End of Fintech? Biden GSE Release?

January 1, 2024 | Premium Service | A number of readers have asked about our recommendations for the New Year. This is the obvious question because the narrative of approaching economic pain and woe that prevailed at the beginning of Q3 2023 has been replaced in a matter of weeks by less than cautious optimism, even exuberance.  Buyer beware.

There are more than a few questions as we head into the New Year, but one certainty is that market risk in the form of volatility remains the most notable factor as it was in 2023.  The other, very large question hanging over equity and fixed income markets is the federal budget deficit. Treasury auctions prior to the New Year were weak and securities were allocated near the top of the range, suggesting rising LT rates in 2024. 

The most remarkable stock in terms of the percentage move in 2023 across our bank, mortgage and fintech groups remains Affirm Holdings (AFRM). This operationally mediocre company saw results weaken, yet the stock rose 400% in 2023, peaking at over $50 just after Christmas. The crowd is exuberant, but this trade is getting very old.

We persist in reminding our readers that AFRM is still well-below the all time-high of $160 in October of 2021. Coinbase (COIN), Upstart (UPST), and SOFI Technologies (SOFI) followed behind AFRM in terms of triple digit gains, but you could argue that SOFI performs better with less volatility. 

It is interesting to see the Street research analysts abandoning AFRM, perhaps because the recession-is-coming story that drove up the stock is now moribund in a no-recession, soft-landing narrative. Several analysts are talking about the stock falling double digits in 2024. We would take the cash off the table.

News that WalMart (WMT) is expanding the buy-now-pay-later offering to sell at the self-checkout aisle was seen as a catalyst for POS providers like AFRM, but maybe not.  Of note, PayPal (PYPL) and Block (SQ) both have a bigger share of BNPL than does AFRM. Given the small dollar size of these transactions, why do we care?

There is so much momentum and nonsense already priced into the AFRM story that we could indeed see a sharp selloff in the New Year. Why? First, the prolonged lack of GAAP profitability is starting to weigh on the stock. Second, as we’ve noted earlier, AFRM is maturing from a hot new fintech entrant to a familiar face headed for a bank license??

Mizuho Securities analyst Dan Dolev has a 12-month target of $65 for AFRM, yet he describes the bear case very directly in a recent report. "We expect the debate around Affirm to increasingly shift from BNPL and partnerships like Walmart, to [Affirm] becoming a full-fledged financial services firm with direct deposits, saving, etc.," Dolev wrote in a note to clients. Yikes. 

Fintechs that become banks become, well, boring. The fundamentals of both PYPL and SQ are strong, yet excitement is lacking. If readers of The IRA recall the stories of SQ, PYPL and Lending Club (LC), all became banks and then immediately became dead money as fintech stocks. Both now trade reasonably well compared to banks but at the bottom of our fintech group.

It is less than clear just who are the next fintech players, suggesting that the whole episode was a mirage created during QE. Of note, we added Nu Holdings (NU) to our fintech list. This is a mature payments platform in Brazil that is an interesting comp for Mercardo Libre (MELI) in Uruguay. NU is touted by some analysis for having better operating results in prospect in 2023, but again there is a certain lack of excitement. 

Fintech

Source: Bloomberg (12/29/23)

Speaking of fintech, one of the better performing banks of 2023 was Customers Bancorp (CUBI), the PA-based regional lender that has been providing “fintech forward”  banking to its customers. The Upstart Securitization Trust 2023-3 ("UPST 2023-3") just rated by Moody’s, for example, consists of unsecured consumer installment loans originated by Cross River Bank, FinWise Bank, Customers Bank, all utilizing the Upstart platform. 

While only $21 billion in assets, CUBI punches above its weight in terms of the diversity of activities and its willingness to take risks. In many respects,  CUBI pursues many of the same customers and markets as Signature Bank, but avoided the fatal taint of a deposit run fueled by crypto currency activities. CUBI manages to operate in many of these same markets without suffering similar negative repercussions. We met CEO Jay Sidhu almost a decade ago when we rated the bank for KBRA.

The bank has excellent asset returns, with a gross loan spread over 7% vs 5.9% for Peer Group 1. As you would expect, the bank’s net loss rate is also above peer and capital has a "7" handle. The bank’s brutally low operating expenses, resulting in an efficiency ratio of 45%, vs 60% for Peer Group 1, leaves a lot of room for the bank to manage credit.

We like the fact that CUBI is repricing its balance sheet aggressively. Note that CUBI has a positive number for other comprehensive income in Q3 2023 when much of the rest of the industry was insolvent. You don't need to tell Jay Sidhu about duration risk.

Back in March of 2023, CUBI was trading below half of book value and today is 1.3x book on a 1.6x market beta.  With JPMorgan (JPM) at 1.7x book, the banking group is not particularly cheap – unless you expect above-consensus growth in 2024. We do not and, in fact, expect a soft recession in 2024, with credit costs slowly rising in lower quality consumer portfolios. Consumer lenders such as Ally Financial (ALLY) and CapitalOne (COF) which rallied in Q4 2023 may give ground in 2024.

Aggregate default indices show consumer delinquency still below the troughs of the pre-COVID period.  This won’t be your father’s consumer-led recession, more of a selective blood letting in terms of higher credit costs. And meanwhile some (but not all), commercial and multifamily assets will remain under pressure. So the answer on financials, for our portfolio, is to pick the better performers. 

Bank Equity

Source: Bloomberg (12/29/23)

Among the top ten names in 2023, we own New York Community Bank (NYCB) and have started to accumulate Wells Fargo (WFC) because of the bank’s steady operating improvement.  Among the top five depositories, WFC is to us clearly the name with the most upside potential among JPM and top five asset peers. JPM has become a parking lot for unimaginative equity managers and ETFs, so finding upside among the top names is tough.  

We now own two bank common equity positions, WFC and NYCB, but readers need to be patient as we may get a chance to buy both names cheaper in 2024. But God does have a sense of humor. We note that the top three names in the world of mortgage issuers were Fannie Mae, Angel Oak Mortgage (AOMR) and Freddie Mac.

Q: Why are two GSEs sitting in government conservatorship racing ahead of private issuers? And why on earth is AOMR a public issuer?

Mortgage Equity

Source: Bloomberg (12/29/23)

A while back, a well-placed Washington observer tolds us a story about a possible release from conservatorship for the GSEs by the Biden White House.  The name of a prominent investment banker long associated with the cause of GSE shareholders was also mentioned as spending a lot of time trying to sell the idea to team Biden.

We don't believe that operationally either GSE is prepared to return to private control and we'd expect bad things to occur in the event. For a start, most of the personnel at both GSEs with real market competence have departed, leaving behind an angry cadre of bureaucrats focused on progressive idiocy. Just try taking a pool of new conventional loans to the cash window of Fannie for a bid.

Second, Moody's is likely to downgrade Fannie and Freddie to "A+" prior to release. There is a reason that the GSEs have a 20% risk weight under Basel III compared to a zero capital risk weight for Ginnie Mae MBS. We disagree with this rating scheme, as we discuss in our comments on the Basel 3 Endgame proposal later this week.

Third is timing. This is not a great time to seek a new public listing for a mortgage company. Given the record levels of financial incompetence in the Biden Administration, however, anything is possible. The driver for a quick release is said to be fiscal, possibly creating a couple hundred billion in spare cash for Ukraine. We kid you not.

Nothwithstanding a modest decline in short-term interest rates in 2024, we expect to see at least one more Ginnie Mae reverse mortgage issuer default and slide into government control. Even with SOFR at, say, 5%, the advances on a portfolio of home equity conversion mortgage (HECM) notes are deeply underwater.

Of the four remaining HECM issuers, we think that at least two could fail in 2024. Readers of The IRA will recall the trevails of Texas Capital Bank (TCBI) and the litigation in TX with Ginnie Mae regarding the bankrtuptcy of Reverse Mortgage Investment Trust ("GNMA, FNMA Seize Assets from Reverse Mortgage Funding Estate"), which filed bankruptcy on November 30, 2022. You will notice that officials of Ginnie Mae are maintaining especially low profiles of late.

We hear in the credit channel that TCBI has been quietly stepping back from commercial lending on HECMs, a bad sign for the dwindling number of lenders in the reverse space. Another default among HECM issuers could have serious ramifications for forward lenders in the Ginnie Mae market more broadly.

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