Vexed!

Last week Goldman Sachs announced it would enter the consumer lending business. Up to now, it’s never really bothered with the hoi polloi — you know, people who work for a living and turn to unsecured loans to make ends meet.

Ever since it was founded in 1869, Goldman’s business has focused for the most part on investment banking and wealth management services for corporate and “high net worth” clients. Last year Goldman earned its $12.4 billion in pre-tax earnings doing a variety of things (see pp.2–6) none of which involved direct loans to consumers.

Reversing the Battleship: The man hired to run the business comes from Discover, whose first credit card was issued by Sears Roebuck in 1985. Having taken a long time to gain wide acceptance at retailers, Discover built up a very consumer-friendly business by offering cards with great perks. One customer-oriented banker, however, does not a consumer-friendly bank make. You may remember that a few years ago Goldman was referred to as a “giant vampire squid” looking to suck blood out of the “muppets” it called clients.

The hyperbole may have gone too far, but the fact that Goldman sold securities that, according to one of its employees, it believed to be “one sh*#y deal” does seem a bit, well, unfriendly. (For a fictional portrayal of who does what to whom during a massive financial market meltdown, check out the film, Margin Call. It’s clear that to the Chairman of this fake firm, played by Jeremey Irons, king of the chilling villians, counterparties and clients are at the bottom of the heap.)

Is it a Good Move for Goldman? Discover is an example of a business making a foray into uncharted territory. It came about after Sears decided that profit margins in financial services looked a whole lot better than margins in retail. It went out and bought Dean Witter, a brokerage firm, and Coldwell Banker, a real estate company.

The new businesses did well but distracted management from the fact that Walmart had arrived to eat away at Sears’ main business of selling tools, appliances, and clothes to a mass market. Sears found itself a long way from the Chicago-based mail order catalog it was in 1906 when…wait for it…Goldman Sachs first took it public. In an effort to bulk up, Sears and Kmart joined forces about ten years ago. The company hasn’t fared well against competition from Walmart.

Hi, My Name is Algorithm, and I’ll Be Your Loan Officer Today. It remains to be seen whether or not Goldman can serve a mass consumer market without stripping it clean. Online lending platforms such as Lending Club and Prosper have a jump start, arriving on the scene in 2006. Both sites use a person-to-person model where anyone, subject to some credit scoring, can borrow money to pay for day-to-day expenses such as groceries, medicine, and clothing.

A quick look at the Prosper site gave me a sense that most of the people seeking loans seem pretty low-net-worth, heretofore not Goldman’s sweet spot. The day I looked, of the featured 25 loan requests, seventeen of them were going toward debt consolidation in amounts ranging from $12,000 — $32,000. In other words, people were looking to borrow from someone on more favorable terms than what they were getting from their bank or credit card company. That’s a good thing. I can imagine the relief that people must feel in having access to credit at lower interest rates. It works for borrowers only if they can keep up with their payments. Looking at the aggregate performance of these loan portfolios, default rates on these online platforms are around 5%, higher than the 2% rate on consumer loans made by more traditional players. However, the easy access of online platforms certainly beats the tedium and rejection associated with many bank processes. USAA is an exception and I plan to sing its praises at some point. (#IloveUSAA)

Best use of time and money? Goldman Sachs plans to use its deposit base to make these loans and, therefore, will seek a return on capital to cover the cost of that capital, any predicted losses, and maybe some other kind of opportunity cost. So, it sounds like online consumer lending could be good for Goldman, but what about the rest of us?

Yes — the market for online loans could benefit from having a large-scale copycat entrant to help build it. Some argue (like the former Goldman partner that I ran into at a cocktail party last night) that online platforms are the banks of the future largely because they make banking economical in an era of stiff regulation by the Dodd-Frank Act. They may have a point given that it seems like community banks are the ones who have taken it on the chin since the law’s passage.

There are many reasons why credit is harder to come by since the financial crisis. That’s why it’s more important than ever for people and banks to think hard about how they use capital. It’s fine that Goldman wants to figure out a 21st century business model, but there are parts of its 19th and 20th century-era business that add a lot of value to society. Its investment banking and advisory business houses expertise that help companies make crucial decisions about how to use their capital to grow that, in turn, drives economic activity such as job creation and product innovation. The move into consumer lending may distract it, as Discover did for Sears, from the core business that led to its prominent role in the banking system that it has today.

It strikes me that the steady, rising income that comes from full-time employment would make a better ladder out of debt than more debt even if it’s at a better price. We know that behind the innocuous-sounding label “consumer lending” stands a group of people struggling to manage all kinds of debt — mortgage, student loans, medical bills.

But if you’re a bank, credit is your hammer, and every person looks like a nail.

Come on over to my site for more posts and a chance to sign up for my weekly e-newsletter.