While the Nasdaq Composite, a benchmark index for the tech industry, has rallied more than 22% this year, the one-stop-shop financial services company and digital bank SoFi (SOFI -1.39%) is only up about 10.5% this year.
SoFi has seen its stock struggle since reporting its first-quarter earnings, which beat consensus estimates and included a small raise to the company's full-year guidance.
The market has been worried about SoFi's large-and-growing personal loan portfolio and how management is marking those assets and preparing for loan losses. It's clear the market is very skeptical of SoFi right now. Here's why.
Wonky accounting
Since the student loan moratorium went into place immediately following the onset of the pandemic in 2020, SoFi has leaned into personal loans and now regularly originates $2.5 billion to $3 billion per quarter.
Image source: Getty Images.
The fintech company, which has obtained a bank charter, has adopted a wonky accounting methodology for its loans, where it holds them for six to nine months on the balance sheet and then sells them to investors. This effectively gives SoFi the best of both worlds because holding loans on the balance sheet and collecting recurring interest payments is more profitable than a one-time sale. However, if SoFi held the loans until maturity it would have to set aside reserves for loan losses, which can take a big bite out of earnings. Holding the loans for sale allows SoFi to avoid doing this, although it has to mark the loans on a fair value basis.
The problem for SoFi and others that sell their loans to investors is that as interest rates have soared, the capital markets have dried up and investors are not really buying personal loans right now. Investors such as asset managers are currently dealing with higher funding costs themselves, loan yields have not fully repriced, and investors are worried about how credit quality will hold up during a recession. SoFi has not made any whole loan sales from its personal loan portfolio in the last two quarters now.
Management seems overly optimistic
Given that SoFi designates its personal loans for sale and marks them based on their fair value, investors get an update on how the loans are valued each quarter. In the fourth quarter of 2022, SoFi did an upward cumulative fair value adjustment of more than $271 million. In the first quarter, the upward adjustment grew to more than $428 million to its now more than $10.5 billion personal loan portfolio.
CFO Chris Lapointe said on SoFi's first-quarter earnings call that the loans are valued by a third-party firm, which takes into account the weighted average coupon, default rates, prepayment speeds, benchmark rates, and spreads.
But over the last few quarters, the environment and outlook have gotten more difficult and credit has begun to normalize. A competitor of SoFi, LendingClub (LC -0.98%), which is also a big personal lender, has had a slightly different experience. LendingClub does not designate a lot of loans as held for sale because it either places loans on its balance sheet or sells them shortly after origination. But in the last two quarters, LendingClub has had net negative fair value adjustments on its small balance of loans held for sale, which would seem more normal given the deteriorating macro environment.
SoFi does serve a higher-quality borrower but it's not far off from LendingClub. SoFi's weighted average income and FICO score in its personal loan portfolio are $164,000 and 747, respectively. For LendingClub, the average income and FICO of loans held on its balance sheet were $116,000 and 729. For loans in its servicing portfolio and sold to investors, they were $113,000 and 717. This is data from the fourth quarter of 2022, although management indicated on LendingClub's recent earnings call that new loans it added in the first quarter have similar credit characteristics.
Currently, LendingClub expects a 5% lifetime loss rate on its current portfolio, while SoFi expects 4.5%. However, given the uncertainty about where the economy will land, LendingClub is building in a big buffer and plans to bring its total allowance for loan losses somewhere around 8.5%, which includes a qualitative overlay from management. SoFi doesn't do this because it designates its loans as held for sale.
The market is skeptical
In my view, it's easy to see why the market is skeptical of SoFi. SoFi has grown personal loans incredibly fast in recent years and there is reason to believe the marks on its personal loan portfolio are either off or far too optimistic, given that we don't yet know the severity of a potential recession.
What's more, the company has no real way to build a strong buffer if the economy takes a turn for the worse. If it is eventually forced to mark down its portfolio and sell loans at a loss, that could eat into earnings and force the company to miss its guidance and potentially conduct a dilutive capital raise.
SoFi also has no track record of underwriting through the cycle, which makes the recent growth and upward marks on its loan portfolio concerning. CEO Anthony Noto has been buying SoFi stock heavily, which is a good sign, but until the company can move some of these loans and reassure the market, this presents a big risk that is not worth buying into, in my view.
