Surprise! Peer to Peer Lending is Risky

January 19, 2010 by Jim

ww.bargaineering.com/images/in_posts/green-aliens-toy-story.jpg" title="Green Aliens from Toy Story" class="r">Earlier this week, Mark Gimein wrote a great article on TheBigMoney.com detailing, statistically, how risky person-to-person lending really is. I’ve always known it to be peer to peer lending or social lending, but the article calls out the riskiness of Prosper.com, the first and one of the largest of the peer lending networks.

To look at the results of Prosper’s loan marketplace, though, is to see not a solution to the credit crisis, but a microcosm of it. Loans to unqualified borrowers; reliance on mathematical models that turn out to be a lot less useful than they seemed; failed hopes that high interest rates could make subprime loans profitable; sky high default rates—Prosper has it all. Prosper’s Web site advertises returns of 6 percent to 14 percent for lenders. But the reality is that the lenders who loaned $188 million through Prosper have not earned anything like these returns. On the contrary, the majority of them have lost money, as they’ve watched their loans go bad at shockingly high rates.

The takeaway from the article isn’t that you should avoid Prosper, it’s that you probably should avoid peer to peer lending entirely. (In fact, I think Prosper should be lauded for making their loan data public!) There simply wasn’t, and likely isn’t, enough information for you to adequately price in the risk of default. Are things better today than they were in 2007? Probably, but the reality is the peer to peer lending marketplace is a lot riskier than you think.

Whenever there’s something new like this, there’s a subset of its users who will find a way to benefit. For the longest time, the early adopters thought they were the ones who benefited. Unfortunately, as it turns out, the true beneficiaries were the social lending networks (who take a percentage of the loan in fees) and the borrowers themselves (who received loans they probably wouldn’t have qualified for).

When I tweeted this article out, @PotatoPeeler said – “Do we need a whole article to tell us that lending money to random people on the internet is an absolutely horrible idea?” I wholeheartedly agree!

I know people who have been lucky enough to avoid the default plague so far and it seems as though it’s only a matter of time. A little bit of me is now glad that Maryland residents aren’t permitted to “invest” in these loans.

(Photo: nitrofive)

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