Tag Archives: Borrowing

Ways to Improve Peer-to-Peer Lending

30 Sunday Sep 2012

Posted by in Credit, Economics, Finance, Investing

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For a long time now, I’ve been interested in the potential for Peer-to-Peer lending (P2P). Rather than people depositing money with a bank, which then turns around and lends the money to borrowers while keeping most of the profit, in P2P lending some service matches borrowers and lenders directly. Ideally, this allows borrowers to get loans at a cheaper rate, while still giving lenders a better rate of return. It also allows nontraditional borrowers to get funded, if they can tell a good enough story. But there are problems with P2P, to which I would like to propose some solutions.

Right now, the biggest names in American P2P lending are Lending Club, and Prosper.com, where I was a small lender back around 2007 or so. When I participated on Prosper, I was able to see instances where the model worked perfectly, and other instances where the model caused problems. Among the advantages were that groups of people who knew each other (whether In Real Life or on the internet) could provide each other with funds at below-market rates, as an expression of their fellowship. This is something I liked a lot, since Judaism tends to frown on lending money at interest anyway. (More on that topic in another post…) Additionally, some borrowers whose credit score was relatively low were able to convince borrowers that they were a good risk anyway, because of factors that their credit score did not reflect.

The bad news came from several sources. First of all, because all money had to be provided by the individual lenders, as opposed to a centralized source of funds like a bank, many otherwise-attractive borrowers who didn’t know how to market themselves went unfunded. Second, the need to market yourself in the first place can be a turn-off. Borrowing from people you know can lead to tension and a loss of privacy. One of the biggest advantages of the modern system of bank or credit-card lending (as opposed to borrowing from friends and family, as the “unbanked” tend to do) is that banks can lend functionally unlimited amounts of money if they choose to, and your financial circumstances are strictly between yourself and your banker. With Prosper as it stands now, neither of these two factors are at work.

The next problem was due to greed. In the early years, lenders were attracted to the high rates paid by low-quality borrowers, particularly “HR” or high-risk borrowers who could be made to pay up to 30% interest per year. The problem was that in most cases, these borrowers were staggeringly bad risks; those of us who jumped in with both feet ended up losing quite a bit of money when the loans were not repaid. Ultimately, we lacked the knowledge and temperament to tell a good borrower from a bad one, and to resist the lure of fat profits for taking unacceptable risks. There is a reason that (until the era of government bailouts) bankers had a reputation for sobriety, prudence, and conservatism. Bankers who lacked these qualities soon ceased to be bankers.

Note that Prosper responded, ultimately, by excluding the lowest-quality borrowers from the market. This managed to improve default rates; but the fundamental problem remains, that lending decisions are being made by amateurs, many of whom do not understand the risks well enough.

Another institution that claims to be P2P, the British institution Zopa, avoids this second problem by soliciting investor capital and simply making all the lending decisions itself, as a traditional lender would. But in this case, there is no actual interaction between borrower and individual “lenders”; Zopa is actually something like a mutual fund for lending with investor funds, rather than bank capital. It is not really a true peer-to-peer vehicle.

Is there a way to mitigate the problems of P2P without going to the other extreme and quashing the social aspect altogether?

Suppose that you have a Lender institution, a depositor (David) who wants to earn some money, and several borrowers (Brad, Ben, and Betty). David puts a chunk of money (say $5000) into his bank account with the Lender. The Lender then asks David if he is willing to lend money to particular people, at any point in the future, and at what minimum interest rate. David knows Brad, Ben and Betty; he decides that he would be willing to spot Brad up to $500 at a time, but only at the market interest rate—he’s not a close friend or anything. Betty, on the other hand, is someone that David likes, so while he’d only trust her with $200, he’s willing to lend the money to her at a nominal 1% interest to cover fees. He knows that Ben is irresponsible with his money, so he’d rather not risk his own money on Ben.

Note that during this process, David does not know if Brad or Betty are actually trying to borrow money right now. That information is kept from him. So Brad and Betty get to keep their privacy. If Brad or Betty should choose to lobby David for more money, that’s their choice. In the meanwhile, money that’s not specifically earmarked for particular borrowers can be treated like a normal bank deposit, earning some amount of money for David and having some level of guarantees.

Now suppose that Betty finally decides to borrow $20,000 for a new car. The Lender can see her credit score, and other such raw numbers; but it also can see that David, and several other depositors, are willing to trust Betty with money. This does two things: first of all, it shows Lender that people trust her, which can be an additional factor in the Lender’s decision to lend or not. Second, it means that they have to risk less of their own money for the same profit, because they can use money from the depositors who know Betty while still earning servicing fees.

The final decision is the Lender’s; if Betty remains a bad risk, Lender can protect the depositors from her. But on the flip side, if people who know her only pony up $5000, the Lender would be able to make up the difference with its own funds if they like Betty as a borrower, instead of letting her languish in social-lending purgatory. The portion of the money coming from depositors directly could be at below-market interest rates if they like, keeping the social aspect of P2P lending. The balance, coming from Lender, would be at market rates.

Obviously, such a system would not be for everyone. Some people would do well enough on Prosper.com or similar sites, even without such a system. Others might prefer Zopa, or even a traditional bank. Still, I think that the proposed system would make P2P borrowing and lending more attractive for a lot of people, mitigating some of the problems while keeping most of the advantages.

(Anyone who likes can implement this system. I only ask that you drop me a note or a comment letting me know, if you got the idea from this post.)

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An Idea for How to Make Renting Homes Better

01 Sunday Jul 2012

Posted by in Credit, Economics, Finance, Investing, Real Estate

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Many fortunes are made in real estate. And, lured by those stories of success, lots of people have tried their hand at real-estate investing as well, with highly variable results. Meanwhile, many people who cannot buy homes of their own decide to rent instead.

But the present rental market has a lot of flaws in its structure. Take, for example, a common strategy used by new investors who don’t want to sink a lot of capital into a house. They will instead rent a place, perhaps for a long term to bring down their monthly rent, and then turn around and sublet it out to someone else for a higher price.

Now, these people are certainly providing a service of some kind. They are providing income to the owner of the property; if they chose a longer rental term, they are also providing a guarantee of long-term occupancy. But the eventual renter is paying a higher rate for his home than the owner is receiving. It’s possible that the renter has low credit and would not otherwise qualify, or perhaps would not have heard about the apartment without the marketing efforts of the investor-renter; but still, it seems that there ought to be more opportunities for mutual benefit.

One thing that’s always struck me about renting is that most landlords do not allow you to prepay your rent. There are good legal reasons for this, but it still seems to be a missed opportunity. The typical landlord carries a mortgage with an interest rate of more than 5%, sometimes much more. By contrast, 10-year Treasury notes are yielding around 1.6%. If a renter could sink extra cash into prepaying rent, with an annualized discount of (let’s say) 3%, and the landlord used the extra cashflow to pay down the mortgage, it would benefit both sides. All that is necessary is to create the appropriate legal structure.

When you think about the components of a property’s value, you could break it down into two parts: the right to live in a place for a given time, and the actual ownership of the property. Suppose you actually broke them into separate pieces. For example, I could have a house I wanted to rent out, but I wasn’t interested in collecting a rent check every month. Instead, I created a product: the right to live in my house for ten years. I then assigned that product a value, just like a piece of real estate. Say the house itself is worth $100,000; I then value ten years of use at, say, $40,000. If I find a buyer, I can get all that cash upfront and not have to worry about collecting rent every month. At the end of the term, I still own the house and can benefit from its price appreciation, tax depreciation, and so on.

Now suppose I’m a renter, or investor-renter. Buying a ten-year lease gives me a discounted price, compared to having to pay for it month by month. It also lets me lock in the price for the entire term, giving me stability. Plus, since I don’t actually own the house, I don’t have to worry about property taxes. But how might I come up with all that cash up front? If this becomes the norm, it ought to be easy to borrow that money from the bank—especially when you consider that a ten-year rental term is an asset like property is, and can be used to sublet the house in turn, or repossessed by the bank if necessary.

It would be easier for a bank to repossess rental rights than a full property, meanwhile. At all times, there is an actual owner who is interested in maintaining the value of the property, as opposed to home foreclosures that often sit vacant and get trashed, destroying massive amounts of value. And it is easier to rent a property than to sell it, and lots of managers that the bank can call upon to fill up their newly-repossessed asset. Finally, it ought to be easier to appraise use-rights than the actual underlying property, making underwriting easier. So from the bank’s perspective, this might be an attractive asset class.

Subletting a rental-agreement house will provide more gains from trade, in this scenario. I, the investor-renter, have provided the benefits of upfront capital, allowing me to get a good price. I can then sublet to a traditional renter, who does not have to provide upfront capital but can still pay a price comparable to the going rate. I make money from the difference between my discounted upfront payment, and the month-by-month payments of the renter, without having to “overcharge” as subletting investors must do today.

This all will need fleshing out, of course. Navigating the legal minefields alone will be an effort, not one that I care to undertake right now, and people would have to work out the practical problems involved with any new asset class. And this kind of structure will not be appropriate in many cases. Still, its mere existence would cause ripple effects out into the market that would benefit everyone. And perhaps someone more enterprising can see this idea and make use of it.

Bills of Exchange, Banking, and the Little Things

05 Tuesday Jun 2012

Posted by in Credit, Economics, Finance, History

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Jared Rubin writes about the diverging history of the Christian and Muslim systems of finance back in the Middle Ages. At the time, both Christianity and Islam was enforcing restrictions on lending at interest; Islam also had a ban on financial speculation in general. At the same time, the Islamic world had a financial tool called the bill of exchange, which was meant to facilitate the movement of money between cities. When this tool spread into the Christian world, it became the basis for an explosion of international banking unlike anything seen in the world before then. Why? And why did it not have this effect in the Islamic world?

Bills of exchange worked like this.  Suppose you were a merchant traveling from Baghdad to Basra, to buy trade goods there. However, you don’t want to carry a great deal of money with you; to do so, you would need to hire bodyguards, not to mention the pack animals necessary to carry the precious metal itself (remember, silver and gold are quite heavy). This could be quite expensive; for example, the cost of moving gold bullion from Rome to Naples in this period has been estimated at between 8% and 12% of its value. So you deposit your money with an associate in Baghdad, and receive a bill of exchange for its value. This you must present to your Baghdad associate’s business partner in Basra, who will then give you cash. In this way, you don’t need to physically transport cash. And later, the business partners in Baghdad and Basra can settle their own balance, perhaps with a similar bill of exchange going the opposite direction.

Now, one can think of this transaction in two ways, which are not mutually exclusive. First, the business partners in Baghdad and Basra are clearly providing a service to you, the merchant, who can avoid the danger and expense of transporting your money. But remember too that you are fronting money to the issuer of the bill of exchange. Looked at this way, the bill issuer is borrowing your money.

Islamic law came down firmly on the side of the first understanding. The law required the merchant to pay a fee to the bill issuer—that is, the bill issuer is effectively being paid to borrow money. Furthermore, bills of exchange were dated, and needed to be redeemed by the specified date. If a bill were redeemed late, the merchant would be forced to pay a cumulative penalty. Unscrupulous businessmen sometimes exploited this by refusing to redeem bills of exchange on time, inflicting the penalty on the hapless merchant.

What this meant was that it was extremely risky to deal with bills of exchange from people you didn’t trust. Furthermore, you had little incentive to expand the network of people whose bills you used, since you were being forced to pay for the privilege. So bills of exchange, while useful in certain circumstances, did not stimulate the creation of the sprawling banking networks that grew in Europe later.

To understand the effect of the bill of exchange in Europe, we must understand the difference in conditions.

European trade was made particularly difficult because the different lands each had their own currencies. Furthermore, kings and princes often imposed bans on importing foreign coins into their lands. These bans existed for the good of the ruler alone: when the ruler issues his own currency, he earns seigniorage, the difference between the value of the silver or gold in a coin and its face value. So the more of his coins a ruler can impose on a captive populace, the more money he makes. (Worse, it was a depressingly common practice for rulers in need of cash to debase their currency, reducing its silver content so that each coin was worth less in reality.)

So to trade across lands, a European merchant needed a way to convert currencies—without paying the massive fees that local princes usually demanded. The bill of exchange answered the need. A merchant would deposit money with a banker in Florence, let’s say, and receive a bill of exchange payable in Lyons. The difference was that the bill of exchange was for a different currency than was deposited.

This was prohibited in Islamic lands, where currency swaps of this kind were viewed as speculation. But speculation was not banned in Christianity. So merchants were able to evade capital controls by creative use of debt contracts. Even better, merchants could take advantage of the predictable shifts of currency rates so that they would be repaid in more valuable money than they had lent out, effectively earning “stealth” interest and evading the Christian prohibition on usury.

Thus, Christian merchants and bankers had a huge incentive to expand their ties with other cities, since every additional city offered more opportunities to issue bills of exchange and therefore to lend money profitably. This is how the fabled Medici banking network was built up, for example: by establishing subsidiaries in cities across Europe and transacting bills of exchange between them, at considerable profit.

The upshot was that the creative use of bills of exchange supercharged international trade in Europe (while stunting intra-national trade, since there was no profit to be made in exchanging currencies), where its effects in Islamic lands had been more modest. And in Europe it led to the creation of the first international banking empires, where it did nothing of the sort in Islamic lands. All because of a few seemingly minor details: the Muslim prohibition of speculating in currencies, and Islamic law allowing the bill issuer to charge the lender instead of the other way around.

What lessons can we take away from this? First of all, the little things can have big effects. Second, there’s no way to predict the systemic outcome of a given tool, once human ingenuity gets turned loose to play. Third, the history of finance is pretty cool.