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Makin' Money

Financial innovation and social lending

Chris Farrell Apr 16, 2012

Despite all the talk from bankers and Wall Street rocket scientists, financial innovations that better match up savers and borrowers is relatively rare. It’s what the finance system is supposed to do. Much of what passes for financial innovation on Wall Street is little more than the clever relabeling of money so that corporations, financial institutions and other major institutions can evade regulatory restrictions and lower their tax bills. The mathematically sophisticated trading strategies dreamed up by Wall Street financial engineers are typically fancy methods for making spectacular leveraged bets.

There have been some innovations in recent years, however. For example, entrepreneurs and former entrepreneurs have long invested in bootstrap companies too young and too raw to attract the attention and money of professional money. Over the past decade or so, investing by so-called “angels” has gotten far larger and more sophisticated, moving from a financial tributary to large networks of motivated entrepreneurs looking for another deal to back.

Another intriguing financial innovation is peer-to-peer lending, also called social lending. Peer-to-peer (P2P) websites bring together individual lenders and individual borrowers online for a fee. Think Math.com, but for savers and borrowers. Peer-to-peer lenders cut out banks and other mainstream lenders so their rates are lower. The P2P marketplace is growing fast and it will pass the $1 billion mark soon. Two well-known financiers have joined the boards of the two largest social lending networks, Lending Club and Prosper Marketplace. John Mack, the former CEO of Morgan Stanley, has joined the Lending Club board. Eric Schwartz, a Goldman Sachs alumnus, is on the board of Prosper. Institutional investors are starting to put some money into peer-to-peer lending. The lure: Prosper’s lenders have earned an average of 10.46 percent on their loans.

I’ve enjoyed the rise of social lending, although with a skeptical eye. In many cases, it’s a good deal for debtors and investors. Yet it’s an axiom of modern finance theory and historic experience that the only way to create the opportunity of earning a high return is to take greater risks. A 10.46 percent return on lending is certainly high considering today’s low interest rate environment.

I had a conversation last Friday with Joseph Toms, chief investment officer at Prosper about the peer-to-peer business. He pointed out that data from the Federal Reserve shows the credit card business has been consistently profitable. For instance, since 1985, the business has generated a net positive spread of 10.8 percent. The lush margin reflects the high interest rates on so many credit cards.

The basic business of peer-to-peer lending is to live off high-interest credit card debt. Let’s say you’re paying 18 to 21 percent on your credit. You want to get out from under that debt burden, but it’s a struggle. The peer-to-peer lending companies have an investor network willing to lend money at lower rates.

The rates on loans vary, depending on the length of the loan, its interest rate and the borrower’s credit quality. The more creditworthy borrowers get a better rate, and vice versa. The minimum investment in a note is $25. Toms says, in their experience, diversification of investments is key, with investors putting money into a minimum of 100 equal weighted notes. (In other words, you want to avoid having a handful of notes making up the bulk of a portfolio and its performance.) You should spend a lot of time thinking about risk, because some of the debts will go bad, especially the higher the yield on the notes. “The critical element is diversification,” Toms says.

Growth will bring its own challenges. The business is expanding beyond its original true believers in creating a social lending marketplace that bypassed the banks. Institutional investors are starting to invest in the notes. (The Wall Street Journal has a good overview of the market: Would You Lend Money to These People? Big Investors Are Piling Into the ‘Peer-to-Peer’ Lending Market. Here’s How to Do it — Safely.) The business is still young, so it’s default experience should still be approached warily. At some point the credit card companies and other consumer lenders could decide to lower their rates to stave off the competition from peer-to-peer lenders. However, that day is probably far off, since social lending is still way too small and much too young to pose much of a threat.

Social lending is a genuine innovation that takes advantage of technology, social media, and the high-interest rate business model of credit card companies and other consumer lenders. The growth in the market reflects a desire by more people to get off the financial precipice. “More people are saying to themselves, ‘I need to manage my finances better,'” says Toms. “In 5 years, I anticipate people saying debt is OK, but only with a low interest rate and only with a way to pay it back.” That’s progress.

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