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Financing follows social networking

Online lending operations encourage ‘investing in people’

October 15, 2007

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An emerging Internet-based financing tool that brings borrowers and lenders together the way eBay links buyers and sellers is gaining momentum, turning more Main Street investors into Wall Street wannabes.

Called peer-to-peer or social lending, the concept has gotten a big boost in recent months, thanks in part to a credit crunch that has tightened traditional lending channels at the same time that online social networks like Facebook have spread the word about how such financing works.

"I have 89 loans out right now," said Israel Gross, a 24-year-old Wrigley Field beer vendor and University of Chicago graduate student. "It's small amounts to a lot of people. It's a positive way to make money."

Gross is making his loans through Prosper.com, a two-year-old pioneer in the business that has so far made about 15,000 loans for a value of $91.2 million, according to the company. This year, the average loan size has grown from $6,100 to $7,000 and continues to trend upward.

Now, other firms are starting to catch on to the potential market size - a multitrillion-dollar industry controlled by credit card firms - where people help people finance a new business or simply get a better interest rate to consolidate credit card debt.

"It's an alternative investment vehicle for people," said Ben Decio, president of GlobeFunder.com, a firm in Kalamazoo, Mich.

For people like Gross and 25-year-old Kells Nollenberger, a freelance musician, the opportunity to invest a few thousand dollars through these sites allow them to feel like bankers, but ones with hearts.

"I like investing in people," Nollenberger said. "And you know who you are investing in. I think it's a really cool idea."

A scroll through Prosper shows potential borrowers who want funds to start a muscle car business, invest in an apartment building and buy a $2,000 racing bicycle for commuting.

Accepting risks, rewards

Here's how peer-to-peer lending works:

Investors determine how much they want to invest and the level of risk they are willing to accept. Typically, people will invest $1,000 and then determine the return they want. Investors who elect to invest in borrowers with excellent credit ratings can expect returns of "about 9 percent to 10 percent," said Chris Larsen, Prosper's founder, "with about a 1 percent risk of default."

For lenders willing to take a bigger risk and go for returns of about 14 percent, the default rates rise to about 10 percent, Larsen said.

Prosper, LendingClub.com and GlobeFunder essentially act as middlemen who create the marketplace but also process the loans and arrange for payments. They do not guarantee the loans, as the financing is unsecured.

The companies encourage lenders to spread their investments, Decio said: "We tell people to buy little pieces of a lot of loans."

Gross, for instance, started lending on Prosper in 2006. He has invested $10,000 and now has about $11,500 in his account. He reinvests the interest he has earned. He has loaned as little as $50 to some borrowers.

For borrowers looking for a loan, the sites gather credit information from reporting agencies like Experian. That determines what lenders know about the borrowers and helps set the interest rate.

Borrowers with top-notch credit can get a loan for less than 10 percent, Larsen said, typically less than credit card rates. But if there are some question marks on a credit report, the rate can hit 12 percent to 14 percent. High-risk borrowers, those with bad credit, generally are not accepted.

Personal marketing

Borrowers market themselves to lenders through personal descriptions of their financial situations, using photos to personalize their pitch.

At Lending Club, which launched in May, more than half of the loans are used to refinance higher credit card debt, said Renaud Laplanche, the site's founder.

So far, there are few analysts or critics of these sites, largely because they are so new.

The concept is "certainly promising," said Avivah Litan, a banking analyst with Gartner Inc. "It's not a big enough presence right now for us. I haven't followed how many of their loans go bad, or what the collection rate is, for instance.

"Personally, I think it's too risky," she said. "There's no underwriting and no guarantees. It's all based on trust."

Jason Coleman, a founder of InvestorGeeks.com, a financial site for 20somethings, has been monitoring Prosper.

"Some of the higher-risk loans are starting to default," he said. "But the higher-quality loans, those paying back around 9 percent, appear to be doing OK.

"If you're a lender, you would want to stick with the high-quality borrowers, but there's still a lot of buyer beware," Coleman said. He suggested it could be a good investment for people with a little "throw-away money, but nobody should move their retirement money here."

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