Wall Street banks are scaling back their role in supporting debt sales that have helped online lending companies double their originations every year since 2010.
Investment banks earn fat fees by helping lenders pool and store their loans until enough are aggregated for sale to investors. But Goldman Sachs Group Inc., Credit Suisse Group AG and JPMorgan Chase & Co. are among the Wall Street firms considering limits to their financing for companies that lend to certain higher-risk borrowers, people with knowledge of the policies said.
The caution comes in response to a May ruling by the U.S. Appeals Court in Manhattan, which threatens to remove a protection that non-bank lenders have relied on to make high- interest loans. The issue boils down to whether these lenders can pay a bank in an unregulated state to make loans to borrowers in other jurisdictions, where the interest rates could be considered usurious.
The ruling, which is binding in New York, Vermont and Connecticut, presents an "acute risk'' to the fast-growing crop of Internet companies led by LendingClub Corp. and Prosper Marketplace Inc., according to an Aug. 21 report from Compass Point Research & Trading LLC analysts Isaac Boltansky and Michael Tarkan.
Sales of whole loans and bonds tied to these firms' high- yield lending have facilitated the borrowing growth, according to Morgan Stanley researchers led by Smittipon Srethapramote. The so-called marketplace lenders, many of which are startups, are muscling away business from traditional banks and finance companies and are on track to comprise nearly 9 percent, or an estimated $900 billion, of the unsecured U.S. consumer loan business by 2020, the analysts said in a May report.
"The concern is focused on enforceability of the notes, which affects their ability to be sold," said New Oak Capital LLC's Richard Kelly, a managing director at the asset-management firm.
The industry works in a roundabout way, which is why the case — originally fought between a borrower and a debt collection unit of Encore Capital Group Inc. — is translating into caution on Wall Street. These lenders don't make their own loans. Instead they use a bank in a jurisdiction with little or no usury restrictions to do the originations on their behalf, buy the loans back after they are made, then sell the debt to investors.
Federal law allows the banks to originate loans throughout the country at interest rates that might not comply with laws in all states.
The ruling, however, is putting pressure on lenders to alter the way they originate the debt. It may force them to lower the interest they charge, Moody's Investors Service said in July. Reducing rates could make their debt less attractive to investors willing to finance risky loans. Investments tied to such lending returned more than 8.5 percent on average last year, according to data compiled by Orchard Platform.
"Big banks may be concerned that they're essentially lending money on collateral that isn't enforceable or salable," Kelly said.
LendingClub has made about $11.2 billion in loans since 2011, the company said in an August presentation.
The current legal uncertainty is not impacting its ability to finance its business, according to Chief Executive Officer Renaud Laplanche. "We continue to see sufficient appetite from investors for loans in New York, Connecticut and Vermont,'' he said in an e-mailed statement. "Our borrower members in these three states have had no difficulty getting their loans funded.''
BlackRock Inc. and Citigroup Inc. are among the firms to have sold large bond deals backed by loans made by Prosper. About 8 percent of the loans backing Citigroup's deal came from borrowers in New York, according to a July Moody's credit ratings report.
Bank of New York Mellon Corp. which acts as a trustee in bonds sold to finance the debt, has halted its involvement in a number of upcoming bond sales as a result of the uncertainty caused by the case, a person with knowledge of the matter said. BNY had been working on as many as eight smaller deals, said the person, who requested not to be named because the matter is private.
Sarah Cain, a spokeswoman for Prosper, declined to comment, as did spokesmen for Goldman, Credit Suisse, Citigroup, JPMorgan, BNY and BlackRock.
If the case is heard by the Supreme Court and upheld, LendingClub estimates about 12.5 percent of its loans may be in excess of state interest rate limits, according to the August presentation. Michael Edman, whose firm Synthetic Lending Marketplace Inc. is pursuing derivatives on these loans, said the exposure is larger. As much as 58 percent of LendingClub's loans and 59 percent of Prosper's could be affected, he said, citing public loan data his company analyzed.