A Quick Response to the Wedbush Downgrade
Wedbush came out with a bearish downgrade on SoFi today to join glowing reports published by Citi, Truist and BofA this month. The arguments posed in the piece were quite similar to the bear cases we’ve already responded to in recent issues. For consistent readers, this may sound somewhat repetitive.
Whole Loan Sales:
The Wedbush analyst talks about fee income growth slowing from less whole loan sales into capital markets. Let’s start there. Apparently this analyst thinks the holy grail and best case scenario of SoFi’s personal lending business is a consistent 4% gain on sale margin. Interesting. Let’s do some easy math.
SoFi’s weighted average coupon on personal loans sits at 13.2%. Its cost of funding is 0% for equity, 4.2% for deposits and about 6% for warehouse capacity usage. It has about $16 billion in loans on its balance sheet as of March 2023 and is using $3.5 billion in warehouse capacity. Conservatively assume its average cost of capital for originations is 5%. Why would it take a 4% gain on sale margin today if it can enjoy an 8%+ gross spread on the credit by stashing it on its balance sheet for longer periods of time? If the credit is healthy, there’s zero reason to liquidate as ROE optimization requires holding and liquidating at a later date. Is the credit quality healthy? Yes it is. Let’s review this again.
SoFi’s borrower earns over $150,000 per year and boasts a FICO score over 750. It’s a very affluent book of credit. That’s the cause and strong metrics is the effect. Several quarters into souring macro, SoFi’s life of loan loss rate is materially below pre-pandemic levels. It continues to handsomely outperform industry benchmarks and enjoy credit performance beyond what it hoped for. But STILL, it expects credit deterioration to take place and for unemployment to spike throughout 2023. That pessimism is part of its annual guide. When pairing healthy repayment levels with robust net interest margins, the choice to hold loans becomes quite tempting. When also pairing that with the “excess liquidity” CFO Chris LaPointe consistently talks up, holding vs. selling becomes the responsible decision to maximize yield.
But is its decision really a matter of ROE optimization, or is it by necessity? A Q1 asset backed securitization (ABS) deal points to strong funding supply and this truly being ROE optimization. It sold nearly $500 million into ABS markets last quarter and (again) has explicitly told us that access remains wide open. But wait… what about the appeal of that actual deal? It was 8x oversubscribed on the demand side with credit spreads improving by nearly a full percent as a result. ABS markets are MORE FRAGILE across credit cycles than whole loan markets. If it can access the former, it can access the latter.
For more evidence of this liquidity not being a pressing concern, it has elected to repurchase its previously sold pools back from capital markets to juice interest income. That’s what “excess funding” and capital ratios well over regulatory minimums let it do.
The report states that when “SoFi reaches the upper reasonable limit on fair value marks” growth could plummet. A few things here. First, SoFi (for the millionth time) does not mark its loans at fair value. It uses an independent 3rd party firm to do so thus removing conflict of interest. Perhaps the analyst should have figured this out before publishing “SoFi may attempt to continue to increase the fair value of its loans.” It doesn’t unilaterally choose fair value but accepts fair value markings based on expected cash flows… determined by another firm. Fair value changes are expensed or enjoyed on the income statement quarterly to avoid pent up losses surprising investors down the road. The fair value increase this quarter was not random, but a response to coupon rates rising faster than benchmark yields along with continued healthy repayments rates. And if we trust a team that has given us zero reason to be skeptical, access to capital markets at the current markings is robust if the firm sees that as the best action to take.
The next piece of the argument was around SoFi’s classification of loans as held for sale (HFS) instead of held for investment (HFI). It argues that SoFi holding its loans for longer periods of time will lead regulators to force it to switch its classification. That would remove some of its book value. Wedbush further thinks SoFi would have to raise money to cover liquidity needs to be able to continue growing. It used a “new” risk in a SoFi filing about GAAP profitability being delayed as proof that it may need to do so. First and foremost, that was not a new risk disclosure. It’s a cookie cutter disclosure commonly used in some capacity by virtually every public firm that isn’t yet profitable.
Beyond that, HFS loan classification has nothing to do with the holding period. As long as the firm intends to sell the loans at some point, they should be classified as HFS. That is how the rule is structured. While regulation could always change, the motivation to do that to SoFi specifically does not exist. That motivation would come from credit book deterioration or current expected credit loss (CECL) estimates spiking. CECL penalizes HFI valuations more directly than HFS.
None of that is happening. CECL for SoFi’s loan book fell sequentially last quarter, and again, its loan book health remains pristine with ample capital market demand at currently marked fair value. If it continues to generate strong interest margins on held loans, continues to enjoy a capital market demand surplus, continues to boast strong loss ratios, continues to underwrite prudently and continues to let others set the valuation of its loans… there’s no reason to think regulators will seek out its model of business. Why would they? The report even acknowledges that by saying it doesn’t expect accounting classification for SoFi loans to change. Following the SVB debacle, regulatory focus should center around more frequent valuation updates, tighter equity classifications and bias-free markings. That is what SoFi’s model inherently accomplishes.
In the unrealistic scenario of SoFi being forced to reclassify HFS loans for HFI loans, what would happen? CECL to be incurred on loans would be realized at an accelerated clip to hurt profits which would impact book value. However, the book value hit offered by Wedbush was inaccurate while assuming its entire loan book is unsecured and fully unseasoned. That vastly propped up its CECL estimate and the book value impact. Effective fair value accounting and CECL-based accounting yield loan valuation levels more similar to each other than this report claimed. Fair value accounting considers collected cash flows, expected cash flows and risk just like CECL does. It’s green apples and red apples… not apples and oranges here.
But still, would reclassification really mean it would be forced to raise money or halt growth? Not when the company is enjoying excess liquidity and when (again) its credit continues to perform so well. It would certainly be a temporary hit to operations… but in no way an insurmountable one. SoFi Technology’s equity capital could easily be used for SoFi Bank to meet liquidity needs if that was required (which it currently isn’t).
Furthermore, while it would hit net income in the short term, it would support its growth over the long term if SoFi can continue earning more than a 4% yield on its unsecured loan book — which is quite realistic. That added profit would erode the immediate hit to book value over time.
Personal Loan Headwinds:
Finally, the report argues that origination growth for personal loans will slow in the coming quarters. We actually agree with this piece. Unsecured personal loans thrive amid soaring rate environments as people are driven to refinance variable debt at fixed rates. Well? The rate hike cycle is now wrapping up, and future cuts could possibly take the shine off of personal loan growth demand. That is an accurate concern, but ignores the true appeal of SoFi’s investment case: Its product breadth. SoFi does everything for its customers which ensures it has products that thrive amid soaring rates, and some that do so when rates plummet. That’s why it bought Wyndham Capital: To ensure it was ready to enjoy home loan growth as rates fall and personal loan growth becomes more challenged… not to mention the student loan product that should be coming back this year.
The report picked at every possible negative risk to SoFi’s investment case. And while this is ALWAYS a valuable exercise, it became less valuable by seemingly ignoring all of the nuanced positives that coincide. It reminded me more of a FinTwit short report than a piece of institutional research.