The Sovereign Society Offshore A-Letter
Friday, April 17, 2009 - Vol. 11, No. 96

The Bank of Tomorrow
And Why the SEC Shut ‘em Down

Dear A-Letter Reader,

Imagine a new kind of “bank”…

One that could never possibly cost taxpayers a dime…no bailouts…no leverage…no FDIC receivership…no capital injections…

In fact, this bank had very little “exposure” to any kind of debt, lending, or other traditional bank liabilities. Because – and this is the best part – this bank doesn’t lend.

You read that right; this bank isn’t in the business of lending. And they’re not in the business of taking deposits either. In fact, they don’t “do” banking at all really…the leave that up to you.

That’s right, this bank cuts out the middle-man, allowing everyday people like you and me to borrow and lend money directly to each other, peer-to-peer (P2P) to use a popular tech term. Instead of getting into the highly-profitable business of taking deposits, proffering loans and collecting fees and commissions, this bank offered a new, leaner, more efficient flavor of lending.

Sadly, it was not to be…

The Death of Prosperity

The “bank” was called Prosper (www.prosper.com), and to be fair it was more of a marketplace than a traditional bank. Here’s how it worked:

Say you had a little bit of extra money and you wanted to see a good return on it. You’ve got plenty of alternatives, but none of them – stocks, bonds etc. – allow you to cut out all the middle-men and loan directly to another individual.

A pity too, because this kind of lending can be a gold mine. It’s the kind of lending that started Marcus Goldman’s career in the US. He used to walk around the street markets and offer loans to vendors, collecting IOUs in exchange. His career that became so successful he started his own company. Maybe you’ve heard of it…it’s called Goldman Sachs.

But that was back in the halcyon days of the Industrial Revolution…when America was a much smaller place. And Marcus lived in New York City. So what about the rest of us? The “transactions cost” – things like time, gas for your car, and the opportunity cost of finding borrowers – outweighs the benefits of making those small, P2P feasible loans for most of us.

Well Prosper changed all that. Suddenly, if you had a computer, some spare cash, and a little time, you could make an interest-bearing loan to one of your fellow citizens. Imagine it…

An auto-repair shop in Cleveland needs a few grand to fix one of their repair bays. A few retirees in West Florida, a few techies in San Fernando and a few kids in South Carolina all pitch in and make a loan. The repair bay in Cleveland gets fixed, and all the lenders get paid back with the added revenue made by the fixed repair bay. Plus additional interest payments for their trouble.

As you might imagine, Prosper really took off. From their inception in February of ’06, they made approximately US$175 million in small, peer-to-peer loans before the SEC shut ‘em down in November of last year.

Some of their marketing material even claimed that Prosper’s average returns beat the S&P 500 (and that was before the stock market crash!)

So if they seemed to be doing their job pretty well…filling a gap, and providing a necessary service in an arena where they found little competition…then why did the SEC send them a Cease-and-Desist?

Well Nobody’s Perfect

First I want to start by repeating, nobody’s perfect. And Prosper was no exception.

Since it was first founded in ’06, 18% of all the loans Prosper made went into some form of delinquency or other. And a quick scan of their default rates showed that a Prosper loan could be pretty speculative investment at certain credit ratings.

But hey, who cared? The point was that Prosper was a free and transparent marketplace…and the market was allowed to set the interest rate. So if the market decided Prosper’s debt was pretty speculative – meaning below the safety of investment-grade, which it did – it could charge a higher interest rate to compensate for defaults and discourage frivolous borrowing. Which it did.

And I also can’t help but making the comparison between Prosper and your average Pawn Shop or Payday Loan Hut. Why? Well, that’s the ballpark Prosper played in. Low face-value loans (usually less than a few grand), unregulated collateral and generally free market transactions. Compared to your average Payday lender, Prosper’s lenders were saints, pure and simple.

But then, in rode the SEC. And with long and overly-legal C&D letter, they announced that Prosper’s loans were actually securities and needed to be regulated as such. I’m glad the SEC found the time – between headline cases like Martha Stewart and Mark Cuban – to do something remotely resembling their duty.

I understand that they couldn’t be bothered with trivial things – like keeping ratings agencies in check, sussing out mortgage security fraud or warming up for the Madoff disaster that would blow up in their face in about three short weeks – but the actual timing seems a little…curious to say the least.

They shut down Prosper on November 24th of last year. Curious timing indeed, eh?

That was after Lehman imploded and the Credit Crunch set in. Banks were failing left and right, and the remaining banks were failing to get the job done; thanks to billions in toxic subprime garbage and a fundamentally flawed lending structure. Everyone from former President Bush to PE Obama was talking about “getting the credit flowing again,” and yet here they are, stomping out a revolutionary new channel for credit. What gives?

Maybe they were scared.

Now I’ll steer clear of the conspiracy talk today. But if you’re trying to remember the term, it’s called “rent-seeking.” The Economist defines rent-seeking as “Cutting yourself a bigger slice of the cake rather than making the cake bigger. Trying to make more money without producing more for customers.” If you were wondering who tugs at the SEC’s leash, this whole event might be a good indication.

So Why Are We Talking About This?

I tell you about Prosper partly because a few readers are upset at the negative tone of your daily A-Letter lately. They wanted to hear some good news, to see the sun if just for a moment. And Prosper is – to me – was one of the financial world’s most positive developments in a long time. In my considered opinion, I don’t think you’ve heard the last from Prosper and P2P lending…not by a long shot.

And aside from being a great story – and possibly a great example of economic fascism and rent-seeking at work – Prosper serves as background for the point I really want to make;

I think the government needs to step in when it comes to Pawn Shops and Payday Loan outfits. Prosper was only the first step…the rest of this tiny loan “free market” needs to be regulated, fiddled and messed with. We need to get proactively into the business of evaluating market values on things like old guitars, broken Xboxes, wedding rings and eight-track tape players. That’s the only way we can be sure these pawn shops are properly collateralized. Please! Let’s get somebody like Bahney Fwank in there before any more success breaks out.