Despite its relatively small size, the $9.1 billion asset bank Live Oak Bancshares (LOB 3.24%) is one of the largest originators of U.S. Small Business Administration (SBA) loans in the country. SBA loans are made to slightly riskier businesses than a bank would normally take on, but the loans are heavily guaranteed by the SBA, making them much more appealing.
Lenders like Live Oak can put these loans on their balance sheet or sell the guaranteed portion of the loan, which is typically around 75% guaranteed by the SBA, into the secondary market, which helps with liquidity. Live Oak has recently seen secondary SBA loan sales slow. Is the stock still a buy? Let's take a look.
Difficult market conditions
In the second quarter, Live Oak only realized a net gain on loan sales of roughly $6 million, which is significantly lower than what has been the norm over the last year. The bank only sold $50 million of SBA loans into the secondary market, down significantly from the $92 million the bank sold in the second quarter of 2021 and the $211 million it sold in the first quarter of the year.
Image source: Live Oak Bancshares.
In its second-quarter earnings release, the bank said the slowdown can be attributed to dislocation in the secondary market largely because of rapidly rising interest rates and difficult market conditions. When rates increase, investors in the secondary market have a higher cost of capital, which drives up the required returns they will need from the loans they purchase. Additionally, as the macro outlook gets more cloudy, with the potential of a recession, investors start to get concerned about loan performance.
The slowdown of loan sales in Q2 was more apparent among the fixed-rate SBA loans Live Oak originates. Very few of these loans were sold in the second quarter and the premiums paid by investors on these loans slipped from 106% to 102%, likely because while investors will need to pay a higher cost of capital the yields on these loans do not adjust higher with interest rates nearly as much as variable-rate loans.
Live Oak also took an $8.7 million hit after it had to reevaluate its loan servicing rights due to higher rates in the quarter.
While the step down in loan sales in Q2 and difficulties in the secondary market may have caught some investors by surprise, Live Oak CFO BJ Losch did warn investors to prepare for the impact of higher rates on the bank's first-quarter earnings call on April 28.
"While premiums remained relatively stable with recent trends during the first 45 to 60 days of the quarter, we did start to see some meaningful changes in demand and pricing due primarily to shifting market sentiment on the Fed's rate and economic outlook," Losch said. "So with the fintech gain of $120 million booked in the second quarter, we will take the opportunity to moderate our guaranteed sales in the second quarter and allow the markets to further digest the Fed's rate moves."
Is Live Oak stock a buy?
Right now, most banks or fintech companies that sell loans into some kind of secondary market are dealing with the same issues as Live Oak, so the issue is not specific to the bank or a result of poor management.
And while the income from these loan sales moderated, it was partially offset by higher income from loans held on Live Oak's balance sheet, many of which saw their yields reprice higher along with higher interest rates.
Live Oak also saw healthy origination volume in the quarter of $960 million, which is up from the first quarter of the year. Additionally, since 2013 the bank's credit quality has widely outperformed the broader SBA lending program and the bank has strong levels of capital.
Live Oak also continues to execute on its strategic vision of becoming America's small-business bank and more holistically serving the small-business community. Management has adopted and implemented cutting-edge technology that has enabled it to begin to roll out products that help small businesses run their day-to-day operations and make Live Oak an attractive banking partner.
The market should eventually adjust to rising interest rates and with the Federal Reserve recently saying that it may soon start to slow the pace of rate hikes, issues in the secondary market could end up being a near-term headwind. I still think Live Oak stock is a good long-term buy.
