Update: Banks & Fintechs

June 14, 2023 | Premium Service | In this edition of The Institutional Risk Analyst, we go down the list of banks in our surveillance group and provide some color to the updraft that has pulled PacWest Bancorp (PACW) back towards half of book value.

Some names in the group like Comerica (CMA) are of special interest and were of particular concern back in April and May, when Fed and Treasury officials were tracking the level of bank deposits via telephone. In the age of AI, US bank regulators verify end-of-day deposits by telephone.

IRA Bank Surveillance List

Source: Bloomberg (06/13/2023)

The first word of caution for our readers is that bank stocks are going up because institutional managers are buying despite the operating outlook. Are exemplars such as U.S. Bank (USB) cheap at 1x book, unequivocally yes but with the caveat that book value may decline over the next couple of years. Please note that top-five bank laggard Bank of America (BAC) still wallows below book despite the rally.

A combination of mark-to-market losses, negative spreads and, last on the list, credit concerns are the negatives weighing on the analysis of US banks. But none of these very real world concerns seem to matter in a market starved for duration in bonds and lacking new, large-cap offerings in equity markets. Meanwhile, large swaths of the investment map like China are now off the menu for global equity managers, who have watched AUM fall for most of a year.

Our foray into New York Community Bank (NYCB) is a long-term play that is a function of interest rates falling and mortgage volumes rising. Same goes for Guild Holdings (GHLD), which is busily rolling up dead mortgage banks. The fact that CMA announced its intention to exit commercial lending to mortgage banks, Inside Mortgage Finance reports, is good for #2 warehouse lender NYCB, which operates in the wholesale channel under the Flagstar brand behind #1 wholesale lender JPMorganChase (JPM).

The leader of the group in terms of equity returns over a 1-year time horizon is SoFi Technologies (SOFI), the $19 billion asset BHC that reported a loss at year end. As we’ve noted in the past, investors still attribute tech magic to SOFI, which is essentially a consumer finance company with a bank license. With an efficiency ratio of 116, the bank is losing money and needs to grow 2-3x in order to generate sustained profitability, assuming that the firm can control operating expenses.

SOFI is up 90% in the past month for a 1.7x book value multiple, but not because of any tangible growth in shareholder value. The stock has almost touched $10 in the latest rally, but investors should remember that SOFI was above $20 in 2021. The slide below from the SOFI earnings shows management's preferred presentation of the bank's financials focused on EBITDA, a metric inappropriate for a bank.

The SOFI financial disclosure follows the idiotic style of Silicon Valley techno spin rather than that of a bank holding company. You must get to Page 15 of the SOFI Q1 2023 presentation before they tell you that they lost money, again, in the first quarter of 2023, although at a falling rate of loss vs Q4 2022. Hallelujah. When the folks at SOFI decide to grow up, they should follow the public disclosure presentation format of the larger consumer finance banks.

Like most banks, SOFI saw its interest expense rise dramatically in Q1 ‘23 (+166%) but is likely to see funding costs rise even faster in Q2 2023. At Q4 2022, SOFI reported a gross yield on loans and leases of 8.51%, slightly below CapitalOne (COF) and about half of the gross spread of our new addition to the bank surveillance list, Synchrony Financial (SYF). SOFI is basically +300bps to the gross yield over at Ally Financial (ALLY), not our first choice of a competitive position.

SOFI acquired cloud-based banking platform Technisys for $1.1 billion in 2022. And SoFi just announced that it is acquiring Wyndham Capital Mortgage, which explains why a company that reports consistent operating losses managed to report higher tangible book value in Q1 2023. As and when SOFI begins to report profits, then the fact that this is just another small bank focused on consumer finance will perhaps become apparent to investors and financial media.

Next after SOFI is Discover Financial (DFS), one of the more profitable banks in the US year in and year out. DFS saw interest expense rise 267% in Q1 2023 vs the year before and will likely see another jump in Q2 2023. Despite this, revenue net of interest expense rose 29% in Q1 2023. Rising operating expenses (+22%) and a 10-fold increase in credit loss provisions drove DFS into a $266 million loss in Q1 2023, something we expect to see more with other banks in Q2 2023. The table below comes from the DFS Q1 2023 earnings presentation.

DFS reported a gross yield on its loan book of 13% at year-end 2022 and 14% in Q1 '23, a figure that is likely to rise in coming quarters. Like SYF, DFS manages its $131 billion asset business to maximize asset turns and returns on earning assets, yet the operating environment will remain challenging. Note in the most recent financial that DFS has raised its liquidity portfolio and has not been shy about using the FHLBs and the Fed discount window.

Even if US banks are reporting losses in Q2 2023 because of surging funding costs, we expect to see continued share price appreciation. Equity managers neither know nor care about the considerable operating challenges facing US banks in terms of funding costs and, down the road, credit expenses. Yet, leaving aside the fintech crowd, look for the better performers to outpace the laggards in 2023 as funding costs chase T-bill yields.

With inflation fears moderating, we expect Buy Side managers to construct a rationale to buy bank stocks – even if earnings performance remains constrained due to the legacy of COVID and the Fed’s radical manipulation of interest rates and the bond market. That said, volatile credit and operating factors may provide some unpleasant surprises for investors during the balance of 2023.

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