Just when Americans need small loans the most, the SEC shuts down innovative lenders.

The Internet has spawned many regrettable things, such as dancing babies, sneezing pandas, and Star Trek porn, but peer-to-peer lending isn't one of them. The Web really has created some unique new situations and business opportunities that not even the omniscient Framers of the Constitution could have foreseen. Like electronically bringing together anonymous people who wish to lend their money to other anonymous people in a double-blind auction, facilitated by high tech-Web 2.0 technology of the sort eBay uses. That's precisely what sites like Prosper, Lending Club, and Loanio are trying to do: use the Web to create a network of regular people who wish to borrow and lend money to one another, at agreed upon terms that are a result of bidding and counterbidding. The Web sites even allow pools of people to fund loans partially in amounts that typically range from $1,000 up to $25,000, and to resell their loans to other members. It's like adultfriendfinder.com for financial hookups, minus the tawdry photos. And it's been working beautifully.

But in November 2008, when you might have thought the SEC had bigger fish to fry—like busting the world's biggest Ponzi scheme—they somehow found the time to slap a cease-and-desist order on little old Prosper. Until the San Francisco company registered with the SEC, they were ordered to facilitate no new loans. Oh, and they had to stand mute in the corner for a while, too—the usual mandated "quiet period"—which they are still doing today. Loanio voluntarily followed along without having to be told.

Why, in the depths of the Great Recession, would the federal government be stepping on the necks of John Dough and Joe Sixpack who just want to float a little cash to help each other get through the tough times?

They have shut down, for now, a powerful engine. Up until last fall, when the SEC white hats rode into town, Prosper had enabled 25,000 loans between its 750,000 members that averaged $6,000 each. That's about $150 million in serviced loans. The U.K. site Zopa, usually considered the granddaddy of P2P lending on the Web, reported that it had 200,000 members, and lenders were averaging 7.3 percent returns—better than twice the rate of a typical bank account and infinitely better than your average share of stock. Most impressively, perhaps, Zopa said the default rate of its members' loans was stable at an ultralow 0.02 percent.

But there were nagging questions. What if too many borrowers failed to pay? What if lenders charged criminal levels of interest or started whacking bad borrowers? What if the Web site went out of business? These questions were—as is so often the case on any frontier worth its tumbleweeds—pushed aside. As long as no one showed up at the saloon with a badge, everything was cool. At the heart of the matter was a question only a lawyer could love: Who could or should regulate this market? Traditional banking regulators? Or someone else? What, exactly, was this new thing: animal, vegetable, mineral, or complex three-party electronic transaction?

The crackdown appears to have begun with Lending Club; based in Sunnyvale, Calif., it is Prosper's main competitor in the United States. With venture capital money behind it and a high-powered team of former executives from American Express, Goldman Sachs, MasterCard, and E*Trade, the company decided to be proactive and hired lawyers who reached out to the SEC in early 2008. "We wanted to help define the space, to participate in the dialogue about how our industry would work, and how it would be regulated," CEO Renaud Laplanche says. "Because we really expect this business to grow huge in coming years, and we wanted to be sure everything was done right." Lending Club got in touch with the SEC's Office of Financial Services. Together, the lawyers parsed the business, and they came to see a peer-to-peer loan as a security. They reached this conclusion for a couple of reasons: P2P lending was, crucially, being marketed as an investment opportunity with an expectation of a return; P2P loans were offered to the general public; they enabled lenders to profit from someone else's labor; the Web sites actually issued a promissory note from a bank, which was then sold to the lender; and, most important from a regulator's point of view, there was no expertise required to participate, there were few protections, and there didn't appear to be any other agency or department actively engaging with the new industry.