Yesterday, I discussed why I’m now a believer in peer-to-peer loans as a new asset class for investors.
Now, I’d like to look at how investors can lower their risks of defaults on these types of loans and boost their overall returns.
The problem with P2P loans
Like in most areas where information is asymmetrical between two parties entering a transaction, p2p loans present an informational problem.
Borrowers know a lot more about their potential to repay a loan than those making the loan.
In a traditional banking relationship, banks have resources to attach a number (a credit score) to a loan. Given experience and data, banks can estimate the probability that a borrower with that number will default. It’s an imperfect solution but works (at least, most of the time).
Borrowers on p2p marketplaces like Prosper.com aren’t given an actual credit score. Instead, they’re grouped into categories of credit worthiness which further complicates our ability as investors to assess their ability to pay us back.
Also, because multiple investors invest in the same loan, each individual investor may lack the incentive to do proper research (free rider problem). That’s according to Do Social Networks Solve Information Problems for Peer-to-Peer Lending? Evidence from Prosper.com
How social networks help investors better their returns
To mitigate this problem, p2p loan marketplaces have created their own versions of social networks where borrowers can friend people and organizations.
And you guessed it — these groups are key to helping us investors determine the chance that our investments pay off (or don’t).
Why? Because research has shown that borrowers with friends on these investment platforms are:
- more likely to get their loans funded (not necessarily a good thing — we want borrowers to get funded and be more likely to pay).
- less likely to default on their loans (bingo!)
The results suggest that verifiable friendships help consummate loans because they are credible signals of credit quality
We want to invest in loans that provide us with a good return but are also the “right” type of borrower. Using friends and endorsements are key to solving this issue.
We show that borrowers with online friends on the Prosper.com platform have better ex-ante outcomes. This effect is more pronounced when friendships are verifiable and friends are of the types that are more likely to signal better credit quality. The results are consistent with the joint hypothesis that friendship ties act as a signal of credit quality, and that individual investors understand this relationship and incorporate it into their lending decisions. To further pin down why friendships matter, we examine whether friendships are related to ex-post loan outcomes. We find that borrowers with friends, especially of the sort that are more likely to be credible signals of credit quality, are less likely to default.