Peer-to-peer lending promised to be an alternative to traditional banks and credit cards for small borrowers. But this fledgling industry, which has been operating freely on the Internet, recently has come into regulators' sights.
Regulators argue that some lending sites are essentially selling investments that need to be registered.
This has sidelined the largest peer-to-peer lending site, Prosper.com. And the timing couldn't be worse for consumers with so many banks tightening their standards and making it difficult for even some good credit risks to get a loan.
But as much of a headache as regulation can be, this might be what the industry needs to take it to a higher level. Regulation can bring greater transparency and protections for investors who provide the money for loans. And if these investors feel more comfortable, they are more likely to pour money into new loans.
Peer-to-peer lending is only a few years old. These Internet sites basically match people who need a loan for, say, $1,000 to $25,000, with dozens or hundreds of strangers willing to lend amounts as small as $50. Lending sites act as the go-between, collecting borrowers' payments and forwarding them, along with interest, to the myriad of lenders.
"It's a great idea for the consumer. It's a great idea for the consumer lender," says Jim Bruene, editor of Online Banking Report. Borrowers can shop for loans from numerous lenders without it dinging their credit score, he says. Lenders can reap better returns than with some other investments.
San Francisco-based Prosper Marketplace is the biggest player in peer-to-peer lending. Prosper has handled more than $178 million in loans since launching in early 2006. Its site is filled with pictures and stories from consumers about why they need the money.
But late last month, the Securities and Exchange Commission issued a cease-and-desist order against Prosper, claiming the company was selling unregistered securities.
According to the SEC, a borrower gets a loan from a bank that Prosper works with. Stakes in that loan, in the form of promissory notes, are then sold to lenders. The notes are investments, the SEC says. Even Prosper's Web site tells lenders the notes can outperform stocks and money markets, the SEC says.
Within days of the SEC order, some lenders filed a lawsuit in California against Prosper, saying they were unknowingly sold unregistered securities. The plaintiffs, who say $21.7 million in Prosper loans have defaulted as of October, seek class action status.
And last week, Prosper agreed to pay $1 million to about 20 states, including Maryland, to settle claims that it sold unregistered securities.
Prosper in mid-October suspended making new loans, and has filed to register its notes with the SEC and to get approval to create a secondary market, where lenders could sell their stake in loans to others. Prosper declined to comment while it's in a so-called quiet period where regulators limit what can be said publicly before a decision is made.
Regulatory issues have been rippling through the industry.
Zopa, from the United Kingdom, withdrew from the U.S. market in October. It had tried a different business model here, hoping to avoid the regulatory issues now facing Prosper.
And New York-based Loanio, launched in October, recently suspended its activities to undergo the registration process with reuglators.
Lending Club, a major player, is the only one with regulatory approval.
Founder and CEO Renaud Laplanche says the company started talking to the SEC a year ago and concluded that the industry was headed toward regulation. Lending Club began the process of registering with the SEC in April and finished in early October.
"We are dealing with people's money. It should be regulated," Laplanche says.
California-based Lending Club reopened to new lenders in mid-October and has attracted more than 3,000 of them, Laplanche says.
It helps that competitor Prosper stopped making new loans just as Lending Club reopened. But Laplanche says lenders also see peer-to-peer lending as an attractive alternative to the stock market now.
Lenders typically invest $4,000 spread across many loans. After factoring in fees and defaults, investors on average earn 10 percent on their money, Laplanche says.
Lending Club sets the interest rate on loans based on a borrower's creditworthiness. Borrowers must have a credit score of at least 660. The higher the score, the lower the interest rate on the three-year loan. Rates range from 7.237 percent to 20.11 percent.
Lenders can click on a prospectus to get details about borrowers and loan terms.
Bruene, of Online Banking Report, says regulation will be a significant barrier to other companies that want to enter peer-to-peer lending, meaning fewer choices for consumers.
But investor Eric Di Benedetto says regulation won't crimp the industry. The Californian has been investing his family's $1 million in retirement funds with Lending Club since it launched in 2007. Even though his large portfolio of loans had some defaults, he figures his annual return is about 12 percent.
Di Benedetto sees regulation as a natural next step for the industry.
"It provides an additional level of security and transparency," he says.
He predicts new peer-to-peer sites will continue to crop up, and some of those new entrants might be traditional banks.