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The financial crisis is making borrowing money more difficult due to the financial system’s reluctance to extend credit. The reluctance is part of the continuation of the deflationary process resulting from our previous credit bubble.
As is usually the case, the market usually finds a way to satisfy demand. Peer-to-peer (P2P) lending is increasing in popularity with sites like Prosper and Lending Club filling the void. These sites seek to match borrowers needing money for such things as home repairs, college tuition, and debt consolidation with lenders lured by high interest rates. These types of loans are not well-suited to mortgages since Uncle Sam is working hard to fill that void with precious tax/borrowed money.
Reports indicate that prior to the credit crisis in 2007, P2P lending was $647 million in size. The market has grown to $3 billion and is expected to reach $5.8 billion next year according to Celent, a consulting firm tracking P2P lending. A recent article in Parade Magazine indicated the average lender in Prosper makes $3,500 in loans and earns 9.38% interest. Clearly, loans at these percentage rates carry default risk though the P2P sites are taking steps to minimize this risk by raising the credit score required to borrow.
The implications to the financial system are as follows. First, if P2P lending reaches $5.8 billion in 2010 that means our financial system does not generate $5.8 billion in credit. The withdrawal of $5.8 billion in credit has a multiplier effect within the scope of the money supply since banks pyramid loans well in excess of their deposits. This multi-billion dollar reduction in the money supply is deflationary. While $5.8 billion in credit extension (plus the multiplier effect) is small potatoes in our economy, it demonstrates how a simple entrepreneurial action focused on lending creates a deflationary effect. Secondly, with P2P sites behaving as commercial banks, it will create dialogue on the subject of money/credit creation. If I do not need go to a bank to borrow money and I am averse to loan sharks or pawnshops, there may be an eager pool of investors willing to make unsecured loans. We do after all live in a credit-based society so the sudden withdrawal of credit can have pernicious effects for many.
The concept of making personal loans is not new. Household Finance Corporation was one of the largest in this field though it was acquired in 2002 for $15 billion by HSBC. While HSBC is a bank subject to bank regulations, the P2P sites were devoid of such regulation. In 2008, P2P lending sites were temporarily closed when a new regulation forced them to register with the Securities and Exchange Commission. If P2P lending continues to blossom, rest assured it will receive more regulatory scrutiny particularly if it begins to influence the money supply in an appreciably larger manner (deflation). Investors should consider the birth and growth of this P2P lending as another influencing factor on our road to deflation.
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