Opinion

Felix Salmon

The problem with peer-to-peer lending

By Felix Salmon
January 19, 2010

Mark Gimein has an important story today about Prosper, which is required reading for anybody — myself included — who has some hope about peer-to-peer lending helping to disintermediate banks and get credit flowing again to individuals and small businesses.

Prosper was one of the first companies to market in the peer-to-peer space, and in hindsight its arrival at the height of the credit boom was incredibly ill-timed. If you lent money through Prosper back then, when most of its loans were extended, there’s a very high chance that you’ve lost money — in some cases, a lot of money. “Of investors with a portfolio of loans that are an average of at least two years old,” notes Gimein, “folks who have lost money outnumber those who’ve earned 6 percent annual return by more than six to one.”

Prosper was founded in the days before everybody had heard the term “model risk”, back when it made perfect sense that credit risk could be modeled accurately by a computer algorithm using little more than a FICO score.

One of the big problems that Prosper ran into — the massive credit crunch and the ensuing Great Recession — could reasonably be considered to be a one-off event with a low likelihood of happening again. But another is endemic to the model: Prosper borrowers with a given FICO score are inevitably going to be more likely to default on their debts than most other people with the same credit score.

It wasn’t meant to be that way. Peer-to-peer lending was meant to create a personal connection between borrower and lender, and therefore make borrowers more likely to repay their debts than people faced with large obligations to hated, faceless banks. But it seems that adverse selection effects overwhelmed the site’s attempts to be warm and fuzzy. As Gimein explained in an email to me,

I think in this case the adverse selection issues are insurmountable. Folks go to P2P loans almost always because they can’t get money through conventional channels, and often there is a reason. I’ve cut up the Prosper numbers in a bunch of ways, and one thing I’ve noticed is that some of the worst returns come from folks with okay credit who are willing to pay very high interest rates: they’re willing to pay a lot because their finances are in worse shape than they seem.

Also, re: adverse selection, this reminds me of a story I heard years ago from a guy who started a company that marketed credit cards online. What he found was that when you set up a site and have people come to you, you get a really dangerous class of borrowers. This is why credit card companies don’t really make much effort to get people to go to their websites and apply. They would rather *offer* than let people ask. Because ultimately a paradox of lending is that the people who are more likely to repay are those who *don’t need the money*. And Prosper attracts those who do need it.

I’m still hopeful that Lending Club, in particular, can succeed in this space; it certainly doesn’t suffer from the kind of egregiously misleading public communications that Gimein details at Prosper. But insofar as Lending Club can succeed where Prosper seems to have failed, it will have to do so through overcoming the adverse-selection problem with an extremely tough and diligent underwriting program which rejects as much as 90% of the people asking for loans. As such, it’s only likely to make a difference at the margins — and it might find it hard to make a profit itself out of the 1% take it skims off each loan.

Effective underwriting is difficult, labor-intensive, and expensive. And there’s always a worry that at some point any peer-to-peer intermediary will start cutting corners on the underwriting front in an attempt to make more money. Which could be disastrous for lenders.

Update: Gimein points me to the second chart on this page, which shows that Prosper, too, funds less than 10% of the loans that get applied for there. Maybe rejecting lots of loans isn’t, in and of itself, a sign of diligent underwriting.

Update 2: Lending Club CEO Renaud Laplanche emails to explain the difference between his shop and Prosper:

The “10% funding rate” of Prosper and Lending Club are different in nature: Lending Club approves 10% of the loan applications – that’s an underwriting decision. These 10% most creditworthy loans are made available on the platform for investors to invest in, and all loan listings get fully funded. Currently, the platform is “demand constrained”, meaning that we have more investors willing to invest in these loans than loans available. We are increasing our marketing efforts on the borrower side to make sure demand catches up with supply.

Prosper’s 10% is very different in nature: most loan applications received by Prosper get listed on their platform, and only 10% actually get funded, either because of insufficient supply of investors funds, or just because investors don’t want to fund the other 90% of the loans. The question here is whether the 10% that get funded are “the right 10%”? Marketplaces need 2 things to be efficient: sufficient supply and demand, and no information asymmetry between buyers and sellers. I believe Prosper’s marketplace lacks both. So would Lending Club’s by the way, which is why we are making the credit decisions and setting the rates. The consequence is that Lending Club’s 10% are those loans that are the most creditworthy, based on factual information from the credit reports, employment and income verification, anti-fraud measures, etc.

Update 3: Prosper responds to Gimein.

Comments
15 comments so far | RSS Comments RSS

My favorite real-world example of adverse selection is finding someone to look after bags in an airport while you use the restroom. We intuitively understand we’re a lot safer asking the stranger in the next seat instead of a guy who walks up and offers.

I’ve run across people teaching their kids the same principle; if you’re lost or in trouble, go find an adult, but don’t talk to any who approach you first.

Posted by petewarden | Report as abusive
 

Why didn’t you publish this a couple years ago and save my a bunch of money. I became an investor in prosper at a top of the boom. Only invested about $4,500 but i have already booked a lose of $900.00 with over half my remaining loans headed toward defalt.

On the other hand, i also borrowed $25,000 on prosper which of course i have nearly finished paying for with timely payments to protect my credit.

At the time is sounded great, i could borrow at a low rate because of my good credit, pay off some higher interest bills and loan out to others at a higher rate. Add this to all the other lessons i’ve learned the last couple years…that my house was the best investement i could ever make and it would only go up (its off 40%)!!!

Posted by Ronfletcher | Report as abusive
 

You are right, Mark Gimein’s article is a must read.

It is well researched in contrast to the “usual” media articles on Prosper. Over the last years I was always surprised who the media reprinted Prosper statements on default risks and ROIs without questions when several blogs already published critical analysis.

However Prosper is an extreme case. Default levels at othe P2P lending services are higher then initially expected at the time they launched (expect for Zopa UK with low default rates) but they still enably positive ROIs for the majority of lenders.

The article would be better titled “The problem with Prosper”

Best regards

Wiseclerk
Editor
http://www.p2p-banking.com

Posted by Wiseclerk | Report as abusive
 

I really liked this piece, especially the focus on adverse selection. But let’s just go back to basics for a second, something that all finance students learn in introductory courses: the indivisibility of risk and return. If you see someone willing to compensate you at such high spreads over the traditional lending rates, than that is one hell of a risky asset. The spread, of course, is derived from many risks, but the most substantial risk would be that of credit risk. If you see someone trying to offer you a spread of 10% or more over traditional lending rates, then get the hell out of there… unless you are a risk taker in the strictest sense.

Posted by charlesv | Report as abusive
 

I looked at the different p2p lending sites and I went with Lending Club. I thought that the other sites were do gooder sites and I do not lend money to feel good. I lend money to make money. I have been lending money thru Lending Club since March 2008.My return on the money that I have lent, as of today, is 12.04%.Every two weeks I check my loans to see if the credit scores have dropped since I bought my part of each loan. If the credit score has dropped down to 600 or under, I immediatly put the loan up for sale and git rid of it. Like everything in life, you have to put forth some effort if you want to do any good. I keep track of my loans checking them on a regular basis. If the payment is due, for example, Jan 18 then Jan 21 I will check to see if the payment is processing and if the credit score has dropped since the loan was make, check to see what the score is. I sold a loan that was current last week but whose credit score had dropped to the 550 range. It sold very quickly, I priced it at a slight discount to the principal owed, and I noticed yesterday when I looked at the loans I had sold it was in grace period. I put in the effort and the effort paid off. I unloaded a loan that might of been a problem loan. You can talk about other sites but I am really happy to be loaning money thru lending club. 12.04% return on my money is a return I am really happy with

Posted by silverfox100 | Report as abusive
 

Very interesting article and responses from Lending club and Prosper. I think Renaud from Lending Club is right to stress the importance of underwriting in reducing credit losses by minimising the adverse selection you correctly identify. This is something we take even further at Zopa in the UK and has resulted in losses to date of less than 1% (and therefore very postive returns for lenders) since we started this whole P2P lending thing in March 2005.

It’s actually as much of a marketing challenge as a credit one as it’s obviously cheaper not attracting the wrong sort of people in the first place than having to decline them later!

What I think it means is that P2P lenders have to apply the same disciplines to lending as conventional lenders and I don’t know too many successful ones of them who simply rely on credit scores. I think it also goes to show that individuals aren’t able to make such effective credit decisions on their own, both because they don’t have all the required information to be able to do so, and because they are too easily influenced by “emotional” factors that have no relation to credit risk. I also believe that P2P lenders can benefit from the more “social” side as our experience has shown that responsible borrowers are more likely to repay us than other financial institutions as long as we get the basics right. This is suggested by our credit losses being lower, as far as I know, than any other financial institution in the UK.

Giles
Co-founder and CEO, Zopa

Posted by zopagiles | Report as abusive
 

Perhaps it is useful to think about the money which is lent and borrowed on these sites not in conventional, economic neutral terms but as a form of social exchange. The roots of credit lie in the social relations of communities not in the theoretical world of economic science (interest becoming a signifier of loans between strangers as opposed to those within closed groups – specifically Athenian demes or families). Declaring my own interest in the creation of zopa, as a researcher, I observed first hand the shift in attitudes between the idea of borrowing from / lending to 500 people and borrowing from a faceless institution which insisted on treating me as just a ‘number’ or ‘consumer’ of credit.

P2P lending enables people to collaborate and form reciprocal relationships within a market context rather than try to become rational calculators (only one form of market exchange championed by neo-liberal economists, I am a bigger fan of Mauss than Friedman).

Zopa creates an environment where lenders and borrowers operate at a carefully controlled(and fundamentally egalitarian) level of social relation which encourages sustainability of the community over naked self interest (within reason). Sure there are those that exploit gaps and niches in the markets but their efforts (and higher rewards) form a useful purpose in fulfilling loans.

In this context the role of credit scoring is not about replacing the human element of assessing risk (as it does in banks with centralised risk systems) but rather extending the human/social ingredients of risk management to gain the benefit of spreading your loans across a number of individuals without spending your whole life reading listings.

One final thought is to turn the situation around and walk down the street trying to give away money. People generally will either think you are mad or your money is bad – even though you are trying to give it away. P2P finance is successful when it facilitates the right social environment to encourage individuals to form bonds of trust sufficient to allow the flow of money between them (and implicitly obligate its return).

Posted by oikonomics | Report as abusive
 

First I have to say that in France banks don’t use credit scores and it works pretty well.

The peer to peer lending websites base the credit decision on credit score not because it is the most secured analysis but because this is the easier information to use in a computer-based system.

The social lending websites will not reach a critical mass With this kind of model and will be only a niche market. The only way they have to get bigger is to give more information to their lenders than a credit score. I like to remind that money invested through these websites is a very small amount compared with any financial services company.

Avoiding the risk by selecting borrowers who have the best credit grades is not a solution to manage the risk because it is a way where there is no risk.

Zopa and and Lending Club doesn’t cut the middleman because they are the middlemen! They invest money on behalf of their lenders. I don’t really understand why they claim such thing.

When bankers try to use peer to peer model they still think as they always did.

Posted by wgg | Report as abusive
 

Is that all they receiving in return? 12-16% by loaning money to total strangers? When I first started my home business I was offering 35-45% over 5 years and no one wanted a piece of it! Now they constantly calling wanting me to borrow money! I always ask them: where were you when I neede you?

Posted by changingseasons | Report as abusive
 

P2P Lending will continue to grow because of the efficiency provided by technology and the ability to squeeze out the greedy banks. People want to help other people…and make money doing it. The biggest risk with most models is that loans are unsecured. Companies like http://www.money360.com are changing the game by offering secured P2P loans. Surely a sign of more improvements to come in this exciting industry.

Posted by Carter1965 | Report as abusive
 

The stock market is a better investment than being a P2P lender. Why in the world would someone want to lend to a total stranger? Leave it to the physical banks and online lenders like http://www.choicepersonalloans.com.

Posted by juliemann | Report as abusive
 

I think everyone raises a good point.

One thing I’d like to point out is that P2P is still a relatively new phenomenon. This means that OF COURSE there’s going to be information asymmetry and adverse selection.

However, these problems are present in any kind of financial industry (think of the information asymmetry in the car insurance industry). Hell, even the big boys aren’t immune to these problems. AIG, Lehman Brothers, etc. all have a thing to learn about these topics.

My point is that just like life insurance and car insurance, the P2P lending industry will learn to adapt and thrive. Information asymmetry always exists; you just gotta figure out a way to deal with it efficiently and properly.

Personally, I use Prosper a lot. My ROI for 2006-2008 was -17%, but that partially my fault because I wasn’t diversified (I only held 7 notes; can you imagine only holding 7 company stocks??).

Since 2009, my ROI was been 21%, partially because I’m much more diversified (82 notes) and because of Prosper has been doing a much better job “rating” loans using their own system which is only partially based on the credit score. (e.g., a $25,000 loan is much less likely to get repaid than a $2000 loan, even if the individual’s credit scores are the same).

What the P2P system needs is people who are likely to repay to go to them -first- instead of the banks. P2P shouldn’t be the lender of last resort.

Posted by TheAlchemist | Report as abusive
 

My assumption is the best avenue for any consumer is to head to a local credit union and request for a signature loan application, generally these offer the best financing terms and easiest borrowing methods. There are other options, such as http://www.paydayadvanceloan.co where a consumer can borrow money from 1000 to 20 or 30k. As for p2p loans, they may seem enticing but with the credit markets improving, some larger banks are now offering personal loans again, so do some research and find out all of the loan terms before you apply!

Posted by donmarks | Report as abusive
 

Writing from UK I think that -
If Credit Unions here were doing their job well, there would be no need for any new schemes such as P2P
My local Credit Union has ended all interest payments to
Lenders! …….. Its now just a Charity

Posted by oldjimmy | Report as abusive
 

There are already websites out there helping p2p lenders make higher and or safer returns. Try lendstats.com or p2panalytics.com

Posted by p2plender | Report as abusive
 

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