated content including eBay, MySpace, blogs, Wikipedia, Amazon, Flickr, YouTube and others and compares that to the success of the social lending space. I think he is very correct there. Beyond all financial considerations, the social aspect is one of the big allures to many at Prosper. Brad also makes the point that online communities can do what financial institutions do at less cost.

"...it turns out that online communities can do a lot of what banks, credit card and payday loan companies do and cheaper. The opportunity lies in consumers' mistrust of financial institutions. According to a Forrester study, 'most people believe their banks put their own interests ahead of consumers', and a majority doesn’t think their financial institutions have strong ethics.'”

I have mixed feelings about this statement. In many ways Prosper and other peer to peer marketplaces are less efficient. The cumulative time that dozens, sometimes hundreds, of lenders expend to fund one loan is very high. Although time consuming, in some ways, the social lending marketplace can be more vigilant than banks. The story of Jessica Wolcott's scam is a good example. Hundreds of lenders engaged in online detective work to prevent fraud, something that would have been cost prohibitive for a normal bank.

Brad provides a bullet list of the nine advantages of peer to peer lending. They are:
  • Avoid banks and other middleman
  • Anonymous transaction
  • A whole new asset class
  • Optional rates and loan amount
  • Lower interest rates for borrowers
  • Higher returns for lenders
  • Faster and easier process
  • Increased transparency and control
  • Satisfaction

I disagree with one of his points - anonymous transaction. He argues, "All transactions are done anonymously and borrowers are not inundated with emails and telephone calls as are borrowers registering with traditional online lending companies." I think that loans which occur on Prosper are less anonymous than loans might be through a bank. You place your credit history and other personally identifiable information where they can be accessed by anyone. Even though it is against Prosper's TOS, group leaders bombard borrowers with invitations to join their group. Many borrowers send pay statements and other personal financial records to group leaders to become vetted.

Brad makes a point about the imbalance between lenders and borrowers.

"...the biggest problem at the moment at these online lending marketplaces is theimbalance between number of lenders and borrowers. There is just not enough money in thesystem to meet all the reasonable needs."

He's right. There are many more borrowers than lenders. This is good for lenders but, in my opinion, if the market were to become much more competitive then interest rates would come down and lenders will lose the incentive to bid. I don't think interest rates can come down much more and still provide an attractive investment option to lenders. In addition, according to a post on Money Walks, about 80% of the listings are made up of E and HR credit grades. As Matt has discussed earlier, too many of these high risk loans on Prosper default to make it worth bidding.

There is an interesting comparison between Prosper and Zopa in the article. Some of the information is dated but I thought the paragraph on diversification was interesting.

"Zopa extensively use diversification as the key to mitigate default risk. Zopa is able to manage default risk by taking a more protective approach with respect to lenders by only accepting borrowers with high credit quality and by forcing lenders to diversify their loans across at least 50 borrowers. At Prosper, lenders can diversify, but are not forced to do so. It allows lenders to bid small amounts on all or part of loans; it is easy for lenders to create well-diversified portfolios."

I didn't know Zopa forced diversification. I can see pros and cons to that. It probably reduces the lenders remorse of inexperienced lenders who place bad bids but I can see how it might frustrate more experienced or aggressive lenders.

Brad highlights the social aspect of Prosper.

"Prosper.com was created with the objective of making consumer lending more financially and socially rewarding for everyone....Compared to Zopa, Prosper has added a number of community elements, the most important one being groups. Prosper relies on a strategy borrowed from hoi: shame, believing that people repay real-world co-operatives because they fear losing face among peers. It works on the principle that people from close communities act more responsibly towards each other."

I think this statement is right on the mark, but also runs counter to his earlier contention about the ability of borrowers to receive funds anonymously through the peer to peer marketplace.

Brad wraps up the article by mentioning several players in the peer to peer lending marketplace. Many I had not heard of before - kiva, PalTrust, Moneytwins, Rippleplay and CircleLending. From his conclusion:

"Currently these websites work for relatively small, unsecured, and primarily personal loans. With maturity the market may potentially see some other entrepreneurs entering the market and eventually starting up other financial services e.g., mortgages for homeowners to finance purchases or refinances. Such sites could ultimately supplant the existing financial institutions. As a response, the incumbent financial institutions may either start their own lending marketplaces or will partner with the niche P2P lending marketplaces."

What do you think? Will the peer to peer loan marketplace expand to include mortgages and other financial services? Is the outlook as optimistic as Brad contends?

(Thanks wiseclerk for the tip.)

1 comment:

Matt said...

I think right now a high percentage of Prosper borrowers are people that have trouble getting financing through banks. As this medium matures I think that it will attract a wider audience of people.