What happened

Shares of the one-stop-shop financial services company and digital bank SoFi Technologies (SOFI -0.28%) traded close to 10% lower today after a scathing research report and downgrade by analysts at Wedbush.

So what

Wedbush cut its rating on SoFi's stock from neutral to underperform and lowered its price target to $2.50, which implies material downside from the stock's current roughly $4.50 share price.

At the crux of the argument is SoFi's accounting treatment of its loans and capital position. SoFi has leaned heavily into personal loans since the student loan moratorium but the company also has a bank charter.

Its approach has been to designate the loans as held-for-sale, holding the loans on its balance sheet for six to nine months and collecting monthly interest payments, and then selling the loans to investors. This approach also enables SoFi to avoid setting aside capital for loan losses, which would cut into its earnings.

But in the first quarter, SoFi did not mark down the fair value of its loans held for sale, despite the fact that credit has begun to normalize. The company lends to a high-quality borrower, but there still should be some losses, especially on unsecured personal debt. In the first quarter, SoFi, which uses a third-party firm to value its loans, increased the fair value of its personal loan portfolio by more than $428 million.

Wedbush believes that SoFi's "capital levels may be overstated using fair value accounting." If SoFi had to hold the loans for investment and set aside capital for loans losses, looking at what peers have done, Wedbush believes "SOFI's financials would result in SOFI's tangible book value being reduced materially by nearly 60% on an apples-to-apples basis to $1.27/share from the current $3.05/share."

While Wedbush does not anticipate that SoFi will change its accounting methodology or the fair value of its personal loan portfolio in the near term, it argues that regulators could give the company a nudge, especially after what has happened in the banking sector recently.

Furthermore, Wedbush pointed out a line in SoFi's recent regulatory filing that says, "if our current net losses continue for the foreseeable future and we are not able to achieve GAAP net income profitability in 2023 as currently expected, we may raise additional capital in the form of equity or debt, which may not be at favorable terms when compared to previous financing transactions."

What now

While I'm not entirely sure if regulators would step in, I definitely agree with the Wedbush team that this is a huge risk. SoFi did no whole loan sales from its personal loan portfolio in the first quarter, suggesting there wasn't demand from investors.

SoFi may eventually need to mark down the fair value of its loans, which could prevent it from achieving profitability later this year and force a capital raise. I've always believed that SoFi traded at too rich of a valuation. Until this big risk abates, I would recommend investors stay on the sidelines.