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Private Lending: High Reward, Higher Risk?

Lindsay Nadrich|CNBC Production Associate
Wednesday, 21 Mar 2012 | 10:21 AM ET


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.

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.

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.

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. “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.

“I would be remiss to suggest anyone invest with one that is not registered with the SEC,” Schock said.

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
Greg Yamamoto
James Lull

“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.

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.”

To see the full story of James Lull, watch "American Greed" Wednesday, March 21 at 10 p.m. 1 a.m. ET.

To see the full story of James Lull, watch "American Greed" Wednesday, March 21 at 10 p.m. 1 a.m. ET.

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  • "American Greed" is narrated by Stacy Keach. The award-winning actor of stage, film and television is well-known for his portrayals of Detective Mike Hammer and Ernest Hemingway, for which he won a Best Actor Golden Globe.