Money is a commodity in very high demand. That’s not because there’s any less supply, but because people who have too much of it hoard it. And those that need money can’t get it easily, so they borrow it.

Lending money has been one of the oldest professions on the planet, and often abhorred like Shylock and others. Because lenders expect to be paid more than they lent, the difference being an “interest” – a charge that effectively compensates the lender for not having that much money to use in the meantime.

Within lending, there’s usually the difference between “secured” and “unsecured”. The secured concept is that if I lend you money you give me something that I can sell and recover my money in case you don’t pay back. That something is my “collateral”.

Unsecured, as the word specifies, is lending based on trust. Lending is based on three “C”s – Collateral, Capacity and Creditworthiness. If you don’t have collateral, then your capacity (income or means to pay the loan back) and Creditworthiness better be darn good.

Take a housing loan. They’ll take your house as collateral. They’ll ask for your bank statement or Form 16 as income proof. And they’ll check your CIBIL score to see if you’ve defaulted elsewhere earlier. They’ll need all three to be okay in order to lend you money.

But, just too often, we find that “unsecured” loans are a major problem. One “C” is missing: Collateral. And that means you as a lender, have to depend entirely on the capacity/income of a borrower, and hope they retain their creditworthiness.

Personal Loans: The Proliferation

This hope has driven a lot of loans recently. Banks have offered massive amounts of loans of a “personal” nature – meaning, unsecured. Credit card loans are one such – where credit is given without any security. And then there are the regular “personal loans”. These, together add up to more than Rs. 5.7 lakh crore (5.7 trillion) rupees!

To give you context, this category is higher than loans given to medium or small industry, to trade, or to NBFCs by banks. It’s the four largest category of loans (after Large Industry, Housing and Agriculture loans).

Non Banking Finance Companies also provide unsecured loans. Companies like Capital First and Bajaj Finance also lend people money without collateral.

And then there are the microfinance companies. They lend in small sizes to groups of people. These loans are even favoured by the RBI as “priority sector” loans. The microfinanciers have become big – from the Bharat Financial which will merge with Indusind, to a Bandhan that has by itself become a bank, we have large entities now in the unsecured loan ecosystem.

They do it because the lending rates are high. A housing loan is at 9%. A personal unsecured loan is at 15%. Obviously, the banks and NBFCs want this high spread because their borrowing cost is around 7% to 8%.

The problem is here: Even individuals are trying to get into this game by lending money directly. Directly to other individuals through mechanisms like P2P platforms or chit funds.

Retail Versus Sophisticated

If a Bank lends out money, it typically takes collateral. You pay back because you’re afraid to lose that collateral. Like a house you live in.

Sometimes the collateral isn’t enough. For instance, assume you’d taken a housing loan for a second house being built by a builder named, speaking hypothetically, Jay Pee, who has trouble with his finances and runs away without completing your house or 400 others that he has promised to build. You have to return your loan, and the bank doesn’t have any collateral to speak of – the house that they have as collateral has not been built. So can you default and walk away?

The answer is: yes. But there are consequences, and you might not like them.

A central information bureau, like CIBIL, keeps tabs on all individuals and their borrowing. The minute you stop paying for your home loans, CIBIL is informed. So the next time you go for a loan, your “credit history” shows you had defaulted, and the new lender shows you the thumb pointing in the wrong direction.

The fear of losing their creditworthiness is a lever that lenders use – but only banks and NBFCs can report such defaults. Put another way, it’s a sophisticated lender that is allowed this lever. You don’t get it as an individual – so stop thinking of reporting a friend to CIBIL because he didn’t return that magazine he borrowed from you in college.

Microfinance companies use additional levers such as social control. They lend to a group of people – say women in a village. One person defaults, and the lending rate for the entire group goes up. If you don’t want your neighbour hating you, you will try your best not to default. (That’s in good times. In bad times everyone defaults, so this isn’t that much of a deterrent)

The banks also have other mechanisms. They can send “collection agents” to your house or to call you and beg, plead or threaten you. Some of it is illegal but as a resident of India that word is not a deterrent, it’s an invitation.

What lever do you have if you lend directly to people? The answer: Nothing. If they default, you have nothing to work with.

What’s the problem really? Can’t you Diversify?

That people borrow money but don’t pay it back. Or pay some of it back, and then ditch the rest.

This even happens when friends borrow from each other. Or relatives. We know that. But the P2P platforms and other forms of lending try to ‘diversify’ and say that you should spread out your lending.

This is a pain. Because if I lend out Rs. 500 to 100 people, I have lent out Rs. 50,000. Assume I charge 20%. Then, I’m expecting to get Rs. 60,000 at the end of it. But some of those people may not pay me back. If 20 people refuse to pay me back – that’s Rs. 10,000 I don’t get back – I will then have only 80 people return money and, after the whole deal, be left with 40,000 (principal for the 80 borrowers) plus Rs. 8,000 (interest for those borrowers). That’s a total of Rs. 48,000 – a loss of Rs. 2000 on the original capital.

Default rates of 20% on a pool of lending means you’re effectively going to hurt badly. Is 20% default rate too high? Why would one out of five borrowers default? Read on.

You might say, come on, why are you lending to people who won’t pay you back? Because that’s precisely what a lot of “retail” people are doing.

From Chit Funds to “P2P” Platforms

Chit funds are  a pooled form of lending. People put money together saying they’ll pay in Rs. 1000 each month. Twenty five such people might form a chit fund for a 25 month tenure. Every month, there’s Rs 25,000 available. One of the 25 people will then bid to take this money- so they might bid Rs. 23,000 (meaning they will receive 23,000 out of the money) and they’ll end up paying their monthly share for the rest of the tenure, so they will give out Rs. 25,000 back. The profit is effectively an interest rate that is shared across everyone in the chit fund. The most successful chit funds take collateral from all entrants, which then ensures you don’t bid for the chit in the first month and then vanish.

The new vehicle is the digital one: Peer to Peer (P2P) lending platforms. Companies like Monexo and Faircent organize borrowers and lenders and ask them to deal with each other.  To the borrower this is a great idea – get a loan from other individuals, who may still give them money even at high interest rates.

To the individual lender this sounds fabulous, because they can earn 18% to 20% on their money instead of the horribly low 7% on bank deposits.

The problem? There is a huge incentive to default.

India’s Subprime Underbelly

People who get to chit funds or P2P platforms typically don’t have any access to credit. Banks and NBFCs may not give them credit because they may not have documentation (like address proofs and income proof and so on). Chit funds will typically ask for a guarantor or for collateral, and the ones that don’t usually end up in large scams where someone runs away and the others are left to fend for themselves.

P2P platforms are even worse. They target a borrower who typically has some access to the banking system – they will own PAN cards, have a bank account, etc. They don’t get credit from the formal banking system, or from NBFCs, or even from Microfinance companies: Mostly because they may not have a steady income, or have defaulted in the past.

This is truly the Subprime borrower. And this borrower offers to pay 18% to 20% because he cannot get a loan anywhere else where it’s cheaper.

Look now at the incentives:

  • If they default on a P2P loan, there’s nothing you can do that makes their life any worse.
  • Even if you found a way to report to CIBIL, they don’t care because if their CIBIL score was good they would have taken a bank loan in the first place at cheaper rates.
  • You hardly even know them and have to trust whatever documentation they “upload”. Meaning, you have no social leverage also.
  • You can’t “force” them to pay back – and the P2P platform can’t either.
  • At best you will have to find a lawyer to file a case. But if each loan is tiny, like Rs. 5000 per loan, the cost of even getting an FIR will kill your return.

Knowing this, any borrower who has a horrible CIBIL score might be happy to ask you for money, and if he wants to choose to delay or default, you can’t do much to him. The incentive is to default simply because there’s no disincentive to doing so.

Default Rates are massive! More than 20%!

Recently a conversation with Arundhati Ramanathan, journalist at the Ken, brought about an interesting data point she had found: that default rates in P2P lending were over 20%! They have an article on that subject.

I then posted a tweet to confirm. Responses and messaged poured in – that indeed, default rates were very very high. On our Premium Slack channel, we had detailed confirmations – to avoid naming anyone, here’s some people’s experience:

  • 14 loans, of which 3 are now delayed but 3 others ended up paying back early but only principal.
  • A loan book with about 20%+ defaults, where loans which were more than 20% a yearar seemed more likely to default than the ones lesser.

The high default rates make things complicated. Because if you’re losing 1/3rds of your loans, you’re just about breaking even on the rest even at massively high interest rates.

While this may be anecdotal, there is no third party bureau certifying default rates. Plus, the default rates of any individual borrower may be vastly different from the P2P platform. The platform keeps getting new people to borrow and lend. The newer loans may not qualify for a “default” until say 30-90 days. So where a P2P platform keeps getting new people at a faster clip, its overall default rate will be low, but the older lenders on the system will see higher default rates.

The analogy for India may be in “prosper.com” – a lender in the US that’s P2P. Their prospectus talks about high-risk default rates being more than 15%. In the US! Here, you typically can get credit from banks or NBFCs if you have a pulse, so you would indeed be a “high risk” borrower if you’re on a P2P platform, which means the 20% default rate is probably real.

If you have a 20% default rate, then you need to charge at least 25% to recover your capital with ZERO return. Meaning: If you lend Rs. 100,000 and 20% of it defaults, you have Rs. 80,000 lent out. That 80K must earn 20K in interest for you to break even. 20K is 25% interest on the 80K principal.

The higher the default rate, the higher you need to charge as interest.

The higher the interest, the more desperate the borrowers.  And thus, the higher is the default rate.

It’s a circle.

Won’t The P2P Platform Help?

Chit funds were run by politicians and goondas. Because collateral can also be the fact that if you repay you will have your bones intact, otherwise there is potential rearrangement and that’s not very comfortable.

P2P platforms have almost nothing to stop you. This bone thing doesn’t translate well to an online thing. Most can’t report to CIBIL. The ones that can will get people who are desperate enough not to care about CIBIL scores. As more and more people figure this out, there will be those that create fake profiles and raise money for the standard stuff: home improvement, working capital and to pay for marriages or medical expenses. And then, after a month of repayment, they’ll vanish.

This is not a prediction – it’s already happening, and everyone loves a free lunch.

P2P platforms will, at best, tell you to file a police report. It will cost you time and money, sometimes more money than you have lent in the first place. Imagine trying to file a police complaint for a Rs. 5,000 default by someone in a faraway state. The cops will give you a lesson on “negative return on investment”.

A typical thing that platforms tell you is that they give you access to the borrowers bank statements, credit scores etc. But if you diversify with a 100 loans, do you really have the time to check through 100 different bank accounts, scores, check for fraud, cross-verify etc? The P2P portal may say they’ve gone through it but you will still need to do. If you don’t, or you trust the P2P site, then the defaults are your problem.

Apparently platforms like Rangde have worked better, because they offer interest free rates for education. When people get their degrees and jobs, they pay back.

RBI Regulations Too

RBI has regulated this space recently. The rules involve creating the platform as an NBFC, but the platform can’t lend directly. They also can’t offer a guarantee on the funds (effectively, some were willing to absorb the risk in order to attract lenders. This was free money) They can’t cross sell insurance or other products.

Also, borrowers can’t take more than 50K from one lender, and Rs. 10 lakh from all lenders. As a lender you can’t lend out more than Rs. 10 lakh across all P2P platforms. Loans can’t be for more than 36 months. This is now at best an expensive hobby for a lender.

Only one platform has registered so far.

Our View: Why Do This?

There are good bonds now in the market at 9.5% yields. These don’t involve filing police claims, and there are proper multiple party assessments available. Plus, some of these bonds are secured against company assets too.

 Being a subprime lender sounds attractive, because of high yields. But when you’re lending to people no one else is lending to, you have ask yourself: Why aren’t others jumping in at these yields?

The rush towards subprime loans sounds attractive. It’s huge in China too. (Read post). But you must be careful, because subprime makes no sense to lend to when there is full incentive to default. And as a non-sophisticated, time constrained, small ticket lender, you might do a way better job just investing in less intensive fixed income avenues: Bonds, debt mutual funds or small bank fixed deposits.

Now, tell them about it: