Goldman Sachs enters retail lending. What could go wrong?

Goldman Sachs, the investment manager of choice for the super rich, is about to pursue new profits by lending to the merely prosperous.

This is an epochal change on Wall Street worthy of the Tuesday morning placement at the top of the New York Times front page, even though the news actually broke a year ago.

Potentially Goldman will make it easier, faster and cheaper for people and businesses to take out loans from a few thousands of dollars to a few tens of thousands of dollars. But in doing so, it just may weaken retail banking, resulting in less competition and more power for Goldman. It also is not without risk to taxpayers and Goldman customers, not least because the law has yet to define the relative rights and duties of such borrowers, lenders and investors in the new banking trend that Goldman said it will join next year.

So while this new venture may be an economic and social good, we should be wary, given Goldman’s long and troubled history of taking advantage of customers and taxpayers alike. Keep in mind that Goldman tarnished its reputation for decades because it took care of itself first in 1929, ruining the fortunes of many famous clients.

When the financial crisis struck in 2008, caused in no small part by dishonest Goldman tactics that dumped overvalued mortgage securities on pension funds, the company converted from an investment bank to a bank-holding company. That conversion allowed it to receive a $10 billion super-cheap loan from the federal government, even though there’s no indication it needed any help.

Goldman has always preferred help to pulling itself by its own bootstraps. To juice its profits, the firm applies for all the corporate welfare it can get, raking in taxpayer money from more than 240 welfare programs since 2000 at the local, state and federal level, according to the nonprofit research organization Good Jobs First.

Its $2.4 billion headquarters, built in 2008, was financed with tax-exempt, government-authorized bonds. The headquarters, by the way, bear no sign or logo that would give any passerby a hint that Goldman owns the building at 200 West Street in Lower Manhattan.

Goldman’s decision to go downscale as a retail lender appears to be motivated by a confluence of technology and a world awash in cash, but with few profitable places to invest. That’s because sagging incomes and slow job growth mean people lack the capacity to buy much in new goods and services. As a result, demand for its traditional underwriting business for new stocks and bonds is less than robust.

Retail banks are in the business of borrowing money at wholesale rates and lending that money out at the higher rates charged retail customers. In this they are like supermarkets, which profit off the difference in the price they pay for groceries arriving by the truckload at the backdoor and the price paid by people with paper bags at the front door. The markup on the price between wholesale and retail generates big profits from relatively small investments.

“Three and three” was the historic rule in banking: Borrow at 3 percent and lend at a markup of 3 percentage points more. (There was also the third three: Hit the golf course by that time in the afternoon.)

Goldman, however, can borrow money wholesale these days at less than 1 percent and then lend to creditworthy borrowers with much higher markups, certainly 5 percent more and perhaps even 10 percent more.

It can also process loan applications electronically using data to make judgments about loan terms. That cuts costs, an example of robots replacing people in skilled office work. If the robots are smart about who gets their loans approved, more outsized profits for Goldman.

Goldman may also go down the path set by Prosper Funding and Lending Club, which make unsecured loans taken to individuals and then get investors to buy pieces of each loan, known as syndicating. Those pieces are as small as $25. The firms charge a fee of 1 percent as the loans are repaid.

Prosper Funding and Lending Club both charge interest rates of about 6 percent for the most credit-worthy borrowers to more than 25 percent for loans with a high risk of not being paid back in full. The same Utah online lender, Web Bank, funds both companies’ loans.

Syndicating loans is an old business. Many mid-sized banks arrange loans for local businesses that are bigger than the bank can handle on its own so they sell pieces to other banks. Loan syndication prospered in part because it was more efficient and going to Wall Street for underwriting bonds or secondary stock offerings.

But this new business of individual loans being syndicated is ushering in, legally, the Wild West. The legal structure, and the duties and obligations of the syndicators, investors and borrowers are fraught with uncertainties, as Lending Club disclosed in the prospectus it was required to file before it could sell stock.

It said the loans, also known as notes, “involve a high degree of risk. Investing in the Notes should be considered only by persons who can afford the loss of their entire investment.” It also disclosed that the “holders of any Notes do not have a security interest in the assets of Lending Club, the corresponding member loan, the proceeds of that loan or of any underlying assets of the borrower.” That seems to say all they have is a naked promise that the loan will be paid back.

Syndicating loans to individuals poses another problem: finding creditworthy borrowers and luring them away from banks and credit unions. Lending Club is so far made fewer than 400,000 loans, its disclosure statements show.

There is no problem finding money to loan, especially for Goldman. Pools of cash are readily available.  

Peer-to-peer lending is an economic echo of 1980s junk-bond king Michael Milken, whose insights spawned a raft of billionaires and sank the careers of thousands of loyal employees whose companies loaded up on high interest debt.

Milken carefully studied the rates at which corporate bonds defaulted, — when not all principal and interest payments were made when due. He calculated that if you charged high enough interest rates, and kept default rates low, making risky loans to businesses could be more profitable than buying stocks. The keys were careful underwriting and a diverse portfolio of loans — mixed with an utter lack of regard for workers and pensioners, whose paychecks and annuities often shrank or vanished.

A number of Milken clients became billionaires, while his firm — Drexel Burnham Lambert — went bust, and he went to prison for securities fraud.

Milken’s insights shook up the stodgy business of corporate lending by showing new ways to profit. Now his insights appear to be encouraging new ways of lending to individuals and small businesses, since peer-to-peer lending and Goldman’s vague plans are based on a portfolio of loans, many at high interest rates, following Milken’s insight. Maybe Goldman will be doing something good for the economy instead of just good for itself. We’ll see.