Could a Banking Revolution Start with Neighbors Lending to Each Other? Peer-to-Peer Lenders Take Banks Out of the Credit Equation
With demonstrators occupying Wall Street to demand financial sector reform, community-minded entrepreneurs working to take banks out of the lending equation see an opportunity: After years of obscurity and regulatory setbacks, peer-to-peer lending may be ready to step into the credit void. Where crowdfunding is the banking alternative for startups, this take on direct lending is more personal.
When Greg Dawson wanted to turn his photography hobby into a business, he knew it would require cash he didn’t have. “I was in the infancy of my marketing career in Chicago. I didn’t have the capital means to go out and buy my equipment”—a new camera, expensive lenses, a computer and editing software.
"I went to the bank first. Bank of America, where I was banking for five or six years,” Dawson says. “I was told, ‘not a chance’, because I didn’t have any assets. I didn’t own a house." He also had student loan debt, so despite a good credit score, his income to asset ratio didn’t meet BofA’s standards.
“So I took to the internet,” he says. “I think I was funded for about $4,000 in about 48 hours.” Four years later, he's the proud owner of a thriving small business. Dawson is one of several hundred thousand people who’ve gotten a loan through Prosper.com, a peer-to-peer lending website, and he says that the ability to put a human face on the loan was a big reason he succeeded.
“I was able to tell my story in the actual loan process,” Dawson recalls. "I was able to explain how I got into photography, how I was practicing it.” He was also able explain to prospective vendors that his debt resulted from student loans, not business failures or spending extravagance.
As banks tighten up, more and more business are turning to Prosper, the company says. That's a trend likely to continue, and one that could change how the rest of us bank too.
Show Me the Money
Browse Prosper's loan offerings, and you won’t find a seething bed of entrepreneurship. The most common category of request is for debt consolidation. Then there are home repairs, wedding expenses, and entrepreneurs like Dawson.
Prosper and its only competitor in peer-to-peer lending, LendingClub, both certify loans and place them in different risk categories with different interest rates. The lay lender doesn’t need to suss out if an unemployed homeowner should pay 8 percent or 10 percent for quick cash to plug a leaky roof. Lenders can decide what level of risk they are comfortable with while investing amounts as small as $25.
“The whole idea is to let anyone, any American, to make a loan listing on an open marketplace, and then let anyone with money, not just the oligopoly, the banks, to grant credit,” Prosper CEO Chris Larsen says. If his eBay-like marketplace for loans catches on, he predicts it will change banking—and who profits from loans.
“The spread isn’t really fair now,” he says. “Banks get to decide how much you get for savings, and how much your neighbor pays for borrowing, keeping the spread for themselves. And there’s nothing you can do about it because you aren’t allowed to lend directly to your neighbor.”
Prosper and LendingClub together have served over half a billion dollars in loans to more than 2 million members since 2007. That’s not small change, but most people don't know these sites are an option because regulations keep out many companies who would follow Prosper's lead.
What's Stopping You?
In the eyes of the Securities and Exchange Commission, you aren’t actually lending money to the smiling face you found on Prosper’s website. Instead, you are buying a product from Prosper, and that product is a security that must be registered and regulated just like any other stock or bond offering.
“That meant on a $10,000 loan to a local microbusiness, we have to go through exactly the same hurdles as a $100 million bond issuance,” Larsen says, estimating that complying with those rules cost Proper and LendingClub as much as $10 million. This has hurt the sector, with all but two of the 10 peer-to-peer lenders that existed before 2007 throwing in the towel.
Larsen argues that current regulations are a poor fit for finance in the internet age. Each time Prosper or LendingClub facilitates a loan, they must record it in the SEC’s EDGAR filing system, following the same process with a $25 loan as an investment bank does with a multimillion-dollar security. Thanks to their large volume of small loans, Prosper and LendingClub have the bizarre distinction of being among the top 10 most frequent EDGAR filers, close behind Wall Street titans like Black Rock Capital and Goldman Sachs.
While these rules pose a costly challenge, they've also spurred the innovation that is one of Prosper’s main competitive advantages: They’ve invested in the technology to process those filings as efficiently as possible.
Jason Lampert is a financial planner who personally invests about $4,000 through Prosper, about one-40th of his portfolio. He was looking to diversify his portfolio with an asset that “wasn’t correlated with the rest of the market," he says. "It was about looking for investments that were not controlled by Wall Street. You don’t have to pay a broker, and you don’t have to go through the stock market.”
“On an annual basis, I probably earn about 9.5 percent,” he says. “A pretty damn good return in the past couple years, and very steady.” Of nearly 160 mini-loans he’s made over the past two years, only six have fallen through, a little better than the site-wide default rate of 5.3 percent. Even that is manageable, he says, since he only invests $50 in each loan.
Lampert doesn’t scour profiles or contact borrowers to pick his investments. Instead, he has Prosper automatically assign his money in $50 increments according to risk criteria he sets each quarter.
"There’s a lot of people using the platform in a non-highly rational manner," he says. "I like the touchy-feely part, but I don’t like to make decisions based on it.”
The financial planner cautions that unlike a savings account, Prosper loans aren’t backed by FDIC insurance; if the borrower defaults, you’ll have a hard time getting your money back.
Nor can you cash out on a whim; you have to wait for loans to be paid back month-by-month. In that sense, peer-to-peer lending sites give prospective lenders both the advantages and the tradeoffs of banking: You’ll get a better interest rate, but have to manage the same loss of liquidity a bank does.
“I love the idea [of using Prosper], that’s why I decided to put my money in there,” Lampert says. “If I were going to give people investment advice, I’d say, 'only do this with money that if it were all gone, it wouldn’t kill you.'"
As Prosper and LendingClub grow, they are becoming more sophisticated at assessing risks and alleviating fraud concerns. Big venture capitalists are backing Prosper in a new round of funding, so watch for increased outreach as the site tries to build a bigger following and leverage disaffection with traditional banks.