Here’s why SoFi stocks can’t pick up speed right now

The one-stop-shop for financial services and digital banking companies Sofi Technologies (SOFI -3.36%) saw its stock rise more than 15% after its recent earnings report, which on the face of it looked pretty good, with the company beating consensus estimates and management raising its forecast.

But the stock gave up those gains over the next few days, much to the chagrin of SoFi’s cult investor, leaving some bewildered by the drop.

While many parts of SoFi show promise and progress, I think there’s a clear reason why the stock doesn’t seem to be gaining momentum even after its strong earnings report.

To be a bank or not to be

After a long process, SoFi was finally able to secure a bank charter by acquiring tiny Sacramento bank Golden Pacific Bancorp. that it could use to fund loans. The banking charter also allows SoFi to internalize the origination of loans, which saves its customers money and time.

But management appears to be very opaque with its strategy going forward, which has institutional investors worried. Management said the company’s plan with the banking charter is to hold loans for six months, collect recurring interest payments during that time, and then sell the loans to investors. This allows the bank to legally circumvent a key banking accounting rule related to holding loans to maturity.

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Banks must provision for loan losses very prospectively under the current Expected Credit Loss (ECL) accounting methodology. Thus, if SoFi held loans until maturity, it would have to set aside reserve capital for the lifetime losses of the loans as soon as they were written down.

For the first nine months of the year, SoFi recorded a provision for credit losses of approximately $39.4 million. At the end of the third quarter, SoFi had $11.2 billion in loans on its balance sheet. This equates to a loss provision of only about 0.35%, or about 1.4% annualized. As I mentioned, SoFi is allowed to do this because it classifies these loans as held for sale, which means that the company intends to sell them, and it really can sell them at any time as long as it does so before the deadline.

However, if SoFi ultimately decides to hold the loans to maturity — and it could possibly because those loans may be more profitable — the company would have to significantly increase its provision for credit losses, probably to around 5 or 6 % of total loans it holds on balance sheet (this is an educated guess).

SoFi currently has about $6.8 billion in personal loans on its balance sheet, a segment that sees higher losses, like credit cards. If the company were to hold them to maturity, a 5% credit provision would equal $340 million, which would obviously hit the company’s earnings hard.

Investors may therefore be concerned about a future switch to CECL accounting. However, when asked by an analyst about the company’s willingness to grow the balance sheet and hold loans longer, CEO Anthony Noto said he looked forward to “a year in which we have continuity and stability. markets and company-specific initiatives.” He also said the company plans to reinvest 70% of additional revenues back into the business, which means the company still seems more focused on growth than on profitability.

A latent worry

All of this creates short-term risk, however, as SoFi will eventually have to sell all of these loans before they mature. What if the economy slips into a deep recession next year and SoFi investors lose their appetite for lending? Yes, the company serves a very high quality clientele. Its personal loan portfolio has a weighted average FICO score of 746 and its borrowers earn an average of $160,000.

But if you look at what we just heard from another company in the personal loan business, loan club (CL 2.78%), the demand for personal loans is decreasing. Despite strong consumer demand for personal loans, LendingClub originated and sold $433 million less in loans to investors in the third quarter, and its fourth-quarter guidance suggests it could come under continued pressure in the fourth quarter.

Additionally, the average FICO score among LendingClub’s loans sold to investors is 718, which isn’t too far below SoFi’s. For the personal loans LendingClub holds on its own balance sheet, which now have a weighted FICO of 730, the company has reserved enough capital to cover losses on 7.2% of the book.

SoFi also began to see its gain on sales margins for its personal loans compress slightly, from 3.4% in the second quarter, unhedged, to 3.25% in the third quarter. SoFi may have no problem selling loans to investors next year, but we just don’t know what the environment will be like.

More transparency would help

I can see why management might use this approach. First, they try to capture more interest income on loans without having to incur front-end accounting fees.

I also assume they want the market to continue to perceive them as a high-growth fintech company, which would likely have a higher valuation than a traditional bank.

But I feel like this strategy has created this hidden risk where the company may find it difficult to offload these loans for a profit if the economy continues to deteriorate. I wish management could be a bit more transparent here and provide more disclosure on their quarterly financials.