P2P Lending. Not American Greed.

This piece was concocted by CNBC as a promo for the TV reality Show titled: American Greed.

In it, you will notice how the article bounces off the leading and legitimate P2P lenders, Lending Club and Prosper, to the illegal scam artist James Lull, who  ran an investment scam in Hawaii that bilked 50 investors out of millions of dollars (Lull me to sleep), thus making it appear that these entities shared common ground with, and were somehow legitimizing scam artists like James Lull. Nothing could be further from the truth and I am both shocked by and ashamed of the standards of CNBC journalism.

This is a classic case of editorial and advertising guys clearly feeding from the same trough, and journalistic integrity be damned. This makes me, a jerk-off blogger, feel like Rachel Maddow might invite me to dinner. So, read on:

The art of matchmaking is not just to find the perfect mate. It is also used to connect investors to borrowers.

It is called peer-to-peer lending and occurs directly between individuals. Much like matchmaking for love, the use of this process has exploded online.

“They use this platform through the Internet to bring together and make the match between the borrower and the lender,” said Lori Schock, director of the Securities and Exchange Commission’s Office of Investor Education and Advocacy. Written as though it were a super-market tabloid expose. As in, “They use the Internet to hook up black market sex traders with innocent young Russian girls who are looking to come to America through these marriage sites.”

For the investors, it provides the opportunity to make a higher return than rates offered by other investments. For the borrowers, it allows them to receive funding if they do not qualify for conventional loans. Hundreds of millions of dollars in loans have been funded through online websites. As in, “Hundreds of millions of dollars are being laundered through these online black market web sites.”

One of the reasons peer-to-peer lending has grown in popularity is because of tighter lending restrictions imposed by banks.

For example, this process can help a borrower pay down debt. It is successful for borrowers if they have accumulated credit card debt and are stuck paying it back at a high interest rate. With peer-to-peer lending, borrowers may be able to receive a loan to pay off the debt and then pay back the loan to the private investor at a lower interest rate than offered by the credit card.

Two of the largest peer-to-peer lending sites are now regulated by the SEC and are required to disclose information about the investment products. As if they were finally wrangled into the tent of regulatory protection on behalf of the poor defenseless consumer and forced, forced I say, to disclose and become (shocked face) transparent!

Joseph Toms, chief investment officer of Prosper, one of the major companies that brings borrowers and lenders together, says this type of lending is a friendly alternative.

“Really the difference in peer-to-peer lending is it does not have a bank involved. It has a wide democratic group of investors who decide independently whether they want to fund you or not,” Toms said.

Potential borrowers post information about how much money they need, as well as why the money is needed.

“You have to give some information about you, such as an address and social security number and allow us to pull a credit report on you to assess what kind of credit risk you are,” Toms said.

These online platforms also work to obtain a borrower’s FICO score, which uses factors such a person’s previous payment history, current level of debt and length of credit history to determine the credit risk.

“The platforms do their due diligence in trying to get the FICO score of the borrower. They also get their asset information,” said Schock.  (And, here it comes) “But, there is also the risk that someone may not be truthful in disclosing their ability to repay the loan.” 

It is critical to do research before investing. The reality of the situation is that if the borrower is unable to repay the loan, it is difficult for the private lender to get back the money. Really? Where’s the evidence? Oh, that’s right. You were just using the legitimate P2P platforms as a ramp to your story of a bogus scam artist on the Islands. Oh, yeah.

Sub-prime mortgages, I guess we the tax-payers were the private lenders who found it “difficult” to get back our money on that one.

“I would be remiss to suggest anyone invest with one that is not registered with the SEC,” Schock said. Really? You mean like Bernie Maddoff? Right. He was registered with the SEC. How’d that work out for you Maddoff investors?

But, here comes my favorite segue. It almost broke my neck: 

If the website or individual is not regulated, it could open the door to scams like the one former mortgage broker James Lull was accused of orchestrating. While facing sentencing in 2009 for wire fraud in Hawaii, Lull died after his SUV plunged off a cliff.

Prosecutors say Lull, based in Hawaii, offered investors the opportunity to help distressed homeowners by funding high interest bridge loans. He claimed it would help people pay off debt to boost their credit scores, so they could qualify for an affordable mortgage and provide investors with a high rate of return. However, Lull’s loans became too popular among his investors.

“James Lull actually at some point had more investors than he had actual bridge loans to put their money within,” FBI Special Agent Tom Simon said.

Investigators believe without loans to fund, Lull pocketed the money and bilked tens of millions of dollars out of about 50 investors.

It is just like saying that because the Peer-to-peer lending sites have become popular while encouraging investors to put their money with them, that they are just like James Lull’s scam. Amazing feat of journalistic jujitsu.

Now, back to the legitimate P2P lending markets:

To reduce the risk for investors, regulated sites determine the credit risk of borrowers and reject those who do not meet established criteria, such as a minimum required FICO score. Once the credit risk of the borrower has been determined, the loan request is listed in the online marketplace for investors to view.

“The marketplace looks at your loan and all these different investors bid on the loan at as little as $25 a piece or the full value of the loan,” Toms said. “So over about a 14 day period, you will either be funded and get 100 percent of your money or 70 percent of your money.”

Both Schock and Toms suggest that investors reduce their risk by funding small portions of multiple loans, instead of simply funding a single loan.

“The main thing is you need to make sure you have diversification. Don’t invest all of your money in one note,” Schock said. “Maybe spread it out amongst several notes, so that in case of a default, you do not lose all of your money.”

“This is a numbers game, which means that if you only lend to two or three people you are taking significant risk,” Toms said. “But, the data shows if you actually lend to hundreds or thousands of people, your risk of losing money goes down dramatically.”

However, Schock still says there are some warning signs to watch out for when considering this type of unsecured lending.

“I think one of the red flags is that you do not know with whom you are doing business,” she said. “The second red flag is that in case something happens with the borrower and they are not able to repay the loan, your recourse is extremely limited and you might lose all of the money that you have invested in this.”

It is important for both the borrower and investor to do their research and verify the trading platform itself.

One can verify individuals or organizations that facilitate peer-to-peer lending through the free EDGAR database at www.sec.gov or by checking with that state’s securities or banking regulator to see if the platform is registered with them.

“Remember, even though you might know the background or why they say they want to borrow the money, you still do not know the individual,” Schock said. “It is nice if someone says I need this money to buy an engagement ring, and you want to help that person, but you just need to make sure that you are doing your due diligence.”

Without doing research or dealing with a trusted borrower, investors could find themselves in a similar situation to that of lender Claire Mortimer, who invested with Lull. Mortimer thought she was providing money for loans that would help borrowers pay down debt, while she collected a 12 percent return on her money. Instead, Mortimer lost hundreds of thousands of dollars.

“It could happen to anybody,” she told CNBC. “It happened to me. I’m an educated person. I think of myself as being pretty savvy, but I got ripped off big time.”

So, CNBC, my fledgling industry has to thank you for conflating the wholly legitimate and regulated peer-to-peer lending space with a scam artist who ripped off 50 investors, which have nothing to do with each other, while shamelessly promoting your wonderful new show, American Greed. Sounds like you might want to adopt the name of the show for your brand of journalism. Just saying.

Think About This Folks. This is Important.

Three disturbing trends in commercial banking

The recession officially ended in July 2009 (HAHAHAHA), and yet the speed and scope of the subsequent recovery have been disappointing (Shocked face here). Recent economic data have been encouraging (Bwahahaha), but there are three ominous trends in the consumer banking space that signal the waters ahead may be choppy. (This is where I say, It was April of last year when the news came out that the University of Texas decided to take physical delivery of $1 billion worth of gold.

What? Me worry? Ha!

By the way, that doesn’t mean the campus is chock full of gold bars — the university actually stuck the gold in an HSBC vault in New York City.) Kyle Bass of Hayman Capital Partners (the same guy who called the Global Financial meltdown and Greece’s impossible situation, and Europe’s as an extension), was the university board member behind the move, and on CNBC on Monday he explained why.

First, he reiterated that he’s still a gold fan: “The pattern is set, we’re going to continue to monetize fiscal deficits by expanding central bank balance sheets… I call it creating money out of thin air.”

I like it. Let’s all “monetize fiscal deficits”. That’s great! 

And, this is why he is gobbling up all the gold he can get his hands on:

1. No new banks were chartered in 2011

The Financial Times reported recently that not one new, or de novo, bank was created in 2011. (The FDIC actually lists three new bank charters for 2011 — the lowest number in more than 75 years — but they all involved bank takeovers of other failed banks.) What are some of the possible implications?

First, investors are clearly still gun-shy about banking. The dearth of new small banks is also a negative sign for small businesses generally, as they are particularly dependent on small banks for loans. Since most employment growth in the U.S. comes from small businesses that use external finance to grow into large businesses, a decline in these businesses’ access to loans could limit future employment growth as well.

The dominant narrative in 2011, like the 2010 version, was one of bank failures and distressed acquisitions. The FDIC reports that about a hundred banks failed and another hundred were absorbed this past year. But industry consolidation has been prevalent since the 1990s, as this graph reveals.

Overall, the number of banks declined by 15 percent in the past five years, to 7,357, while revenues decreased for the fourth consecutive year, to $737 billion. Although this is partly due to the Federal Reserve’s low-to-zero interest-rate policy, which reduces interest income, non-interest income also fell in 2011 for the second consecutive year.

2. The big are getting bigger

Today, about two-thirds of all U.S. commercial bank assets are at five banks: Wells Fargo, Bank of America, Citigroup, U.S. Bancorp and SunTrust Banks. A related and troubling trend is that much of the growth in lending in 2011 was also concentrated at the largest banks. The implication is that the “bigger are getting bigger” trajectory shows no signs of slowing down. And, by the way, Citi failed the latest capital reserve test by the Fed – just this week.

The graph below shows the trend in assets by bank size. Since 1993, big banks’ share of assets has skyrocketed while smaller banks’ share has been in a near-terminal decline.

In addition, the FDIC reports that banks with assets over $1 billion witnessed an increase in business lending in 2011, while firms under that threshold actually saw lending decline. David Reilly’s speculation on what may be fueling this trend is noteworthy:

The difference in lending may be due in part to the fact that bigger banks tend to have a client base that itself is bigger, more credit worthy and more export oriented. Such companies are likely seeing an earlier benefit from a firming of economic conditions in the U.S.

Meanwhile, bigger banks are going after more middle-market clients in a bid to win market share. And while the biggest banks suffered some of the worst blows during the crisis, they seem to have worked through problems at a somewhat faster clip…

In part, that may be because the biggest banks have large credit-card portfolios where losses are quickly flushed out. Smaller banks with mostly residential or commercial real-estate loan books tend to take longer to work their way through problems. Or it could be that bigger banks capitalized on the fact that they received the most government assistance during the crisis and continue to enjoy a cost-of-funding advantage. Um, you think?

According to the FDIC, big banks’ average funding costs are one-third lower. The average funding costs for banks with more than $10 billion in assets is 0.66 percent, compared with about 1 percent for banks with less than $1 billion in assets. Why is that the case? Well, the largest banks have about 20 percent less core capital as a share of total assets compared with smaller banks (8.7 percent of total assets relative to about 10.5 percent for smaller banks). Less equity and lower funding costs result in a return on equity (the key measure for bank profitability) for big banks that is almost double that of banks with less than $100 million in assets.

3. The government dominates consumer credit through big banks

A war is brewing between the private bank sector and the government over who exactly controls the allocation of consumer credit in this country. Consumer credit is probably too tight today. Really? Ya think? A popular refrain that often follows this observation is that if only the government would return some of the decision-making power to the private sector (i.e., let lenders decide who gets approved or denied for a loan), then there would be more lending and the economy would recover faster.

There is undoubtedly some truth to this argument, but the scary proposition is that many of the largest banks are perfectly happy to allow the government to maintain its broad guarantees on consumer loans, effectively absolving private banks from having to evaluate and manage credit risk while simultaneously ensuring that they receive a steady stream of fee income. If you just dropped in from Mars, you would assume immediately that the banks are all government agencies.

The consumer credit market comprises about $13 trillion in outstanding loans or debt. The mortgage market, or home loans, make up the overwhelming majority of this total (a little over $10 trillion). The other major categories are student loans, credit cards and auto loans (about $2.5 trillion). Today, the government has outstanding guarantees on close to 60 percent of all mortgage-related debt, or almost $6 trillion in aggregate. Moreover, practically every new home loan made today is backed by the government, so this percentage and aggregate dollar amount is only climbing. And for certain mortgages, the government is happy to offer special benefits to the banks or lenders that are responsible for the most loan volume.

The effect is that the government is determining the underwriting standards — who gets qualified for a loan and who doesn’t — and is bearing 100 percent of the credit risk on loan defaults, while private banks and lenders serve effectively as middlemen processing paperwork and helping to match consumers with the right government-guaranteed loan product.

The government has also increased its direct-lending activities over the past four years from $680 billion to nearly $1.4. trillion. Most of this growth in direct government lending has come from a quadrupling of student loans, from $98 billion to more than $425 billion. Today, the government now practically stands behind all new student lending.

With credit cards, private banks are still responsible for underwriting standards and default or credit risk, but Congress has introduced new command-and-control price caps on certain products. Auto loans remain relatively untouched, but the Fed did establish in the heat of the crisis the Term Asset-Backed Security Loan Facility (TALF). The TALF provided government financing for banks and other financial institutions to buy billions in auto loans. Plus, it is important to recognize that the Fed’s quantitative easing programs have been the biggest government lending program of all, as the Fed’s asset purchases have amounted to over $2 trillion in loans to the government-sponsored entities, or GSEs (i.e., Fannie and Freddie), and the U.S. Treasury.

What’s particularly disturbing about these three trends is how the underlying dynamics are interrelated and actually reinforcing one another. Small banks are being pushed to the side by big banks. The banks that are “too big to fail” are only getting larger and adding to their market share of consumer loans. But then a closer examination of who exactly is responsible for the losses when a consumer defaults on a loan (increasingly, it’s the taxpayer) reveals the true depths of the government’s influence, if not control, over consumer credit.

Snapping this vicious vortex is perhaps the greatest challenge that policymakers and the U.S. economy face in the coming years. A future where the provision of consumer credit is increasingly dictated by big banks and government bureaucrats is not consistent with the image that Americans like to project across the world, namely that the U.S. is a beacon or defender of private markets and capitalism. You think?

iSellerFINANCE intends to change all of that by offering peer-to-peer small business loans for the little guys that the big banks ignore. September 1st is the beginning of a whole new world of consumer and small business finance.