A savvy, young real estate investor of mine asked me recently about p2p lending:
"What is this peer-to-peer lending about? Is it true that anyone can lend to strangers on a website without anyone who actually knows anything about investing helping them? They must be getting screwed. Investing is hard. Not everyone should be doing it themselves.”
It's a similar argument to that made by many critics of microfinance recently: that the poor aren't knowledgeable enough to make use of access to financial services wisely. As with naive p2p lenders who far from earning a return, may end up holding useless paper of defaulted loans, naive microfinance borrowers may end up far from improving their lives in the worse shape of over-indebtedness.
These concerns certainly are valid. Not everyone is a savvy lender with knowledge of investing principles and not everyone is a born entrepreneur or businessmen who can reasonably project future income based on new debt. But there are some common principles that both p2p lending companies and microfinance institutions can (and often do) embrace to alleviate these concerns and make them both accessible and fair.
- Simplicity. P2P lending is remarkably straightforward: You (the lender) select the return you want and the risk you can accept, choose borrowers that fit that profile, and agree to lend them money. You then collect a proportion of their monthly interest. This is a process that most people can understand without credentials as a finance genius and creator of synthetic CDOs. And because more people can understand it, more people can reasonably be expected to enter the market and make rational decisions. I’m a believer in not investing what you don’t understand, but a smart person can get p2p lending.
- Transparency. As a P2P lender, your money changes passes from you through one middleman (the lending institution) to the borrower. There are no mysterious detours. You won't be told that your loans will be repackaged into something newer and better that you no longer recognize. To the unsavvy investor, this is paramount -- I can track where my money is at all times. In microfinance, the transparency comes with clear terms and rates. Adjustable rates and balloon payments don’t exist in the legitimate microfinance world. First time borrowers can enter into these agreements with full knowledge of what their repayment commitment will be throughout the course of their loan.
- Quality. When markets are open and quality is poor, disaster awaits. Unsophisticated, early investors on Prosper lended money to very high risk borrowers and were soon burned. P2P lending companies learned quickly from this mess that they needed to focus on finding quality borrowers. In fact, Lending Club now claims that among their biggest challenges is finding enough good borrowers, not lenders. Similarly, many microfinance institutions have embraced a certification/rating mechanism to signal high quality partner institutions that embrace client protection. This is a market mechanism to determine quality (like Moody's, minus the conflict of interest) of the providers and minimize negative effects on the poor borrowers.
I agree that there are risks to democratizing finance. Cutting out expert financial advisors to investors and providing access to capital to poor borrowers can lead to dangerous outcomes if the opening comes without caution. My friend worries about what will happen to amateurs making investment decisions without the help of an expert. The Wall Street Journal and others worry about what will happen to the poor who become overindebted because of newfound access to financial markets. I argue that people can generally make good decisions for themselves if the right prerequisites and protections are in place. P2P lending companies and microfinance institutions offer that chance.