How many of us are familiar with the concept of a chit fund? If you have a friend who is in the business of trading or wholesale, then you must have heard of him (or her) being part of a chit fund. I have a friend who is a trader in Sadar Bazzar in Delhi and he was always part of a chit fund. Here it is how it works in Delhi – certain members of a business contribute a fixed amount on monthly, weekly or even daily basis. The names (chits) of the contributing members are then put in a box and a lottery is drawn – the winner then takes the ‘fund’ for that period. For the next time, the person who won the last time has to contribute to the fund but his name is not included in the box thus ensuring that everyone gets access to the ‘fund’ at least once. In MBA speak, it’s classic short term working capital funding.
There are variations to this model. In Kerala, for instance, the pay out is limited to 70% of the gross collection. Also, members of the chit fund have to bid for the payout – the person bidding the highest gets the fund. The difference between the payout and the bid is then the implied interest. This interest is then distributed between members of the chit fund.
To my mind, there are two key features of a chit fund – Trust and Access to Non-Bank Credit. Trust is why chit fund members in India typically come from the same business or community. The access to non-bank credit is equally important. Bank lending can be prohibitively expensive and bureaucratic (not to mention that they can’t lend to ‘black’ money businesses).
Now finally to the point of this post – looks like ‘Chit Fund like’ funding is picking up in the US!!!! Since most of the ‘funds’ are based out California, they are called P2P Financial Community and use their website as the platform. I am not really sure if the heightened usage is because US banks really haven’t been lending out money for the past couple of years or because the interest rates bank charge are very high but the money lent out using this method just crossed $ 1 Billion!
Fundamentally though, P2P lending is very much like a chit fund. Lets say that for the past 5 years, you really haven’t been able to generate much income from your investments (low interest rates) and now you are looking for higher yields. You then log on to Lending Club or Prosper websites, register yourself and start lending money to other people to pay off their credit card debt, buy a plasma TV, undergo surgery or whatever else.The websites conduct their own research of the borrower and assign them ratings starting from AA+ to HR (this ranking is for Prosper.com, Lending Club has it’s own similar rating). They also have strong collection departments – both internal and external agencies. Any lending results in a ‘note’ which has the amount lent our and the associated interest rate, term and monthly payment stream – not the name of the borrower though. In case you need emergency funds, there also exists a secondary market where these notes can even be traded. However, a note of caution – In Jan 2010, Eric’s Credit Community reported that a staggering 11.8% of 24 month AA loans were delinquent and mean return for a prosper investor was -2.28%!! After their ‘relaunch’ on Nov 2009, the delinquency rates have reduced significantly. As per their website, the loss rate on loans at least 10 months old for AA loans is now 2.29% and investors can expect a return of 5.10%. Now this might not sound like much but the return has to be evaluated in context of the US economy. A typical saving account in the US has interest rates range from 0.05 – 0.8% PER YEAR (compounded for a year – NOT nominal interest rate) and Certificate of Deposit (CD, equivalent of FD) yields a little above about 1% per year. While in India we are now used to over 5% per year for saving accounts and above 8% for a year long FD. Of course this investment is no were as safe as a CD but then all investment avenues in the US have pretty low rates of return. The only people who make money lending out money are the banks where a credit card loan can attract interest rate of over 20% – probably the reason why borrowing to pay off credit card loans is the biggest category on both Lending Club and Prosper.
And did I mention – Lending Club raised $25 million in Aug 2011 and Prosper raised $17 million in June 2011 (Eric Schmidt of Google is an Investor).
Given that Banks are the new villains (in the US of course), looks like P2P lending is here to stay. Of course, it goes without saying that this kind of ‘anonymous’ chit fund can only run successfully in a country which has strong credit records and rule of law!!