The problem with peer-to-peer lending
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.