peer-to-peer lending, the next big banking innovation

the demise of the department store

The story of the big commercial banks over the last forty years is sort of like that of the department stores, only in slow motion.  In the case of the latter, entrepreneurs targeted the most profitable “departments” of the cumbersome retailing giants and competed against them with freestanding specialty store chains offering a wider selection, trendier products and lower prices.  Toys, consumer electronics, jewelry, household goods, cosmetics, and, of course, various types of apparel were all targeted.

The financial world, for some bizarre reason known only to itself, calls this process “disintermediation.”  It has been underway for almost a half-century.

Consider what a bank does for a living:

in the simplest terms, it borrows money from some people, paying, say, 2% interest, and lends it to others at, say, 8%.  It uses the difference (the spread) to cover costs and make a profit.

money market funds

The first big disintermediation came in the 1970s, with money market funds.  These substitutes for bank checking or savings accounts take deposits from customer and make short-term (meaning a few months) loans to governments and corporations.  The entire spread, less expenses, goes to the money market shareholder.  So in normal times, money market funds pay considerably higher interest than banks.  The banks’ only advantage has been government deposit insurance.

The emergence of the money market fund produced a massive shift of customer deposits away from banks.

junk bonds

The second was  junk bond funds.  The first junk bonds were “fallen angels.”  That is, they were issued with low coupons by companies whose businesses subsequently deteriorated.  As a result, their bond prices had dropped sharply (and therefore the bonds’ yields had risen to high levels).  Careful credit analysis would turn up either companies that were on the cusp of a favorable turn in their fortunes or others where the market had considerably overestimated the chances of default.

As they become popular, junk bond funds soon faced a shortage of suitable bonds to buy. This led to the creation of an original-issue junk bond market–or junk bonds as we know them today.  These bonds were direct competitors to the corporate lending operations of banks.  However, junk bond issuers offered lower interest rates plus fewer restrictive covenants to borrowers and they delivered the entire spread, less expenses, to the fund shareholders.

Again, there was a massive shift of profitable business away from banks.

peer-to-peer lending

We’re in the early days of a third big disintermediation.  Peer-to-peer lending is, I think, will end up replacing banks as makers of small personal and commercial loans.

As things stand now, P2P lenders are simply internet-based intermediaries.  They do credit analysis to determine an interest rate for a given loan, put potential lenders and borrowers together and take a fee.  As I see them, they’re very much like the creators of money market funds or junk bond funds, only targeting a different “department” of the banks.  In the junk bond case, though, the “department” quickly morphed into something else.  That could easily happen with P2P, as well.

What’s most interesting about peer-to-peer to me is that the leading firms are preparing to go public by issuing common stock.

More when IPO dates are closer.

 

chit funds, crowdfunding and p2p banking (II)

two lessons from history

Thailand

I was just getting acquainted with Thailand when the Ms. Chamoy Thipyaso chit fund scandal broke.  “Mae” (=Mother) Chamoy, the wife of a Thai Air Force officer, appeared to be running a very large chit fund investment operation that was stringing together a sequence of startlingly high investment returns.  She had agents throughout Thailand collecting new money for her.  Money was pouring in.

The fund turned out to be a gigantic Ponzi scheme, however.

The scheme sustained itself for an unusually long time.  It continued to operate even after it had become so large (US$100 million+) it was implausible to think Mae could find enough lucrative “secret” microfinancing opportunities in Thailand.  Several reasons for this:

–people wanted to believe.

–the fund appeared to have the backing of the military, the ultimate source of political and business leadership in Thailand.  This gave an implied assurance that the investment results were real.  Prominent high-ranking Air Force officers invested with Mae, and forcefully urged their subordinates to do so as well.

–investors who thought about withdrawing some of their “profits” were pressured not to do so, with the threat that if they took money out they would be blacklisted and not allowed to invest in the fund thereafter.

Interestingly, large investors in the Chamoy fund continued to urge their friends and work subordinates to plow money into the fund even after they realized it was a Ponzi scheme.  Their rationale?   …it bought them more time.  That extra time allowed them to continue to enjoy a lifestyle they knew was going to end when the fraud was discovered.  And it allowed them to arrange their financial affairs in a way that would minimize the negative impact on them personally.  To followers of the Bernie Madoff case in the US, this must certainly sound familiar.

my thoughts

In my reading about microfinance, it seems that Ponzi schemes have been a constant problem wherever third-party chit funds–not the ones where friends and neighbors lend to one another–operate.  That means virtually everyplace in South Asia and Africa.  There seems to be an especially large amount of study done of the industry in India, which I have no practical experience with (because the stock market isn’t easily open to foreigners–and I think the political environment is particularly unfriendly toward equity investors.)

Personally, I’d worry more about Ponzi schemes in the US springing up among the firms that the JOBS Act will allow to raise equity.  These are the entities that won’t have adequate financial controls or accounting statements for shareholders.

My chief p2p banking concern is a more prosaic one–that the present very low loan loss rates will prove to be more a function of the industry’s newness rather than of the creditworthiness of borrowers.  Time will tell.  And, unlike fraud, this is a risk we can take precautions for.

Taiwan

There was a unique twist to the Taiwanese chit fund industry that I encountered in the mid-1980s.   Chit fund loans were secured by post-dated checks issued to the borrowers by the lenders.  In Taiwan at that time, “bouncing” a check–having insufficient funds in the account to cover payment–was a felony, punishable by the check writer serving time in prison.

The threat of jail time was thought to be sufficient incentive to ensure repayment.  So no one worried too much about the creditworthiness of the borrowers, which–as it turned out–included large publicly-traded companies.  American accountants I met, who’d been sent to Taiwan to break into the auditing business there, told me that they could see the fact of unaccounted-for money sloshing around in potential client companies.  They just couldn’t see how much.  Because of this, they were reluctant to take any engagements.  And they were continually undercut by local accounting firms who charged virtually nothing for “audits.”   American bank lending officers told me the same thing.

The chit fund business received a major shock, during a mild economic downturn, some large companies had made hundreds of millions of dollars in chit fund loans–all unrecorded in the financial accounts–that they couldn’t repay.  Bankruptcies resulted.

my thoughts

This is another potential problem for equity holders in firms crowdfunded under the JOBS Act.  Without audited financials, it’s impossible for an outside investor to determine what the capital structure of a company is.

I also think, à la Taiwan, a legitimate auditor will simply walk away from a suspect company rather than make a public outcry.  Non-disclosure agreements may force it to do no more.  A less fastidious auditor, one nobody ever heard of, might take the business and issue a clean opinion.  After all, Bernie Madoff got one for years, didn’t he?

chit funds, crowdfunding and p2p banking (I)

chit funds in emerging markets

I began to look at smaller Asian markets as an investor in 1985.  It was there that I encountered the informal self-help savings and lending associations that are typical in developing economies.  My introduction came through chit funds in Thailand and Taiwan, but these structures exist throughout the developing world.

what they are

the simplest

In their simplest form, the associations are groups of friends of neighbors who contribute a specified amount of money to a pool on a regular basis.  The funds pooled each time the group meet are lent to a single participant, determined either by the implied interest rate bid or on a rotating basis.

more complex

At a higher level of organization, groups come to a designated place at a specific time–like by having a meal at a certain restaurant on Saturday–and offer to third parties the money they’re willing to lend.  They may signal their intent simply by piling their money in the center of their table.  Prospective borrowers move from table to table to negotiate loan terms.

the pinnacle

For the largest such chit funds, agents for the fund do the collection and forward the money to the fund’s central headquarters.  Lenders don’t have any direct contact with the borrowers.

why chit funds?

There are a number of motivations, normally all based on the idea that the formal banking system doesn’t function well. For instance:

1.  There may not be any local banks.

2.  Banks may offer very low interest rates to depositors.

3.  Banks may decide to lend only to large companies.

4.  Potential depositors may worry about bank solvency–the possibility that they’ll lose their money in a bankruptcy or nationalization.

5.  People may not want to reveal the extent of their wealth, or the extent of their taxable income.

the US equivalent

Interestingly enough, this emerging world form of microfinancing is beginning to make a strong showing in the US.  It’s taking two forms:

–Congress recently passed the JOBS (Jumpstart Our Business) Act.  JOBS greatly simplifies the procedures for a small company to make an offering of equity.  For companies with less that $1 billion in annual sales, JOBS does away with the requirement that they present audited financials to potential investors (not a stellar idea, in my opinion).  JOBS also defines the maximum amount that low-income investors can put into a given offering.  By so doing, it legitimizes the efforts at equity crowdfunding (see my post) now underway in the US.

–John Mack, former head of Morgan Stanley, recently joined the Lending Club, a P2P (peer to peer) lender.  P2P lending is chit funds come back to life, but on the internet instead of in your local restaurant.  You can go to the websites of P2P firms like Prosper and Lending Club and select the borrowers you wish to lend to by yourself.  Or you can hire a financial advisor to do this for you.

why now?

To start with the obvious, the technology needed to run P2P or equity crowdfunding is readily available.

Interest rates have been low for a long enough period of time–with little relief in sight–that more conventional means for savers to obtain high returns have been exhausted.  Not only that, but getting a return above 2% in Treasury bonds requires committing money for a very long time, exposing the lender to the risk of loss as/when rates eventually begin to rise.

I see the JOBS ACT as an attack (maybe as the first step in a prolonged attack) by Washington on the current IPO practices of Wall Street investment banks.  Conventional IPO costs in the US are very high by world standards, and a private individual stands about the same chance of getting an IPO allocation as a snowball in northern hemisphere July.

The naming of the JOBS Act suggests that Washington wants to be seen as doing something to create jobs.  What a commentary if this is the best they can do.

My first reaction to P2P is that it may be a true innovation, like money market funds and junk bonds were in their day.  P2P could end up being a very big business–unlike JOBS, which I see, in its present form, as gimmicky and filled with opportunities for fraud.

That’s it for today.  Tomorrow:  historic problems with P2P lending, including a word on Bernie Madoff.