Friendly Shylock

Social lending is a rather interesting financial concept that has its roots in micro- financing in impoverished regions. Basically, micro-financing believes in lending money to individuals who do not qualify for traditional banking credit. The assumption is that these individuals can set up their own businesses and break free of the poverty cycle.

Social lending in developed countries is somewhat similar to micro-financing but with some important distinctions. Similar to micro-financing, loans are not secured by collateral and payments are heavily reliant on “social pressure.” The important distinction is that the use of the loans in social lending is totally different from micro-financing. Loans in social lending are mainly used to either consolidate credit debt or to set up new businesses - I came across a post with a man wanting to borrow money to buy a ring for his fiancée- but are not used to lift the borrowers from poverty. The second distinction is that social lending in the US/UK operates in cyberspace on websites such as prosper.com and lending club. As a result, the nature of the social pressure is totally different from that in a village setting. Unsurprisingly, the costs of default are different too. In the case of social lending; the person’s credit history would be ruined by a default, but his neighbor is unlikely to know that he is fiscally irresponsible. A villager who defaults, risks being ostracized by his community or even the grim prospect of death.

Can social lending work in the US? The main problem is adverse selection. People deemed too risky for the banks are likely to make use of social lending. Ceteris paribus, the lack of collateral and weak form of social pressure are likely to increase the default rates. Social lending is even more risky now as US has a high chance of slipping into recession. Of course, lenders can well be compensated by a higher promised rate of return. However, it is unclear at this stage whether social lending has a higher expected return rate than banks’ on a risk-adjusted basis.

But I do think that there are money-making opportunities from certain groups of borrowers. The first group is small businesses trying to raise loans to finance their operations. Recently graduated students attempting to consolidate their tuition loans seem to be another promising group. The hard part is to separate the wheat from the chaff.

I am surprisingly busy for a person rotting away in NS. If I have more time, I would systematically analyze all the borrowers who default on prosper.com and try to have a sense of the factors leading to defaults. Of course, the usual financial barometers like credit history and Debt to Loan ratios will affect the default rates. The hard part is to find the more obscure ones. Women seem less likely to default than men. Perhaps older people are more responsible than the young. Feel free to suggest any factors that you think will affect the default rate to me.

I think it is possible to get a good return from my investment on prosper.com. After all, I am stuck with US Dollars and want to get a better return in the face of a depreciating dollar and interest rate cuts. To me, it is quite fun to be a friendly Shylock and see how my investments play out. It is also a good way to train my judgment of an individual’s words and figure out if he is really using the money for the stated purpose and return the loan eventually. It is obviously desirable to earn money when you are young and when you are old. But I suppose, losing it when you are young gives the scant comfort that you can earn it back eventually. So I am going to give social lending a try.