Microlending, peer-to-peer lending, or social lending is something I’ve been keeping my eye on for the last year. It’s an auction service that bypasses banks and lets individuals loan money directly to the borrowers. It is quickly becoming a legitimate investment option and it won’t be long before it bursts into the mainstream finance world.

The concept is that people who need money request it, and other people bid for the privilege of lending it to them. These lenders spread their loans across numerous borrowers, reducing their exposure to defaults. The borrowers’ loans are filled by “syndicates” of lenders who have bid different dollar amounts on different interest rates.

Several companies have products in this space, including CircleLending and UK-based Zopa. But by far, the biggest US startup is Prosper.com. Here’s their example that explains how the service works:

1.	Joe Davis, Volunteer Firefighter, needs a small loan. So he posts a listing for a loan with the amount he needs and a rate he can afford.
2.	Lisa Barron has a little bit of money to lend. Lisa, along with other lenders like her, bid on Joe’s listing with an amount they’re willing to lend at a rate they think is fair.
3.	When the listing ends, the bids with the lowest rates are combined into a single 3-year loan for Joe. Each month, Joe’s payment is deducted from his bank account and deposited into his lenders’ accounts until the loan is repaid.

I haven’t been this excited about a company since Google and eBay were doing their IPOs. Its a hugely disruptive concept that takes banks out of the loan business. Over the next ten years, it will completely change the credit industry. Like eBay, the bigger the network of borrowers and lenders, the better the service will be.

I’m going to open up an account with Prosper.com, the biggest of the US startups. One of my worries is the level of risk I’m accepting that my borrowers will default on their loans. Forbes eased those concerns in an article called “The eBay of Loans” by providing some quantifiable data on the risk:

What if things don’t work out for borrowers? In its year of existence Prosper has had 0.5% of total loan amounts default and 6.5% fall behind on payments for a month, compared to 4.2% and 4.4% for card companies. Prosper lenders choose among three collection agencies to pursue delinquent borrowers.

Interesting. The 0.5% default rate seems incredibly low. However, Forbes points out some inevitable problems with the system:

While bad loans are minor now, just wait until an economic downturn comes along. Another problem for Prosper lenders is that the loans are not liquid. The company had hoped to set up a secondary market, but that fell through. Lenders are stuck for a loan’s whole three-year term.

I’m surprised there’s not a secondary market for the loans. It seems like that would be trivial compared to setting up the loan system in the first place. Forbes also backs me up in thinking that microlending is on it’s way to the professional finance arena:

While most Prosper lenders are amateurs, some investment pros are dipping in. Jonathan Hoenig, 31, runs Capitalistpig Hedge Fund in Chicago and has more than $150,000 of its money in 1,300 Prosper loans at an average interest rate of 20%. “This is a way to run a credit card company,” he says.

I go now to open up my Prosper account and start playing. I’ll let you know how it goes.