Have you ever lent a friend a tenner? If so you already understand ‘peer to peer‘ lending, this is where one person lends money to another person and there is no bank or other intermediary involved. Traditionally it has been a case of letting a person borrow some money until payday and then they’ll give it back to you, traditionally this was also an interest free proposition, not only because the amount of time the money spent borrowed was generally short term but also for cultural reasons, because lets be frank, if a mate asked for ‘interest’ on a loan for a week or two you’d think of them as an incurable scab.
The current liquidity crisis is hitting banks the hardest, this means that the very stalwarts of the financial world are the ones that don’t have the money to lend out, however, there are many individuals who do and this presents the opportunity for a market niche. The market has responded in the form of enabling technology which connect a borrower with a lender, it is done as an auction, the lender with the lowest rate ‘wins’ the customer. This is a simplified version of how an auction rate bond works, whoever can cover the money at the lowest price wins.
I have always maintained that banks are the embodiment of civilization, movement of finance in a community is what allows the whole wheels of the economic machine to turn effectively, if banks ceased to exist it would be disastrous, a first time buyer would have to pay cash for a house if there was no bank to fund them, however, if there was a peer to peer loan available that could be a solution. However, even a well supplied lender in this situation would run out of money, and would then have to find a money supply, this consolidation would in effect be a ‘bank’. So it is important to remember that a peer to peer loan is not a replacement for a bank, it is simply a niche that is open for one person to lend money to another in a formal way.
If you know banking you know that you are lending out your money on deposit, however, the bank takes care of all of the headache and in return for this you get a cut of the action, this is paid to you in the form of ‘interest’. What is to stop you from looking for a better return on your money? Many current accounts pay almost nothing in interest, and until the crunch came deposit rates were deplorable, the only reason we are seeing good deposit prices now is because of the shortage of money, and you’ll notice that there are not any ‘tracker’ savings accounts out there such as ECB+1.5% which is what some of the savings accounts are paying – but only for a certain amount of time!
If a money holder can get by not accessing their money then why can’t they become a lender? There is no reason, if you did it on any scale you would have to get authorised by the Financial Regulator. However, the places this type of lending has the potential to create the biggest change is when you look at this model in the form of micro-finance, many microfinance loans operate on a person to person or peer to peer lending basis, often a social group (for instance a village chamber of commerce) will co-sign for the loan thus providing additional security and the added advantage of local pressure to have the person repay as failure to do so would result in being shunned.
Some of the companies in this area are Zopa and Lending Club, both are firms are well established at this point, the difference lies in whether loans are ‘pooled’ or literally peer loans, if they are pooled then small portions of everybody’s money is paid to the lender and this helps dilute your risk, if it is purely peer you are taking a bet on another person. Firms like Prosper have all of their loans done as three year amortizing loans. The market is taking shape as the lending needs and funding needs resolve themselves.
It could also be a sub-prime mess in the making but people are more likely to pay back other people rather than institutions, [even though institutions are made up of people!] and this is also reflected in the low default rates, it is a non-quantitative measurement but it would seem that there is a greater ‘guilt’ factor when you know there is another private individual on the other end who will suffer a financial loss if you don’t repay the loan.
An interesting point is that this could be a portfolio play for a private investor, this means that you would look to the market and potentially gain returns by investing for capitalist as opposed to philanthropist reasons. With many person to person loans the interest payable is upwards of what you can get on deposit elsewhere, the downside is that you do assume default risk, however, the default rates tend to be low, aggressive underwriting ensures that the tests are stringent because bad loans mean lenders dry up very fast.
How would you hedge your bets? Simply put you create a lending portfolio, take a smatter of high risk loans, put in some medium risk ones and then concentrate on the low AA rated loans with low debt to income ratios. Each loan can be as low as $50 so you control how deep you go into each lending risk. Granted we may start to see a changing world due to the credit crunch but at the same time, perhaps that is the very thing that will drive peer to peer lending as bank oriented credit starts to dry up.