social capital Archives - Lazy Man and Money

Note to Reader: I intended the following to be a piece of satire in the same idea of Jonathan Swift’s A Modest Proposal. Since I’ve written about 17 million words being a Prosper “fan boy”, I thought it would be fairly obvious that I wouldn’t hurt the marketplace by actually selling my endorsement. From the comments, it seems as if I was wrong. I wanted to make Prosper aware of the issue while trying to advance my writing skills.

I had another goal as well, I hoped people would pick up on the debate of social capital having monetary value vs. money being able to buy social capital. Seth Gitter, Assistant Professor of Economics, says the concept may make an excellent economics paper. You’ll want the read the last paragraph of that post where he mentioned that Michael Jordan’s paid endorsement for Nike is very similar. This is the kind of valuable discussion I wanted to explore. And now for the unedited article:

As some of you know, I’ve been lending money on Prosper since February 2006. I’ve been intrigued by P2P lending for at least these two reasons:

It makes available an asset class not heavily correlated with stocks, real estate, or commodities
It provides an opportunity for a more efficient marketplace for loans by opening it up to everyone

Some people disagree with these statements. That’s fine, there’s definitely some room for discussion on either side of the fence.

When I went to Prosper Days to learn more about Prosper, one of biggest things the company talked about was social capital. There’s real value to connections that can be financially rewarding. As cold and heartless as that sounds it’s true. I’m not saying that social aspects are not worth it alone, but if there’s a bonus of a financial reward for both parties, why not take advantage of that?

Prosper found out some interesting things when they allowed friends to endorse loans. Netbanker recaps in more detail, but here’s the executive summary. Lenders realize that borrowers don’t want to let their friends who endorsed them down and thus see them as a better risk for their dollar. Specifically:

Loans with one bidding endorsement are performing 35% better than similar loans without that endorsement
Loans with more than one multiple bidding endorsement are performing 50% better

Using this information, it becomes clear that borrowers have a lot to gain by getting an endorsement from a bidder. One could reason that the higher the bid the stronger the endorsement. So a borrower could get an endorsement by trying to get a friend to sign up for Prosper as a lender, but many friends aren’t going to be willing to go through all the trouble of opening an account and giving up their social security number to yet another financial institution.

Buy My Endorsement

Another way to get an endorsement is through me. It’s pretty simple really. Contact me and let me know how much you want your endorsement for. Give me that money plus 50% and I’ll bid on your loan. If you end up paying off your loan, I will return the value of your endorsement. The 50% extra is my fee for making your loan more attractive to lenders. This gives you a better interest rate which usually would be worth much more than my fee. Here’s an example: You want a $50 endorsement on your loan. You contact me, we talk, and you send me $75 through PayPal. I bid $50 of that money on your loan with an endorsement and keep $25 for my time. If you make good on your loan and pay it off on time, I’ll give you the $50 endorsement value back. If you default, I keep the $50 (this protects me from potentially losing on the loan). With the endorsement your interest rate may go down 3% (hypothetical example), which over three years, should add up to more than the $25 fee I’m requesting for this service. You’ll want to do the math to make sure that it makes sense for your loan.

Why Am I Doing this?
If you think it sounds dirty, you are right. I’m putting on a grey hat in this case. I want to see how Prosper reacts to such a proposal. They’ve blurred the line by adding the social element to the loan marketplace. I want to blur it more. I want Prosper to look at endorsements and say, “Is this really the right model? Can we make it better?” Innovation occurs whenÂ a potential problem is exposed. Perhaps “buying an endorsement” doesn’t qualify as a problem in Prosper’s eyes. If that’s the case, that’s worth knowing as well.

Lastly, I think it’s a great way to demonstrate the power of social capital. A smart borrower gains with a lower interest rate. A lender (I won’t call myself smart) gains with a unique idea. If there’s a bonus of a financial reward for both parties, why not take advantage of that?

When I was at Prosper’s annual conference, there was a lot of buzz around the term “social capital.” I thought I was alone in wondering what it was. However, when I caught up with Wealth Boy, I found that he hadn’t heard the term used before. I’m going to go out on a limb and hazard a guess that you haven’t either.

Wikipedia defines social capital as the “connections within and between social networks” and the value that they have. Social capital sounds to me like a complex way to define reputation. Others may say that reputation is only a part of social capital. After reading that article, I would expand my layman’s definition as “reputation amongst people of influence.”

My grandfather had a lot of social capital amongst various business owners in his small town. In my world that’s becoming less common. It has been replaced with online social capital. For some it’s Facebook and MySpace, while others have LinkedIn. Personally, I have looked into the value of an MBA simply because, from the right school, it provides an incredible amount of social capital. Instead, I developed my social capital as a software engineer in Boston. For better or worse, when I moved out to California I decided not to invest heavily in creating that social capital. I focused on creating social capital with many personal finance bloggers and you, my readers – a decision that I have not regretted.

Prosper was liberal with the use “social capital”, because it’s core to what they are trying to do. They showed a great example of a Prosper group in Hawaii. Hawaii has a state law that places a strict cap on interest from personal loans – around 12%. For this reason, very few lenders would take anything other than perfect credit from a borrower. Yet some borrowers are getting loans with fairly poor credit history. Why? The Prosper Group leader meet with each borrower individually. She’s been to their home, possibly shared a lunch or two, and has vetted that this person is responsible. The result is that the group has zero defaults. Lenders and borrowers are very happy with their transaction – which in turn makes Prosper happy.

The Hawaii group is just one version of social capital at Prosper. Netbanker reported on the effect of endorsements from bidders and how these loans perform 35% to 50% better than loans without endorsements from bidders. RateLadder put his social capital to the test. He is pretty prominent in the Prosper community. People realize that he has incentive to pay loans back on time and that give them great confidence in getting a return on their money. When he examined his loan, he realized that his social capital shaved about 2.5% off the average interest rate. These are examples of very real savings.

At least I know what to call the phenomenon of “It’s not what you know, it’s who you know.”