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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Walsung1of9

Next time, invest in established businesses and shun education and debt consolidation loans like the plague! Most startups fail in their first year, and there are plenty of college graduates bagging groceries.

June 11 2012 at 2:04 PM Report abuse rate up rate down Reply
scottee

why should it take a community to pay off a loan? I resent government getting me into debt without my permission to pay for their favors and pet projects and sending me the bill!

January 12 2011 at 10:28 AM Report abuse +1 rate up rate down Reply
chrisfs59@hotmail.com

I was on Prosper as well for a while, however I disagree with your criticism of the 'no personal debt collection' rule. The laws regarding debt collection are very strict and the responsibility is on the lender to know them. If you have individual people trying to collect their debt, you are going to get a nightmarish scenario of lenders making veiled threats at debtors and debtors suing lenders and potentially Prosper as well. That would be not at all good. When you write "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."
I don't see how that is the case. The time to set up social ties that will matter is well before they ever miss a payment. If you can't be bothered to talk to them until after they miss a payment, then your contact isn't going to do a lot of good because it's clear that just like a faceless bank, the only thing you are interested in is their money. You need to talk with them before hand, while their loan is still being bid on. Is this an easy thing to do with 20 (or more) people? No it's not, but that's not their problem or Prosper's problem. That's just the nature of human interaction.
When you try to find who, out of a large group of people that you don't know and can't get to know in a real life personal way, are going to repay a loan, you find that you use a lot of the same basic ways that banks use.
Do you have a history of paying back loans?
Do you have the income that would enable you to pay back the loan you are seeking?
Do you have a job ?
I found that when I looked at these items in Prosper borrowers, they tended to repay the loans more often. (I made about 75 loans).
Ironically, it's that the banks, with all their MBAs, and finance PHDs failed to heed these same principles(or didn't care) that caused masses of their loans to go bad as well.
It's sad that people with poor credit can't apply for loans (though I haven't received an email from Prosper to that effect), however, I suspect it's simply the case that with the interest rates available to be charged, a return could not be made for borrowers.

January 12 2011 at 4:16 AM Report abuse rate up rate down Reply
betteparker123

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January 12 2011 at 1:55 AM Report abuse rate up rate down Reply
bygbubba

Unless you have the money to burn, don't loan money.

January 11 2011 at 5:41 PM Report abuse rate up rate down Reply