About 2 years ago, there was a lot of writing done on community lending or social lending and companies such as Prosper. Funny enough, my MBA Strategy exam was on the impact of social lenders on banks (no wonder I got an awesome grade in this class ).

Social lending was meant to great success during the economic boom. However, we all wondered how it would go during an economic crisis while people default on their loan. Would they be able to find people that will still lend money to Sexygirl69 so she can start a new hair salon? The truth is that Prosper went pretty quiet for the past 6 months, trying to find a solution to this huge problem: the lack of liquidity in the credit business.

Instead of injecting money into the credit market, banks are taking the money from US and Canadian government to re capitalize them. Banks that survive the credit crunch of 2008, survived what they call an economic shock. While running their economic stress simulation, they all realized that while they were strong enough to get through the first shock, they are not capitalized enough to face another crisis. Therefore, they keep the money for themselves and do not pass it on to the population looking for credit.

So where is Prosper after the credit crisis?

Well it seems that Prosper is coming back from the dead stronger than ever They actually want to benefit from the credit shrink created by banks. While people don’t have any other places to get credit, chances are that they will turn around and create an online borrower profile and start requesting money through the social lending sites.

The Government of California authorized Prosper to resume its activities and add a whole new feature: Open Market. They will grant loan companies to participate in Prosper’s model and sell loans on the market. I guess they would probably do it the other way around and request money from investors to lend to more people as well. Social lending may come as a great help for banks too!

Through this initiative, Prosper hopes to increase their share of the credit market while providing access to credit to a lot of people in California with their social lending platform. Getting money from banks seem to be quite a challenge these days and Prosper saw the breech in the banks brick wall.

The evolution of this new business model will be quite interesting as the improvement of our economy (a part of it) could result from action of people lending money to others through social lending and restart the wheel of credit. I’m not saying that everybody should borrow money for the sake of the economy, far from it. However, if you need money from a project and banks don’t want to loosen up their wallet, you rather get it elsewhere!

I’ve made a recent search for social lender in Canada and I didn’t find any active one. There is Community Lend and IOU (I Owe You) but both of them are not open yet. I just can’t wait to be able to lend to people .

image: dreamagic.com

After the interview I had with David Andreatta from the Globe and Mail and Canadian Capitalist’s post on social lending, I thought I would go a little bit further in my thoughts. Why social lending appears appealing to me as most people think it is almost evil and doesn’t make sense whatsoever. I can appreciate their concerns as lending money to individual can be hard game as all players are not necessarily playing fair. There are golden banking rules to respect in order to be successful. Reading about how banks look at you on this blog can be very useful to change your thinking toward lending mentality.

Why would I bother lending to individuals when I can get 4% on a saving bank account with no risk?

This reasoning is not bad at first. In fact, why bother investing money anywhere when you are 100% sure to get 4% in your pocket right? Most people that will tell they aim 15% return in their portfolio might have started investing two years ago. Or even worst, they might have never reached their goal once and still pretend. On a borrower’s perception, lending money on a social lending website is being done thinking they can earn 10% on their investment. Therefore, the spread before taxes is now 6%. According to Prosper’s rate chart, only AA credit will be able to borrow at less than 10%. Therefore, I think the potential return is there.

Why lend money when I can invest in mutual funds giving me the same expected return?

Although I am not a big fan of diversification within the same financial product, I think that diversifying ways of making money can be very smart. When you lend to individuals, your return will not be correlated too much to the stock markets. Therefore, you create another asset that is independent from your investment. Rental properties incur the same kind of risk than social lending except that it requires much bigger investment. Nonetheless, both assets require that you trust individuals capacity of repayment. The major difference is that your rental property will increase in value; however, you are tied up with a mortgage that can get you in big trouble if you can’t make the payment. I think that your portfolio should be spread among different type of investment products such as mutual funds, rental properties and social lending.

What is the tax implication of social lending income?

This is definitely one of the bad points of social lending. Income earned thought loans are interest by nature. Therefore, the income is added to your taxable revenue and is subject to your marginal tax rate. For most of us, it means that 40% of what you earn will not get in your pockets but in the government’s pocket. Unless there is some taxation rule that I ignore, I don’t think there is any escape to this. Unfortunately, the borrowers can not pay you the Canadian way.

From what I know (as I was not given the chance to try any system yet), social lending can be another great tool to create assets and to produce income over time. As it is the case with regular investments, your performance will be determined by your involvement (effort and time) toward your credit portfolio.