Straight Story: Peer-to-peer

Economics editor Chris Farrell

TEXT OF STRAIGHT STORY

TESS VIGELAND: All right. Our economics editor, Chris Farrell, is here for the audio op-ed we call the Straight Story. And Chris we wanted to talk a little bit this week about a topic that we're getting a lot of e-mail about these days and it's something called peer-to-peer lending. Tell us what this is.

CHRIS FARRELL: All right. It's called peer-to-peer lending or, some of the other terms I like Tess, social finance, or my favorite -- off-the-grid finance.

Now here's the basic idea: You need a loan. You go to one of these peer-to-peer websites or whatever you want to call it and you find someone, an individual -- not an institution, not a bank -- but another individual and they want to make you a loan.

TESS: And this is probably happening more and more because the banks themselves aren't doing a whole lot of loaning these days.

CHRIS: But here's the straight story: Peer-to-peer lending is a genuine financial innovation. But as the business grows, so will the risks. So you want to play? Hey that's fine, but stay conservative -- very conservative.

TESS: Now, why is that? If somebody wants to lend you money and they have a reason to try that you're going to pay it back, why not go ahead and do this?

CHRIS: There's a couple of reasons. And by the way, I like these sites. It's positive, and if you want to diversify your portfolio a little bit, go ahead. That's a way of diversifying. But here are the two risks that I see: One is default risk -- people default and these are what we call unsecured loans. So it's really if, if I make a loan to you . . .

TESS: I haven't put up any collateral.

CHRIS: Exactly. So that's a risk that's there. And I was reading this blog by a gentleman who did a fair amount of lending and he did have a disastrous experience. But, he said, you know what? People do default. And the line that really struck me is that he's now more empathetic to banks and credit-card companies that charge higher rates.

TESS: Empathy for banks?

CHRIS: Exactly. So that's one risk. Here's the other risk, and this is a suspicion on my part. If you go to these websites, Tess, these are communities. It's appealing to people who want to help out somebody else, want to make a little money, but at the same time they want to be a part of a community. They don't like banks. They don't like these impersonal institutions. You know they're really committed. They're going to pay off those loans and they're going to help other people. But as it becomes bigger, and more websites grow and it becomes a business, you're going to attract less-committed people, people who are going to take advantage of the system and, frankly, I think you're going to end up with a default rate that reflects what happens to Citigroup.

TESS: Right. Let me ask you this very quickly. I've been starting to see some news stories that students are starting to look at these peer-to-peer websites for student loans because, as we've been reporting, the student loan market has tightened up quite a bit because of the credit crunch.

CHRIS: I don't think it is a good place to go to student loans. It's sort of down the list of places, but here's how I would approach it. If you're looking for a little bit of money, and we're talking, you know, $1,000, $2,000, $3,000, you know, why not see what you can get on one of these sites versus a private student loan.

TESS: Right.

CHRIS: But if you're talking about a fairly large sum of money, I don't think this is a good place. Because you have to make those regular payments, there's no forbearance. What if your economic circumstances change? Look at it, see if it may work for you. Sometimes people really do want to help people get an education, but recognize this is not a federal student loan and it doesn't carry a lot of the benefits of those federal student loans.

TESS: All right. Chris Farrell with the Straight Story. We'll check back with you in a bit for some Getting Personal.

CHRIS: Thanks a lot.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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