Arnold Kling

Amateur Bank Lending

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The Wall Street Journal reports,


About $100 million in new person-to-person loans will be issued this year, and that will increase to as much as $1 billion in new loans in 2010, according to a recent study by Online Banking Report, a research firm.

Andrew Balto Jr. of Churchville, Md., says he pulled some money out of certificates of deposits and money-market accounts last year to put into Prosper loans, where he is now earning returns equivalent to an average annual interest rate in the midteens. "What really attracted me were the rates people were paying for the loans," says the 39-year-old small-business owner, who has about $30,000 spread out over 350 Prosper loans. He says those loans make up only a small part of his total investment portfolio.


I think there's something wrong with this picture. As an individual, I do not have the time or the resources to evaluate a borrower's riskiness or to deal with late payments or defaults. That's what banks are for--I deposit my money in the bank, and the bank deals with individual borrowers.

By doing the lending directly, I get a higher interest rate, because I don't pay the bank to do anything. But I expose myself to a lot of downside risk.

What worries me the most is that I do not know how much time and effort I have to put into weeding out borrowers. It depends on what the other amateur bankers are doing. If they aren't putting in any effort, then fine, I can throw darts and get a random sample of borrowers. But if my competitors are putting a lot of time and effort into sifting, then unless I match their efforts, the borrowers I get stuck with will be all the dirtbags.

Nick Schulz, who sent me the pointer, says that it is indicative of our high-trust society that such a market even exists. It is true that institutional advances allow for remarkable transactions to take place among strangers. However, person-to-person lending between strangers strikes me as a market that cannot, and in the long run will not, work.

By the way, the movie "The Call of the Entrepreneur," which is being shown tonight at the Heritage Foundation, has a good explanation of the role of financial intermediaries in making risky lending possible.


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COMMENTS (25 to date)
Matt writes:

So, banks do not do their job. If the loans are earning that much money, even with the number of defaults, the banks should join in.

The problem I have with banks is their closeness to government. They do not deal with the underground economy very well. probably due to the federal govenment using them for tax collection.

The answer, it seems, is a clearing house, a group that conducts minimal checks on the borrower, and certifies the borrower as OK for personal lending.

This problem leads to the general problem of finding some way for the underground economy to be accessible to financing without involving the federal government. This may seem a contradiction, but we do depend on the underground economy.

Karl Smith writes:

Actually this sounds great to me.

The thing is that unsecured loans are often made on a formulaic basis anyway. It is not as if the bank is really taking time to decide what kind of person you are, they are basing off of your credit score, payment histories, etc.

According to the article, individuals making loans have access to all of that information through the intermediary. So rather than a formula making the choice about risk / reward the market is doing it.

The key is being able to distribute all of this information to potential lenders and that is what the internet makes possible. I have not been to the site, but I wonder if you can search potential borrowers by certain stats. This would allow each person to develop their own comfort model, ie

I like people with credit scores above 660, late payments but no defaults, who are willing to pay 17%.

Or I like credit scores above 580 with defaults that happened a long time ago but no recent late payments and are willing to pay 19%.


That market would be a thing of beauty.

randy writes:

you give "experts" too much credit arnold. bankers are just stuffed suits holding cozy relationships with the credit bureaus. neither the bankers nor the credit bureaus have any idea who their customers are. it does have something to do with the underground economy, but that's not the whole story.

consider for one moment the psychology behind all of this. how obligated will a borrower feel to repay a corporation, and how obligated will the borrower feel to repay a private individual?

ed writes:

Perhaps individual lenders are able to better screen out the bad credit risks. For example, perhaps they consider factors that banks would not be allowed to consider because of fair-lending laws. (This may still be illegal, but individuals fly under the radar, so to speak.)

Buzzcut writes:

Who wants to pay 17% interest? That used to be called usury!

Dan Hill writes:

Consistent with Arnold's concern about the riskiness of the loans, ask yourself this. Why would a borrow with good credit borrow money from you at 16% rather than 6% from a bank?

Bob writes:

You can get a sense for what kind of returns are (currently) possible by creating a phantom portfolio:

http://prosperlending.blogspot.com/2007/07/build-your-own-fantasy-prosper-loan.html

There are some useful statistics (best, worst, random, etc.) on the phantom portfoios that users have created.

Does anyone know if defaulting on a Prosper loan hurts the borrower's credit score? If it does, I don't see why the market wouldn't thrive, if only as a niche.

Chris writes:

Given how easy and pervasive credit reports are is the individual investor really doing any less than a bank?
All they do is run my credit score and base decisions around that - it only takes about 30 minutes to get approved for a mortgage (and hours to sign the paperwork).

Gary Rogers writes:

Isn't this just the market working as it should. As banks and other lending institutions add overhead to investment opportunities, it becomes more attractive for investors to bypass their services. Yes, it is risky but it may be a better choice.

Matthew c writes:

Arnold,

all the bank does is run your credit score.

If the individuals are running a credit score and then getting additional info (as well as being someone that hard luck borrowers would rather pay) then they should do at least as well as banks do.

Prosper has a web site with a good 'How it Works' tutorial, that answers many of Arnold's questions.

In a nutshell Prosper allows lenders to diversify their loans, thus reducing risk of default.

Here's a Q&A with one of Prosper's officers that also sheds a little light on the process.

Matthew c writes:

The big problem likely for prosper is too many fraudulent applications due to the fact that they are entirely internet-based, not any problem with "normal" bad loans. . .

Bob writes:

Patrick Sullivan is a bit off. A portfolio won't lower the (expected) default rate, but it will make default more predictable.

Plinius writes:

I wouldn't be surprised if the banks will soon join forces to ban "amateur lending".

As an aside, the mafia lends oney too and they're not too worried about defaults (they have ways to go after them...)

Brad Hutchings writes:

Arnold, How is this much different from renting a home out? Lots of people get into the rental property business with their second home or vacation home or intended retirement home, etc. That is, not terribly professionally. Even when done "the right way", with real estate agents, management companies, etc., the downside can be huge -- destroyed property, unpaid rent, etc. Screening candidates adequately is difficult in light of all sorts of fair housing issues. At least with private loan sharking, you can only lose what you put up.

Arnold Kling writes:

Brad,
If I invest in a bank CD, I am protected from borrower defaults. I don't have to screen the borrower in any way.

The real estate analogy would be for the real estate agent to fully indemnify me for any loss, including emotional costs of having my property damaged.

Hollywood_Freaks writes:

This somewhat reminds me of the idea of Fair Trade. Given, I haven't done too much research on the topic, but when I casually talk to proponents of Fair Trade, they always use the explanation that "it takes out the middle man" as if the middle man adds no value for the producer or consumer, and as if the Fair Trade Organization is not a middle-man.

The link here is this overall belief that the bank adds no value to the lender or borrower, so individuals just try to bypass the bank. The end result will be great failure or great success, but I personally doubt the latter.

Brad Hutchings writes:

Arnold, The way you expressed the real estate analogy is what I'm getting at. There is probably a lot of P2P financial activity that is equivalently risky (or more) than amateur lending.

I've seen forms of this many years ago with local mortgage lenders dealing with difficult applicants. They might get someone like my grandfather to loan the money. Usually the last thing the guy lending the money wants is to end up owning the property, but the interest rates make the deals lucrative, and the borrowers couldn't get a traditional bank loan, so lenders are doing them a big favor. The potential downside always seemed horrendously bad to me, but it always seemed to work out well for my grandfather. It might be a negative Black Swan situation like Taleb describes, but with big losers few and far between, most investors skate.

Tom writes:

Hi. I write for Prosper Lending Review. Bob mentioned one of our posts in an ealier comment.

Prosper covers the risk of identity theft. Lenders assume all other risk. Prosper can be a good way for lenders to earn a decent ROI on their funds in a new asset class. There is enough data to make some prediction on default rates for borrowers. It's a fun, interesting idea. If you do decide to lend I recommend you spend some time reading (official forums, my blog, other 3rd party sites). Don't make the same mistakes that other borrowers have already made. It will be more time consuming than other investments but can be very rewarding.

Adam writes:

I think this was the key part of the article:

Andrew Balto Jr. of Churchville, Md., says he pulled some money out of certificates of deposits and money-market accounts last year to put into Prosper loans, where he is now earning returns equivalent to an average annual interest rate in the midteens. "What really attracted me were the rates people were paying for the loans," says the 39-year-old small-business owner, who has about $30,000 spread out over 350 Prosper loans. He says those loans make up only a small part of his total investment portfolio.
People don't always go to middlemen for advice on how to invest in stocks; why should it seem so surprising that a similar principle could be applied to personal loans?

Amir writes:

My friend runs a small money lending business. He only gave loans to those who earn money on a daily basis, small-time businessman are the most reliable, or so I was told.

Doug writes:

I have approximately $1500 tied up in Prosper as an experiment at a rate of about 13.5%. I hold 25 loans. One loan ended up as fraud and was repurchased. I now have one late loan that made 7 payments before failing. Once a Prosper loan goes late it tends to fail completely - this is subprime lending. That means I'm out $33 and profits from the other loans have to make up the difference. This was an AA grade loan which is supposedly the best credit rating. My experience now tells me that Arnold is completely right - it can not work. These are signature loans to people that for the most part banks already turned down.

Bob Knaus writes:

From personal experience, I can tell you it will not work for most people. I put $4000 into Prosper as an experiment. Most my loans were $100 - $200 parts of loans with a $2000 - $5000 total value. My loan decisions aligned with 10 to 50+ lenders on each loan.

My own choices were to loan to D, E, and HR risks at rates of 20% to 29%. I tried to pick "stories" from people who had been paying much higher interest rates, primarily payday loans but occasionaly other outlets.

The default rate on the loans will erase all of my profits from interest and I expect to take a loss on my $4000 over the next 2 and a half years as the portfolio unwinds.

There may be money to be made lending on Prosper, but I think the average lender will end up losing money. At some point, Prosper will exhaust its pool of lenders willing to experiment, and the enterprise will collapse.

Arnold

In the Zopa markets, lenders already have several filters at their disposal. The system allows lenders to automatically spread their loan principal across 50 borrowers (or choose a different number). After matching, loan completion is subject to anti-fraud and credit-checks. Since launching in March 2005, the default rate at Zopa is less than 0.20%, reflecting the creditworthy nature of Zopa borrowers.

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