Pitfalls for the unwary on banking's frontier in US

New York

SILICON Valley has helped enhance just about every aspect of modern life. Naturally, Mohammad Mansour figured it could help solve his money problems, too.

Mr Mansour borrowed US$7,680 from Lending Club, a San Francisco lender offering loans more conveniently and with lower interest rates than a traditional bank. He then obtained a US$10,000 loan from Prosper, another online lender based in Northern California.

An accountant from Queens, Mr Mansour earns about US$64,300 a year. He took out a third online loan and then a fourth. He now owes US$31,600 to three virtual lenders. And he is struggling to pay off the debts.

He is one of more than a million Americans who have tasted what many believe is the future of finance, in which big, lumbering banks with outdated branches and skittish risk departments are being replaced by lenders that operate mostly online and match borrowers with investors who buy up large chunks of the loans. Using the latest data and credit algorithms, the lenders can approve loans in a matter of minutes.

"Silicon Valley is coming," the chief executive of JPMorgan Chase, Jamie Dimon, wrote in an annual letter to the bank's shareholders, warning of the competitive threat these lenders pose to traditional banks.

The loans win plaudits from consumer groups and regulators for their low costs and straightforward terms. The companies say that they are providing affordable credit to families and small businesses, and that losses on the loans are low.

But some of these upstart companies are exhibiting their own troubling traits, according to interviews with borrowers, legal aid lawyers and consumer advocates.

Marketed as a way to improve people's credit scores, the loans are instead worsening some people's financial troubles. And when these people run into trouble, borrowers and their lawyers said, some of the new lenders are unwilling to modify their loan terms. Some borrowers also took issue with how their loan payments were collected.

The lending process takes place almost entirely online. Borrowers are matched through an online "marketplace" with investors, like hedge funds, mutual funds and even individuals who add the loans to their retirement portfolios. The lenders operate without some of the regulations that govern mainstream banks, such as rules on how much capital they must set aside for potential losses. But they do have to follow federal lending laws that require disclosure of loan terms and nondiscrimination, among other things. And they are now being studied by the Treasury Department, which is weighing both the benefits and the risks associated with this booming industry.

Moody's Investors Service, the credit-rating firm, warned that the marketplace industry bears some similarities to mortgage lending in the period leading up to the 2008 financial crisis because the companies that market the loans and approve them quickly sell them off to investors. Marketplace companies do not suffer losses directly if the borrowers default, which may embolden them to lower their credit standards, Moody's said.

The lenders say that unlike mortgage bankers during the financial crisis, they still have plenty at stake if something goes wrong. Lending Club, for example, does not earn a fee servicing loans that are written off, giving it less incentive to make risky loans. Servicing accounts for 20 per cent of its revenue. More important, investors will stop buying the loans if the company takes too many risks.

"I do believe there is promise here, but the industry needs monitoring," said Gary Kalman, executive vice-president at the Center for Responsible Lending, based in Durham, North Carolina. "The question is whether these companies will continue to use technology to provide fair loans or use it to gouge people like traditional small-dollar lenders." One complaint among some borrowers and consumer lawyers is the way certain companies collect loan payments. In signing up for loans from Prosper - one of the largest marketplace lenders - borrowers must allow the company direct access to their bank accounts so it can electronically deduct loan payments. Banks and credit card companies offer electronic withdrawals as an option, but they do not always require them.

Moody's noted in a report this year about Prosper that the automatic withdrawals made it more likely that "strapped borrowers" would pay their marketplace loans ahead of other expenses.

Prosper says that is not the reason for the electronic withdrawals. The company says having access to borrowers' bank accounts allows the company to deposit the loan funds quickly and allows borrowers to make loan payments conveniently. NYT