Crypto Crash Signal End of Fintech?

November 25, 2022 | As we watch the collapse of the offshore crypto empire of Sam Bankman-Fried and FTX, America’s consumer obsessed media will focus on the victims of the fraud. Long, sympathetic feature pieces will be published in the NY Times and Washington Post about the victims. Tears will be shed. Yet the bigger picture beckons.

Despite all the hyperbole, the great crypto fraud was an insignificant game, like the small stakes poker many crypto enthusiasts share as a common background. Crypto was the aspirational nonsense atop the fringe of nonbank finance, enabled by techno hype and encouraged by the Fed’s decade long pursuit of higher inflation. Unbridled speculation in crypto (and money laundering) was one of the downsides of quantitative easing but certainly not the only or largest negative impact of QE.

Now that the “commoditized fraud” of crypto, to quote one observer, has met the proverbial kitchen torch of rising interest rates, we can turn our attention to the true message of the collapse of the broader sector of new technology: Fintech is dead and mainstream nonbank finance is an endangered species as interest rates rise and originate-to-sell loan volumes fall.

The Motley Fool recently commented that the decline in names such as Block (SQ), Affirm (AFRM), and Upstart (UPST) over the past week is due concerns about crypto. All of these firms and others to one degree or another facilitated or encouraged customers to invest in crypto frauds.

There is clearly unrecognized legal, compliance and financial risk now associated with crypto, especially for banks that participated in this tawdry speculation. Prudential regulators are still behind-the-curve on crypto fraud involving banks, but expect that to change quickly in 2023.

Source: Google Finance

The larger drivers of value for the entire fintech universe can be found in more basic concerns. If you look at the difficulties facing nonbanks such as Carvana (CVNA), the reason for the constraint is certainly not the crypto fraud but rather funding costs. Ally Financial (ALLY) and other near-banks dependent upon unstable brokered deposit are seeing funding costs rise faster than anticipated.

We believe that the most significant headwinds facing the fintech sector are rising interest rates, credit spreads and related market volatility. The benevolent credit environment, both in terms of credit default risk and cheap funding, that enabled these firms to grow is now gone, forcing many of them to make significant changes in business models and funding sources.

Many fintech firms have migrated to a depository model, but without the benefit of a retail core deposit base upon which to build a LT franchise. SQ, for example, owns a UT based industrial bank. Private players such as Cross River Bank and Evolve Bancorp have catered to the fintech and crypto communities. Let’s ponder some of the Q3 2022 results for some of the leading public players.

SOFI Technologies

SOFI Technologies (SOFI), for example, had an investment operation that facilitated crypto purchases for members of the platform. Did SOFI perform know-your-customer (KYC) and anti-money laundering (AML) assessments on all of these participants? We’ll find out. Same question applies to Silvergate Capital (SI), which we have previously profiled.

SOFI’s student loan business is expected to see an upsurge in new origination and refinance activity in 2023. Piper Sandler estimates that SOFI could do over $5 billion in new loan originations vs just short of $3 billion in 2022. Of note, the Biden Administration has been forced to extend the moratorium on student loan repayments due to a court decision voiding the pre-election loan forgiveness announced by the White House earlier this year.

SOFI continues to report GAAP losses due to the massive scale of the insider stock awards being made to management. In the nine months ended Q3 2022, SOFI reported a loss of $391 million and, by no coincidence, some $312 million in stock-based compensation expense. There was also a $36 million down mark on the company’s servicing book.

To give you a sense for just how far out of line SOFI is with its bank peers, overhead expenses for all of the 132 banks in Peer Group 1 was 2.2% of average assets in Q2 2022. JPM was 1.9%. SOFI’s overhead as a percentage of average assets in Q2 was 16% or more than an order of magnitude above peer. How does management justify such grotesque looting of shareholders? Fintech.

Here’s our question: How long are federal bank regulators going to allow SOFI to run GAAP losses to fund stock-based compensation at these levels? In theory, regulators could let SOFI generate GAAP losses forever. The stock-based compensation just dilutes shareholders not the capitalization of the bank. Yet the disclosure is truly ugly.

The organization chart for SOFI is shown below. Notice that the group now includes a UT national bank, a broker dealer which is the SOFI transaction platform for securities issuance, and various other entities used for crypto and investment activities.

Source: FFIEC

While the managers at SOFI obviously see no problem awarding themselves huge equity compensation that drives the company into loss, SOFI is a $15 billion asset bank holding company now and the performance metrics look just OK -- if you ignore the stock-based compensation. Imagine the uproar if an established bank like JPMorgan (JPM) drove itself into loss quarter after quarter to fund insider stock awards. Sadly, there are many such examples of corporate excess in the fintech sector.

Source: FFIEC

So far, interest expense for SOFI is keeping pace with interest earnings, but the future may not be so kind. Net non-core funding dependence was 37% of total assets vs 3% for Peer Group 1 in Q2 2022. The gross yield on the SOFI loan book was 7.3% in Q2 2022 vs 4% for Peer Group 1. The yield on total earning assets is just over 6%. Funding costs were 1% of average assets for SOFI vs 0.22% for Peer Group 1 as of Q2 2022.

Source: FFIEC

SOFI has $5 billion in deposits and $8 billion in debt funding its balance sheet at the end of Q3 2022. As you can see, SOFI lives in the same neighborhood in terms of funding as ALLY, but has 200bp more gross yield on its loan book. These positives aside, the outsized executive compensation at SOFI and resultant GAAP losses result in an efficiency ratio of 126 vs 60 for JPM.

Originations and purchases of loans was $11.6 billion in the first nine months of 2022, an impressive 24% increase. Loan sales by SOFI inexplicably fell to just $6.6 billion, a 30% decline, in the same period. Where did the other $5 billion in loans go to? Could it be that SOFI is starting to warehouse loans that it cannot sell? That brings us to UPST.

Upstart Holdings

A more serious situation is faced by UPST, the poster child of the fintech world that was crushed earlier this year when management disclosed that they had been forced to retain loans that were originally intended for sale. UPST has seen revenues and profits fall significantly as volumes have fallen and interest expense rising. Indeed, UPST is the worst performing name YTD on our fintech surveillance list, but don’t hold your breath waiting for a Sell Side analyst to break the news.

Upstart (Q3 2020)

In addition to declining profits, another risk factor facing UPST and other fintech lenders is increased state and federal regulation. We hear that the FDIC is conducting a horizontal examination of state-chartered banks that have been acquiring loans from UPST and other fintech issuers. Cross River Bank, a private NJ state-chartered bank that was a key leading partner of UPST, perhaps is an institution of interest as well.

Remember that the regulators are still at least a year behind the curve on things like crypto and fintech lending platforms. At least one lender believes that the FDIC exam is just an opening volley and that the agency is likely to return next year to focus more attention on assets acquired by banks from fintech lenders. Is this interest from regulators in fintech loans a precursor to criticizing the entire asset category (and thereby increasing capital risk weights)? We shall see.

There is also a strong assumption among bankers interviewed by The IRA that the CFPB and state authorities will be getting into the game as well, focusing on fair lending compliance. The up-front pricing on some of the UPST and Lending Club (LC) loan products is quite aggressive, so we think the possibility of CFPB enforcement actions should not be discarded. Recall that the CFPB likes to shoot first, then maybe ask questions when it suits them.

But here’s the question: Does the CFPB go after the fintech platform that acquired the lead even if a bank like Cross River, Evolve or others documented and funded the loan?

Block Inc

The company formerly known as Square reported good earnings in Q3 2022 on traditional business lines, but lost ground on bitcoin revenue. A big increase in administrative, product development and other expenses drove the company into loss for the first nine months of 2022. Assuming that bitcoin revenue continues to ebb, we expect to see some serious cost reductions at SQ or more read ink.

As we’ve noted previously, the decision to rename the company Block and move into crypto currencies was a poor decision by management and now exposes SQ to the risks detailed above. In addition, at the end of 2021, SQ was sued by H&R Block for trademark infringement. The lawsuit alleges that the SQ’s rebranding to Block, Inc. and use of a green square logo in connection with the Company’s Cash App Taxes product infringe HRB’s trademarks and are likely to cause consumer confusion. HRB demands that the Company stop using the Block name and associated branding, and further demands that the Company stop using the green square Cash App logo.

In addition to the missteps regarding the change of name, the quality of SQ earnings has deteriorated because of gimmicks related to crypto tokens and offshore acquisitions, customer cash flows and loss recognition. Much of the information presented by SQ to investors is modeled rather than actuals, including:

“Accrued transaction losses, contingencies, valuation of loans held for sale, valuation of goodwill and acquired intangible assets, determination of allowance for loan loss reserves for loans held for investment, determination of allowance for credit losses for consumer receivables, pre-acquisition contingencies associated with business combinations, allocation of acquired goodwill to segments, assessing the likelihood of adverse outcomes from claims and disputes, accrued royalties, income and other taxes, operating and financing lease right-of-use assets and related liabilities, and share-based compensation.”

We view the use of modeled results rather than actuals as a troubling development that warrants caution by counterparties. SQ is still a relatively young company and an even younger near-bank, that is now acquiring foreign assets and liabilities. The adjustment to GAAP reporting that increased cash and cash equivalents for SQ by 50% in Q3 2022 likewise warrants attention.

Source: EDGAR

Of note, SQ is already starting to attract the attention of state and federal regulators. In 2022, SQ received Civil Investigative Demands (“CIDs”) from the Consumer Financial Protection Bureau, as well as from Attorneys General from multiple states, seeking the production of information related to, among other things, SQ’s handling of customer complaints and disputes related to its Cash App.

Over the next few quarters, nonbank financial firms of whatever description will face an extremely challenging environment as interest rates rise, credit spreads remain wide and lending volumes fall. Unlike during QE, nonbanks no longer have an advantage over commercial banks.

The good news for the nonbanks is that investor appetite for paper remains very healthy and issuance of new loans is dwindling so rapidly that secondary market sales may stop entirely. If nonbanks can navigate the twin risks of funding and regulation, then there may be clear sailing in 2024. But more than anything else, we hope to see all of the survivors in the fintech sector put the mirage of crypto currencies behind them and focus instead on building real businesses.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.