Just before Christmas, the peer-to-peer lending site Prosper.com decided to eliminate high-risk borrowers from its site after a high percentage of them failed to repay their loans. Launched and initially funded by e-Loan founder Chris Larsen, Prosper Marketplace was one of a number of peer-to-peer lenders that aimed to democratize the lending process and allow anyone to seek loans from strangers or friends via the Internet, without dealing with banks, risk managers or underwriters.

The theory was that high-risk borrowers wouldn't actually be such terrible risks, based on the idea that micro-loans in the developing world had proven to be safer than traditional measures would have predicted.

Exhibit A in that argument was the Grameen Bank, a micro-credit lending operation founded by Muhammad Yunus. This non-for-profit institution gives small loans to the poorest people on Earth to help them to better their lives through purchases of small items -- things such as livestock or small appliances or even a couple of buckets. But what works in Bangladesh doesn't always work in Kansas, and this latest bumpy patch for Prosper could portend similar problems for other peer-to-peer lending companies.

A Decent Return and Helping My Fellow Man

Back in 2006, I wrote an article about Prosper.com for Inc. magazine, titled Brother, Can You Spare a Dime? -- after one of the most famous songs from the Great Depression -- and was smitten by the peer-to-peer lending concept. Gung-ho to do well and do good, I sank a small four-figure sum into a portfolio of roughly 20 loans. My borrowers ranged from single parents seeking to start small businesses to college students consolidating credit card debt. Here, I thought, was a way to earn decent 7% or 8% annual returns, on average, between high-risk and low-risk borrowers, and to help my fellow man at the same time. Little did I know.

Soon after my initial investment, things started to go wrong. Within the first few months, I noticed that a significant portion of the borrowers in my portfolio were missing payments. Worse still, under Prosper's model, lenders weren't allowed to contact borrowers to request payment. The company told us to leave that to the collection agencies we selected when we signed up. The actual effect of this contact prohibition was the elimination of any sort of social ties connecting borrowers to lenders, the sort of (admittedly weak) human interaction that might cause a person to feel more obligation to repay their loan.

Mind you, the borrowers were allowed and encouraged to contact lenders to ask for loans. And some borrowers sent along updates of their progress, something that I'm certain Prosper.com hoped would happen en route to the construction of a true virtual lending community. Whenever I got a notification that another borrower had fallen behind on payments, I would look at their profile. Was there anything I should have seen, but had missed? How were the delinquent borrowers different from those who paid on time?

A Lack of Social Ties

Was there a pattern? I couldn't really detect one, but I did begin to feel that the reason so many of these borrowers had decided to bail on their debts was that the penalty they faced, in all likelihood, was minuscule. They probably had bad credit already. They would take another credit hit by skipping out on a Prosper.com loan, but the impact would be minor. And they certainly didn't know me from Adam.

In retrospect, my peer-to-peer lending experience would soon be replayed on a much grander stage. The ability of banks to quickly package and sell mortgages meant that community banks no longer held the notes for many of their borrowers. Those borrowers, in turn, felt little or no social stigma for failing to repay their loans. On the other side of the equation, remote and massive lenders holding mortgages couldn't even conceive of trying to work out problem loans, in part because they had no social ties to the debtors.

Banks didn't know borrowers, and really didn't want to know them. Contrast this with Kiva.com, a social lending site that not only encourages contact between lenders and borrowers but also makes it a far more important part of the process. Kiva also has a roughly 98.5% payback rate -- far higher than anything I experienced on Prosper.com.

This is not to say Larsen didn't have the idea of the social bond in mind at Prosper, but the reality is, such ties simply didn't take hold in the system he created.

Exit Strategy

The moral of this story for the future health of the world economy? Lend money to people you know or people who are socially invested in repaying you. Likewise, borrow money from people you know or people who want you to succeed and want to participate in your success over the long-term.

I took a moderate haircut on my stake in Prosper.com and stopped participating as soon as my last loan was paid off. Yes, Prosper.com's peer-to-peer lending concept is a wonderful idea, and it may yet turn the corner. But whether the bank is virtual or bricks-and-mortar, it takes a village to repay a loan.

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