Sunday, March 20, 2016

Don't Bank. SoFi

After its most recent capital raise in September, SoFi, a marketplace lender that focuses on millennials, has raised nearly $1.5 billion in equity capital since its founding in 2011. By comparison, over 100 year old and $7.7 billion in asset Union Bank & Trust in Virginia had $1.1 billion in equity capital, with a market capitalization close to book value. 

Since 2011, SoFi has funded over $6 billion in loans (through December 15, 2015). And today, they are embarked on a campaign against banks.

Warren Buffett was right when he said "You never know who's swimming naked until the tide goes out." SoFi started in 2011, so the tide has not yet gone out on them. Like most marketplace lenders, SoFi claims a borrower risk rating system that is better than the FICO score. And in fact, is claiming a FICO score free zone. How good is their system compared to FICO, or other FinTechs that feel they are more evolved in credit risk management? We don't know. And I suspect we won't know. Until the next time the tide goes out.

Remember during the depression when the National Housing Act of 1934 created the Federal Housing Administration (FHA). Perhaps not. But during the depression, the typical mortgage was a five year balloon. So when 1/3 of borrowers lost their jobs, they were unable to re-finance when their balloon came due. Forcing them out of their homes. In came the FHA, with mortgage insurance to protect lenders, and the beginning of what is now a 30-year mortgage with a significant secondary market.

The secondary market removes unpalatable interest rate risk from financial institutions' balance sheets. Similarly, SBA guarantees reduce risk for small business lending. Reducing risk by transferring it to someone else is not new.

Marketplace lenders reduce risk for their loans similar to how financial institutions do it for mortgages and small business loans. They transfer it to investors. Many of the investors are other financial institutions! 

Sure, the originating institution retains some risk. I'm not privileged to see the contracts and know if there is recourse back to marketplace lenders for their loans. For financial institutions originating and selling residential mortgages, they retain some risk for early pre-payments or early defaults up to a certain point in time. And for fraud without a time limit. Absent those items, mortgages sold in the secondary market are at the risk of the investors.

So, too, I would suspect is the risk to SoFi and other marketplace lenders. Meaning the lion's share of SoFi swimming naked when the tide goes out is born by those that buy those loans. It is an agency problem that we saw before, in the 2007-08 mortgage crisis, when mortgage brokers and bankers, knowing they were transferring risk, pushed all sorts of loans through the system, so long as they adhered, however loosely, to the investors' underwriting criteria. What was best for the borrower was an after thought, in many cases.

Each recession is different. And certain asset classes are affected differently. In 2007-08, the first asset class impacted was residential mortgages. Banks likely felt it more in their investment portfolio as they were chock full of collateralized mortgage obligations and mortgage backed securities. Fannie Mae preferreds, anyone? 

Next recession may be different. And it will be interesting to see how the portfolios generated by these marketplace lenders perform. And who would actually own those portfolios should they tumble.

Maybe we can create another agency like the CFPB! Something to look forward to.


~ Jeff


Saturday, March 12, 2016

Buy Versus Build for Financial Institutions

If I mention "buy versus build" to a bank CFO friend one more time, he's going to punch me. Why do I keep bringing it up? Because the potential acquisition targets that are available don't fit his bank's strategy very nicely. Not even like OJ's glove. So I ask, did you think about building your own franchise in the geographies that you want?

Talk to the hand. 

Acquisition pricing is on the rise. It may be tempered somewhat by the general market decline this year, but the pressure is definitely upward. And would-be acquirers are feeling it. Should they bid high, increasing tangible book dilution, decreasing earnings accretion, and reducing the deal's internal rate of return? Or should they sit on the sideline and run the risk that all of their potential acquisition partners go to competitors?

And sometimes the targets are not prizes. So I ask, if you could have the franchise you want, in the geographies you want, would you do it?

This, of course, speaks to building one. And I think bankers ought to go through this exercise when considering submitting bids on targets. What would it cost and what would be the return to build it ourselves?

I did a sample analysis with the accompanying table. I used an extended period, 10 years, to reach more mature profit numbers of a build it yourself franchise. I assumed either buying a $1 billion in assets bank, or building a similar franchise in the geographies that were consistent with your strategic plan. All "build" branches, and I assumed 13 of them, would cost $500,000 each in leasehold improvements and FF&E for leased branches.


Now I see why bankers are favoring buy. The buy scenario, because you start with $1 billion in assets spewing earnings, plus the traditional transaction cost savings (I assumed 30% pre-tax), delivers profits immediately and throughout the projection period, delivering far superior NPV.

The build scenario takes a while to get off of the ground.

The NPV and ROI numbers at the bottom of the table should not be the end of the story. When a bank buys another, it typically uses its stock as part of the consideration. The premium in our example is $60 million. But the total consideration is $150 million. If your stock traded at $20, and you used all stock, you would issue 7.5 million shares in the buy scenario. Breaking down profits per share may be a different story. Tangible book dilution would also favor the build scenario.  

I should also note that I did not tax effect the Leasehold Improvements and FF&E expenditures. They do count as operating expenses over time but are capitalized and expensed over their useful lives. So I took the conservative approach.

When you build, you select the locations, employees, and markets. Maintaining your culture is easier, as opposed to acquiring an existing culture. 

One reason to buy versus build, however, is the accounting treatment. Sad, but true. The transaction expenses are mostly expensed immediately upon transaction consummation, and do not impact the bank in the next quarter or subsequent periods. The premium paid over the target's book value is mostly put into goodwill on the buyer's balance sheet and is never expensed so long as the buyer suffers no impairment on the acquired franchise. So any "investment" in an acquired franchise has little tail effects on the acquiror's income statement, with the exception of the per share numbers, mentioned above.

The build scenario, on the other hand, can be said to inflict pain over multiple periods. Because the investment and operating losses run through the income statement, albeit over time for the leasehold improvements and FF&E. So senior executives tend to favor buying, so they don't have the long hangover of building it themselves. 

Am I missing something?

Do you run a buy versus build analysis when considering a strategic entry into new geographies? Because target prices are getting higher.

~ Jeff