Ho John Lee's Weblog

This evening I’ve been looking over Prosper (formerly known as CircleOne), a social lending site similar to Zopa, which provides an eBay-like marketplace for borrowers and lenders to transact loans.

Prosper manages credit scoring, loan servicing, and provides social and economic incentives for borrower groups to build their reputation as good lending risks. All loans are 36 months with no prepayment penalty, and Prosper charges a 1% origination fee from the borrower, and 0.5% loan servicing fee from the lender. Groups with good reputations can get some incentive payments for loan performance and lower rates over time.

In addition to using credit scoring, social lending and finance approaches can be effective and much less risky than the borrowers might otherwise appear. Informal lending clubs are common among many Asian and other immigrant communities, and something like this might provide an online venue for a more transparent and widely accessible model. It’s harder to bail out on a debt if everyone knows about it and is also a creditor.

Aside from the philosophical and community aspects, looking at this from the lender’s perspective, it looks like it would behave sort of like buying 36-month bonds with a call option. It’s not like you can do a lot of due diligence on the borrowers, and for the amounts involved it’s not going to be worth the effort, so some combination of reputation and diversification is needed. If there were lots of good-but-unrated credit risks in the borrowing pool, you could build a portfolio of sub-prime loans and possibly achieve something in the range of junk bond returns.

Returning to the philosophical, I like the idea of community and socially based lending, because it values good reputations and provides social incentives for people to perform. On the other hand, it looks like a lot of work for a prospective lender. If they’re looking purely at a financial investment, it’s a lot easier going after a portfolio of bonds or a bond fund, so I think you’d have to want to support the model to participate. The borrower’s case looks much more straightforward, since consumer credit tends to be readily available, but expensive. The listings posted on the site so far include a number of “pay off my credit card” loans, which seems quite sensible.

In a slightly different context, it would be interesting to see something similar which matched borrower groups in relatively poor and developing areas with lenders in relatively wealthy areas. Grameen Bank has done amazing things with microfinance in Bangaladesh, in the sense of helping the borrowing communities building new businesses and opportunities for themselves and making a positive economic return for the bank.

In another different context, it would be interesting to see some kind of market making approach for investing in and financing speculative early stage startups. This wouldn’t work for capital intensive projects, but perhaps there’s some standard terms that could be worked out for asset-light software startups (aka web 2.0). The levels of funding required are too small to justify the level of effort, and there is (or should be) a high mortality rate, which would argue for a lighterweight way to build portfolios of small investments.

(via TechCrunch)

See also:
Zopa – eBay for money?

Corante has a podcast interview with the founders of Zopa. The idea is to build an eBay-style marketplace for individuals to participate in lending and borrowing, using eBay-style reputation scoring.

Some of this seems like a good idea, possibly in matching up people who want to provide funds to communities that don’t have a pool of loans available to them, but would otherwise be a reasonable credit risk. (Something like Grameen Bank’s microcredit program.)

For other situations, this seems likely to end up with many of the same reputation-gaming problems that turned up on eBay. From a risk-management viewpoint, it might be useful to find a way to build credit pools rather than individual loans. This is essentially what the banks do already, but the reputation scoring system might allow a better handle on the creditworthiness of the borrowers, and turn the individual loans into a portfolio, so a bad loan doesn’t become a disaster for the creditor.

There does seem to be a need for something in this space. The ongoing consolidation of banks in the US has generally eliminated local control of most banks, meaning that individual branches don’t usually know their customers well enough to know if they would be a good credit, other than looking at a credit score, and don’t usually have the discretion or interest in making a loan to someone that doesn’t exactly fit their loan profile. If you want to do something creative, you probably need to work with a private banker, or have wealthy friends.

This might also provide a mechanism to form relatively small pools of capital for niche markets. An eBay-style model implies a huge amount of effort on the part of the participants, compared with what consumer banks would typically do. This might make smaller loans more interesting. Otherwise, why not stick with writing super jumbo mortgages at $1 million each for the same amount of work.