Any small business owner who has tried to obtain a loan lately knows that it is almost impossible to find bank financing that is quick and affordable. Even pledging your firstborn children as collateral isn’t deemed sufficient by the heavily regulated banks. Whose fault is it? The banks, the regulators, whatever – the issue is, small businesses are having a terrible time finding bank financing for their projects.
In past columns, we have talked about investment crowd funding and a variation of that same theme is peer-to-peer lending. Websites such as lendingclub.com and prospermarketplace.com are achieving credibility as small lenders. These websites pair the small lender with the small investor so that lenders can borrow at interest rates that are not the lowest but not the highest and investors can lend at more attractive rates of return. All borrowing and lending is done online. No physical premises are offered so there is no high overhead. Theoretically, savings can then be passed to the borrowers.
Is this approach finding traction? Yes. Lending Club reports over $2 billion in loans this year and expects to double that in 2014. They apparently have a stellar Board of Directors and a CEO with a securities law background. Why is this important? Because every time a lender makes a loan, that lender is investing in a “security” and, unless that security is registered with the Securities & Exchange Commission, the security cannot be sold without violating Federal law. Lending Club has taken care of that issue by registering every loan they issue, basically as unsecured notes, with the Securities and Exchange Commission. That’s a lot of loans and the process must be cumbersome from the regulatory point of view – but, the process requires that Lending Club offer investors full disclosure of the risks of their investment.
Even with this, the potential for peer-to-peer lending and investing is limited unless a secondary market for the notes the investor is buying can develop. What do I mean? Unless there is a place where an investor can sell his or her security/notes, the investor is locked into what may be a long-term investment. That works for the small investors, but the larger investors want more flexibility. They want the opportunity to get out of the investment if they need to. If a market develops in the notes offered by websites such as Lending Club, then there will be a place to sell those notes. Beyond that, Wall Street big guys are taking more notice of Lending Club and the dozen other peer-to-peer lending and investment websites because of the money they can make “packaging” the securities/notes. What does this mean? Remember the housing crisis?
Many people believe that the housing crisis was precipitated by the packaging and selling of mortgage loans, specifically sub-prime mortgage loans. Essentially, the “securitization” of mortgage loans started with a good premise. The big investments banks purchased pools of mortgage loans and packaged them into securities that were composed of a percentage of highest quality mortgages, some lesser quality and some poor quality mortgages. Because interest rates paid on such mortgages vary from low interest paid on highest quality mortgages to much more interest paid on riskier mortgages, the combined securities were attractive from a price and risk standpoint. But then something went terribly wrong. Soon, securities were being sold based on pools composed ONLY of sub-prime mortgages—they paid a very high interest rate but the risks were also very high. When defaults in the underlying mortgages occurred, the securities lost all value, investors lost their money, the banks backed away from the business and the market for mortgages collapsed.
Will the same collapse eventually occur with the unsecured notes issued by websites such as Lending Club? The big investment banks are certainly circling these lending and investment websites looking for opportunity. The real question is whether anyone has learned anything from the mortgage crisis. Small businesses need an alternative to bank financing; small investors need an alternative to low interest rate investing. The potential is there to satisfy both.
The question about the future of this alternative to traditional bank financing is two-fold: whether the website business of lending can continue to grow without the development of a secondary market and the support of the big investment banks and whether those big investment banks have learned enough from the mortgage crisis to structure pools of unsecured notes in a conservative way.
About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over 30 years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them” (2013 ebook download available at LegalStriegel.com.). Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.