naked capitalism

Never underestimate the potential of bankers to ruin a good idea by trying to wring too much profit out of it. Subprime lending, mortgage securitizations, microfinance all were products that had merit and were beneficial until industry incumbents pushed for growth and cut corners and/or tried to extend the market well beyond sensible limits.

Peer-to-peer lending may prove to be yet another victim of this propensity. A story in BBC (hat tip Richard Smith) describes the premise and its progress in the UK. The sites take money from individuals and makes loans. Unlike a bank, the lenders’ funds are not guaranteed, but the rates offered are much better, with the site charging a bid-asked spread between the two rates (1% in the case of the UK leader, Zopa). Currently, that means a bit over 7% interest for lender and 8% for the borrower. The lenders are protected by their funds being distributed over many borrowers (the are supposedly allocated pieces of specific loans, £10 each. The 1% retained covers the cost of credit screening, admin, and one assumes, collections. The three major sites have a bit over £250 million among them and claim to average losses of 0.5% (I’d like to see an actual breakdown of repayments, delinquencies, and defaults, to make sure I was comfortable with how that figure was arrived at). The BBC story does no discuss the liquidity of the lenders’ funds, but there are presumably restrictions, like set or minimum terms.

In concept, this is a great idea, and no less than Andrew Haldane of the Bank of England endorses it. There are other versions of this idea that aspire to be alternative money systems, such as Ripple. But while the UK versions have (at least as of now) a bit of an idealistic, New Agey feel, in the US, bankers are eyeing peer-to-peer as a new territory to be conquered. For instance, an April Financial Times story depicted the fact former Morgan Stanley CEO John Mack was joining the board of US peer to peer lender the Lending Club as a sign that the industry was growing up.

Needless to say, a lot of people would happily agree to tie up their money for 2 or 3 years if they thought they would get a 5% to 6% annual return. And my crude sense, based on proliferation of bank branches in Manhattan (displacing all sort of retail stores, just in my ‘hood, a liquor store, a specialty food shop, a Gap) is that banks have overinvested in brick and mortar. But at their current miniscule share of the total lending market, these companies can be stringent about borrower quality and still have plenty of candidates to choose from. What happens when new entrants pressure the incumbents, and when companies like the Lending Club have to keep increasing their total volume of loans to satisfy investors? For instance, the Lending Club looks as if it getting close to an IPO (Kleiner Perkins invested, along with Mack, and Mary Meeker also joined the board).

I’d be happier if these companies were mutualized (as Vanguard is) and management was given back end incentives (say based on the level of timely repayments). The world of finance would work much better if we had operators that would be content building and defending a nice, niche business rather than pushing for growth, which in lending eventually leads to making more and more risky loans. And of course, there is an additional risk of peer-to-peer lending, that of a Ponzi scheme or other frauds on investors. Maybe Occupy should start a peer-to-peer lender and give Mack as well as the big banks something to worry about.