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Non-Standard Credit – Part 2
Person-to-Person Lending and Borrowing

How much do you owe to your parents?  No, I’m not looking for an emotional wedding-day speech here, I’m talking cold, hard cash- and if you’ve been a first-time buyer in the UK housing market, it could be a significant amount.  The seeming never-ending rise in prices mean that getting a foot on the property ladder can be a daunting task- even for those who have been working for a number of years.  According to the annual Halifax review, the average first time buyer is now 33 years old, needing to put down a deposit of £23,967 to secure a place of their own.  Until they manage to stump up this cash, many turn to the cheapest landlords they can find- a recent Scottish Widows survey found that nearly one in five graduates now move back to live with parents after university. 

Though no doubt delighted to be housing their children once more in the run-up to retirement, parents are funding their offspring’s flight from the nest as never before.  Around 18% of graduates now borrow from parents to help out with their first home purchase- a total of £2.1bn over the past ten years (at an average of just over £12,000). 

Of course, financial assistance from the ‘bank of mum and dad’ usually comes in much smaller doses than this.  The 2007 Student Experience Report by accommodation specialists Unite found that 93% of student respondents received annual contributions of between £3,500 and £4,500 “that they need not pay back”.  Outside the hallowed grounds of academia, The Money Shop (advertising its payday loan services) reported that 58% of young people had borrowed from parents over the past year, usually to avoid breaching bank overdraft limits.  Unfortunately, less than half (41%) pay back the full amount , leading to serious family arguments in 7% of cases. 

Friends and Family- the World’s Oldest Loan Market

Isn’t it time for parents to toughen up their act- or at least inject a little formality into these lending arrangements?  Asheeah Advani, a former executive with the World Bank, calculated in 1998 that there was a vast $300 billion global market for person-to-person (P2P) loans of $1000 or more to tap into.  While these loans have the obvious advantage of cutting out banks’ profit margins and fees, their management has always been haphazard.  Advani reckoned there was a gap in the market for an internet provider to alleviate this- and thus US-based CircleLending was born. 

CircleLending , recently acquired by Virgin, aims to formalise P2P ‘friends and family’ lending by issuing legally binding loan agreements and repayment schedules for a one-off $99 fee.  Personal loans, mortgages and small business loans are all available.  So far loans to the value of $210m have been arranged, with default rates at less than 1% for mortgages. 

If the pre-existing P2P market was big, modern internet-based social networking could make it unimaginably huge.  Lending Club , a classic Californian ‘angel funding’ venture, was launched in May this year on the Facebook platform.  Would-be borrowers apply within Facebook- entering in their personal information and the amount they’re looking to borrow (from $1,000 to $25,000).  Lending Club analyses their credit rating and suggests an appropriate interest rate — usually between 7% and 12% percent.  “LendingMatch” technology is then used to pair together parties based on shared connections.  Currently using criteria like shared schools, groups or geography, Lending Club plans eventually to link people through friends of friends. 

Prosper and Zopa: Upfront American or Discreet Brit?

CircleLending and Lending Club are certainly onto something in attempting to leverage pre-existing social or familial connections- but why should we limit ourselves here?  Let’s face it, the biggest shared interest two people can have in this context is the desire to borrow and lend money at a decent rate of interest; remembered schoolteachers and favourite punk albums can surely wait until afterwards.  

Prosper , another Californian outlet, has arranged loans totalling $70m dollars since its 2005 inception.  The website uses a platform much like Ebay, with borrowers listing how much they require, over what period and interest rate.  Clicking further on an entry often reveals borrowers baring their souls for the money- both of the purpose of the loan and details of monthly income and outgoings are detailed for potential lenders to peruse at will.  Photographs of all-American-looking couples seem to predominate, mostly seeking debt consolidation loans.  However, the search engine is as fully functional as that on Ebay, so there’s no problem if you only wish to lend to, say, graphic designers or members of US military ‘special ops’ teams.  

Lenders set the minimum interest rate they are willing to earn and bid in increments of $50 to $25,000 on loan listings selected- most elect to spread their money (and risk) over many different listings.  Once the automated auction process ends, Prosper takes the bids with the lowest rates and combines them into one loan, handling all on-going administration including repayment and collections on behalf of the matched borrower and lenders.  Prosper makes its money by collecting a one-time 1-2% fee on funded loans from borrowers, and an annual 0.5-1% loan servicing fee from lenders. 

Zopa (an acronym for ‘zone of potential agreement’) has functioned in the UK since 2005, and now has over 150,000 members.  The Zopa team match borrowers and lenders themselves - a relatively discreet (some would say ‘nannyish’) British arrangement.  However, lenders can see where their money going and what it's being used for, often via voluntary comments left by borrowers ("At last, steps to the patio and an even surface!" says a happy ‘ Tonkys’ ).  Potential lenders simply enter the criteria for the money they lend (interest rate range, credit rating of borrower and term) and are matched across a range of borrowers by Zopa themselves.  Again, Zopa makes money by charging borrowers and lenders a fee (just 0.5% in both cases).  

Default Risk- and Potential in Sub-Primers

Although the ‘personal’ aspect of P2P loans should hopefully lead to lower default rates than those of institutional banks, the risks are still there.  Zopa avoids the issue by its underwriters reviewing every loan applicant and rejecting all those with poor credit histories.  Prosper is far more open and zippy, allowing lenders to choose from credit ratings AA through to E and HR (=‘high risk’).  They report that about 5% of loans (by volume) older than 6 months have been defaulted on, with payment arrears on about 10%.  

Prosper’s lenders have proven to be rather conservative in their funding choices to date- perhaps surprising in light of their choice to enter the P2P market in the first place.  Recent research by Deutsche Bank showed that only 2.5% of HR borrowers’ loan requests achieved full funding, as opposed to 45% for the squeaky-clean AAs.  Ultimately, P2P platforms like Prosper will always face stiff competition for low-risk borrowers from cheap, standardised loans from retail banks, cutting margins razor-thin- now where’s the fun in that?  

Deutsche Bank reckons that Prosper currently has $227m of unfunded high-risk loan requests on its books (often offering interest in excess of 20%), and that it’s in these that P2P platforms’ competitive edge over the more risk-averse banks lies.  Just like social networking sites, members of P2P loan platforms can join groups offering mutual support, advice and funding .  There are currently about 5000 such groups on Prosper, with mutual interests ranging from religion, profession and geography through to fans of TV shows like ‘Heroes’.  Deutsche Bank’s figures show that the peer pressure of group membership cuts default rates significantly (sometimes by more than half) in comparison with solo borrowers.  Well, there you go- I was obviously too harsh in my comments above on Lending Club’s Facebook link-up. 

Online P2P lending is still at an embryonic stage, yet has already captured the imaginations of many.  Some have talked of online lending as the birth of a whole new investment asset class, one with an unprecedented level of personal choice, involvement and social interaction.  So, when your children come knocking for money to see them through next term or just fund a big night out before payday, you can tell them to go online.  There’ll be no slacking in repayments tolerated, and they may make some new friends as well.