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Pitfalls for the Unwary Borrower Out on the Frontiers of Banking
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 $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 $10,000 loan from Prosper, another online lender based in Northern California.
An accountant from Queens, Mr. Mansour earns about $64,300 a year. He took out a third online loan and then a fourth. He now owes $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than a million Americans who have tasted what many believe is the future of finance, in which big, lumbering banks with outdated branches and skittish risk departments are being replaced by lenders that operate mostly online and match borrowers with investors who buy up large chunks of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 percent 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, which is based in Durham, N.C. “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.
A spokeswoman for Prosper, Sarah Cain, said borrowers could contact the company to stop the electronic bank withdrawals. But Prosper needs to update its website to reflect that borrowers can pay by personal check, she said.
The lenders’ technological efficiency can also have a dark side.
New Innovative Products, a maker of specialty carrying cases in North Carolina, borrowed $70,000 in December from OnDeck, an online lender whose largest shareholders include a venture capital unit affiliated with Google. OnDeck was allowed to withdraw $604 from the company’s bank account each day.
But OnDeck crossed the line, according to a bankruptcy judge, when it kept collecting payments after being informed multiple times that the company had filed for Chapter 11 bankruptcy protection. In July, a bankruptcy judge imposed sanctions on OnDeck and ordered the lender to return the money.
Last month, OnDeck was chided by a different judge for taking cash from Wayco Ham, a company in Goldsboro, N.C., that cures and sells hams and that also filed for bankruptcy protection. After its filing, Wayco Ham opened a new bank account.
In a move the judge called “particularly willful and malicious,” OnDeck tapped Wayco Ham’s new bank account and took out the loan payments. The bankruptcy judge had not granted permission to OnDeck for access to the new account, according to court documents.
In a statement, OnDeck said: “We are taking all corrective actions to rectify the situation, including complying with the court and making any required payments. Additionally, we have instituted further internal process improvements and controls to prevent such lapses in the future.”
When borrowers sign up for a Lending Club loan, it defaults to automatic bank withdrawals. The Lending Club website informs borrowers that they can opt out of the electronic withdrawals by either calling or emailing the company, but they have to pay a $7 processing fee for each paper check.
“It is more cost-efficient for us, and we pass those savings along to borrowers,” Renaud Laplanche, the chief executive of Lending Club, said of the automatic withdrawals.
Some borrowers like Mr. Mansour said they ended up closing their bank accounts because they thought it was the only way to stop the lenders from taking out the money.
“It can lead to people feeling trapped,” said Peter Barker-Huelster, a lawyer at MFY Legal Services in New York, who has advised clients with marketplace loans. “They don’t approach the lender to work out a lower payment because they think there is no way around it.”
Although the $12 billion in marketplace loans issued last year represents only a fraction of the overall consumer and small-business lending market, the industry has all the ingredients to become systemically significant.
Billions of dollars of investments from hedge funds and other Wall Street firms are flowing into these marketplaces, creating a seemingly endless capacity to extend more loans.
Marketplace lenders are also forming partnerships with the same banks they are seeking to disrupt.
Smaller banks are buying up marketplace loans as investments, while others are offering co-branded loans with the online lenders.
One big bank, Citigroup, is teaming up with Lending Club to provide up to $150 million in loans to low- and moderate-income borrowers.
The deal may allow Citigroup to satisfy regulatory requirements for making loans in poor communities. Analysts said the deal could be a model for how other banks could essentially outsource some lending, required by the Community Reinvestment Act, to the marketplace industry. Citigroup said regulatory obligations did not drive the deal.
Some banks have been cashing in on the boom since the start. Wells Fargo, through its venture arm, Norwest Venture Partners, was one of Lending Club’s earliest investors. Today, Norwest is among the company’s largest shareholders.
Marketplace lenders say the loans often help borrowers straighten out their finances and improve their credit scores.
Lending Club’s proportion of bad loans is generally in line with credit card losses at many other banks. The company says most of its borrowers have good credit scores and low debt-to-income levels. And the company says its surveys show that the vast majority of its customers have positive experiences with their loans, which carry an average interest rate of 11.25 percent, compared with the average credit card interest rate of about 15 percent.
Credit cards are an apt comparison to marketplace loans because both are unsecured forms of credit, unlike mortgage or car loans, which are backed by real assets.
Lending Club, one of the few marketplace lenders that are public, was founded in 2006 by Mr. Laplanche.
A French-born lawyer, Mr. Laplanche was inspired to start Lending Club after seeing how little banks paid people to deposit their money and how much those same banks charged to lend. “We wanted to lower the spread,” he said.
The industry’s nonbank qualities appealed to Eric Kim, 33, who lives outside San Francisco.
“I liked that it wasn’t a bank,” said Mr. Kim, who took out a $21,000 loan from Lending Club with a roughly 9 percent interest rate to clear out his credit card debt.
“It felt more like people helping people,” he said, “not some multibillion-dollar conglomerate.”
Lending Club says most of its borrowers, like Mr. Kim, indicate they are using their loans to pay down credit cards.
Mr. Kim prefers that his payments are automatically deducted from his bank account every month because it forces him to stay on a budget.
“It adds a level of responsibility, and I don’t have to monitor it,” said Mr. Kim, who works in operations for a large retail company.
At first, a marketplace loan also seemed like a great idea to Vella Parker, 59, a lab technician who is out of work on disability. She could roll up thousands of dollars of debt from her five credit cards into one Lending Club loan and pay a lower interest rate.
But instead of paying off her credit cards, she spent much of her $8,375 loan to keep up with everyday expenses, including health insurance co-payments and taxis to her doctor’s visits.
“I fell into the same trap as before,” said Ms. Parker, who lives in the Bronx and had a previous bankruptcy.
Her $288 monthly loan payment was far more than she had to pay each month as a minimum payment on her credit cards. She stopped making her payments.
Lisa Giordano’s payments to Lending Club were even larger, about $740 a month. Unable to persuade the company to grant her a permanent loan modification, she stopped making her payments last year.
Ms. Parker’s lawyer, Charles Juntikka, said an increasing number of his bankruptcy clients had marketplace loans. “Up until a few months ago, I had never heard of these companies,” he said.
Lending Club said it tries to work with struggling borrowers, including Ms. Giordano, who lives in Brooklyn. But it is also obligated to investors to honor the terms of their investments.
“By and large, our borrowers are using us responsibly,” Mr. Laplanche said. “Some people will make bad decisions or they are in a situation where they will have to make bad decisions.”
Mr. Mansour, the Queens accountant, readily admits that he made some financial mistakes trying to raise two children on a single salary in New York.
He said the ease with which he could borrow from marketplace lenders — he took out four loans within 19 months in addition to his multiple credit cards — enabled him to live far beyond his means. In July, Mr. Mansour filed for bankruptcy.
“I made my mistakes,” he said. “And I am paying for it now.”