Friday, August 31, 2007

P2P lending in a credit storm

Techdirt is one of my favorite sites. I subscribe to their daily emails, am a member of their Insight Community and love their news analysis. Mike Masnick in particular provides some great economic analysis of niche topics like the RIAA, DRM, piracy, copyright, laws, and the entertainment industry. Today they tackled peer to peer lending sites in an article called Peer-To-Peer Lending Sites Weather Credit Market Storms and got it all wrong. Here's what Techdirt's Joe Weisenthal had to say. It's short so I'll quote the whole thing:

"Will all of the turmoil in conventional credit markets spur greater interest upstart peer-to-peer lending exchanges? It seems possible, since, in a way, sites like Prosper and Zopa are the antithesis of the highly impersonal, securitized industry that's facing so many problems right now. From the outset, these P2P lending sites have emphasized diversification, manageable risks and direct relationships between lenders and borrowers. Whereas traditional loan brokers are closing their doors left and right, these sites continue to do brisk business. Lenders aren't seeing mass defaults, because the standards have been high since the beginning. Of course, the scale is different. You still can't finance a house through one of these sites, but for other needs, they may work just fine. Between the lack of available credit to consumers and a desire to diversify investments on the part of individuals, this moment in the business cycle offers these sites an excellent chance to really prove their worth."

Let's take a closer look at each of his points.

"From the outset, these P2P lending sites have emphasized diversification, manageable risks and direct relationships between lenders and borrowers. "

First, what are the peer to peer lending sites we are talking about? Right now there are only two peer to peer lending sites available to lenders or investors in the U.S. - Prosper and Lending Club. The article mentions Zopa but Zopa has yet to launch in the U.S.

I'm not sure of any way that Prosper has emphasized diversification. In fact, Matt wrote an article last month about this - Most Prosper lenders do not diversify their portfolio. Clearly diversification is one of the keys to successful lending but since the minimum amount that can be committed to an individual loan is $50 most lenders never reach an appropriate level of diversification. 70% of lenders on Prosper have less than 20 loans. If one loan defaults they lose 5% or more of their total investment. (Of course, the amount lost is reduced as the loan matures.)

Lending Club, on the other had, has emphasized diversification since their launch three months ago. The minimum loan amount is $25 instead of $50. They have a program called LendingMatch which is supposed to help borrowers diversify based on their risk preferences. If you use LendingMatch you are required to start lending with $500 and pick your level of risk tolerance on a scale of 1 (less risk) to 5 (more risk). As you move to a 5 the average interest rate on your loans move up and the credit grade of your borrowers goes down.

As far as emphasizing direct relationships, Prosper and Lending Club try. Prosper has a group program that is supposed to bring a community feel to lending. Angry lenders on the Prosper forums don't think it's working. Lending Club uses the Facebook platform to build connections between lenders and borrowers. The potential benefit of the connections is greatly mitigated by the desire and requirement for anonymity for lenders and borrowers as I discussed in this article.

"Whereas traditional loan brokers are closing their doors left and right, these sites continue to do brisk business."

Is this true? There are different ways to define brisk business, of course. On the surface, it appears business is booming. Over $84 million has changed hands on Prosper. Prosper just received $20 million in venture capital and Lending Club got $10 million. Lending Club has hit several quick milestones since their launch in May - $100,000 then $250,000 and they are now at $881,600. Loanio and GlobeFunder are preparing to launch this fall. Zopa is expanding to the U.S. However, a look at loan growth on Prosper shows a different story. This graph, from Eric's Credit Community, shows loan growth is slowing. Lending Stats also has a nice graph showing the same trend.

From a peak of over $8.5 million in April, loans on Prosper have dropped month by month. From roughly $8.5 million to 7.5 million to 7 million to 6.5 million with each passing month. This is despite a new aggressive referral program which has created more than 5,000 new borrowers and lenders.

Although the drop started in May, it cannot be explained away by competition from Lending Club since Lending Club is still under $1 million in loans. The trend is most likely due to a realization among lenders on Prosper that high risk loans have a high default rate and are not a wise investment. To be fair, the August numbers may still improve. It's the last day of the month right now and loans can take a week or two from the time they close to the time they actually originate. The trend does show, however, that lending on P2P networks may not be as brisk as news reports indicate.

"Lenders aren't seeing mass defaults, because the standards have been high since the beginning."

Unfortunately, standards haven't been high since the beginning. At one time Prosper allowed people with no credit to borrow. This was a disaster and they stopped that experiment. Default rates for high risk borrowers, as Matt pointed out in his article about risk and diversification, are very high. According to his article, 45% of HR borrowers are late or in default and 28% of E borrowers are late or in default. This translates into a negative expected rate of return for borrowers. Prosper now warns lenders of the risk when lending to HR or E borrowers.

"Of course, the scale is different. You still can't finance a house through one of these sites, but for other needs, they may work just fine."

Very true, P2P lending sites are better suited for other needs such as consolidating credit card loans or funding a start-up.

There is, however, potential for peer to peer mortgage lending. Circle Lending is a peer to peer lending site that facilitates mortgage loans among family and friends. The big difference between Circle Lending and other peer to peer lending sites is that it's not a good option for investors, just family and friends who want to help out someone they actually know. There has been some media attention into the possibility for Prosper to facilitate small mortgages - those under $50,000 where other mortgage lenders can't help. In addition, there is a new start-up which we wrote about, Equity sharing - Prosper for real estate, which uses a P2P lending model for mortgages.

"Between the lack of available credit to consumers and a desire to diversify investments on the part of individuals, this moment in the business cycle offers these sites an excellent chance to really prove their worth."

There is a lot of truth in this statement. Lack of available credit will push borrowers to other places such as peer to peer lending sites. However, their luck might not be much better. Due to recent defaults, lenders on Prosper and other sites are getting wiser. Sub prime borrowers are not getting funded at the same rate they were months ago. Lending Club does not permit borrowers with a score below 640 to request a loan. Except for very small loans (under $5,000), sub prime borrowers are already very nearly shut out of the peer to peer lending market. Despite all this, Prosper still makes a lot of sense for many borrowers with good credit who are looking for an unsecured loan.

As for lenders, Prosper does give the ability to diversity to a new asset class. It is different than other investments in significant ways. This could be valuable as lenders try to weather the sub-prime storm. It's unlikely, however, that peer to peer lending sites will fare much better than the sub-prime market at large. Matt, in his article about the effects of a recession on Prosper recommended, "...don't put all of your investment money into any one asset class. You should start with an emergency fund in something like a money market or savings account that can be easily accessed if needed for an emergency. Then any remaining money can be diversified among several different asset classes - stocks, bonds, real estate, foreign markets, and Prosper. The allocation percentages should be based on your risk tolerance and investment timeframe. The longer term (10+ year) money can have a higher percentage in stocks, the mid-term (5-10 year) money can have a higher percentage in Prosper, and the shorter term (<5 year) money should be mostly in cash accounts or bond funds."

Techdirt raises some good points. I think we will see new activity in the peer to peer lending markets in this 'credit market storm' from borrowers and lenders. This activity, however, cannot solve many of the underlying problems that are driving this storm. Borrowers who are going to default with a bank are still going to default on peer to peer sites. Lenders who invest in these borrowers are going to lose money and will tend to favor borrowers with better credit. The same borrowers would be eligible for credit from banks.

4 comments:

Jeff S said...

Great analysis. I'm a small time lender at around 1.7K. Any new funds into prosper have ceased for now though. Beware the E-HR!

Matt said...

Well said Jeff, I think Prosper would be doing new lenders a favor by eliminating Es and HRs completely.

I did some research before I started lending and was fortunate enough to avoid Es and HR loans, but without doing the research they are an easy trap to fall into.

Anonymous said...

I think you guys both missed the biggest impact and opportunity of the current "credit storm" -- rate arbitrage.

The present credit crisis is primarily focused in the sub-prime market (E & HR), but near-prime and prime borrowers are still doing fine.

Nonetheless, scared banks and credit card companies are jacking up rates across the credit quality spectrum. So an A borrower who was getting a loan on Prosper for 10% because the bank offered 12 is now getting offers from his bank at 14%, which allows the Prosper lender to potentially get a higher rate from that borrower, like 11 or 12%. The risk hasn't changed, but because of this misperception in the marketplace that the sky is falling, smart Prosper lenders can get better returns.

colin said...

good analysis, and two comments:

1) "Prosper loan growth is slowing"; there have been many developments since April / May when the slowdown began. Prosper altered its group strategy, increased the FICO threshold, and the general dissatisfaction and rampant complaining in the groups. I see those as growing pains, and that leads to the second comment:

2) " ... chance to prove their worth"; I agree on this, am more bullish, and here is why. When Banks pull in their horns and increase risk thresholds, due to low liquidity, their is invariably spillover into good credit classes. For the individual lender in the Bank in such scenarios, its often easier to say no to the customer, than to make any effort with the credit department. Loan growth expectations are low in this scenario, and that combines to create a snowball effect within the Bank. This is especialy true in times of crisis, and within those Banks who are traditionally 'fair weather' banks.

Social lenders on the other hand, can offer a simple viable alternative to people with good credit, that has none of the other noise(economics, bank policy, bank liquidity etc), and is purely focussed on them and their ability to pay.
For more, I wrote here, and referred to The Economist article on the crisis.
http://tinyurl.com/yo8xky