It should be no secret that fees are an important part of Prospect Capital's (NASDAQ:PSEC) earnings. Structuring fees, also known as origination fees, have made up as much as one-third of this business development company's income. It books these fees into income when a loan is made.
I've been critical of this fee-based income stream because it generally requires a lender to grow dramatically so that fees from new originations continue to flow in. Today, though, I want to give some historical precedence for why investors should view origination fees as a low-quality income source for all financial companies.
A walk through history
Let's go back to the early 1980s. Lending is booming, and growing savings and loan companies are popping up on street corners across the nation. These are simple lenders that take deposits and make real estate loans, mostly residential real estate loans.
Mismatched assets and liabilities were hurting the profitability of virtually every S&L in existence. Many were paying as much, if not more, on their deposits as they were earning in interest. It's hard to make money when you're borrowing at 10% to lend at 11% -- spreads need to be bigger.
The industry turned to commercial loans as a savior. Not only were the spreads better, but they also presented the opportunity to book significant fees on new originations. A typical loan might include a 2% up-front fee, deducted from the disbursed loan and reported as immediate income for the lender.
Students of bank history know that the origination fee was one of the worst of the perverse incentives in the boom and bust of S&Ls in the 1980s. A book on the subject, High Rollers, described fees as follows:
Up-front fees were the drug -- the crack, the heroin -- on which S&Ls binged. The bigger the up-front fee, the better the loan; and, perversely but quite naturally, developers of projects would pay higher up-front fees if they didn't actually have to put up any of their own money.
The quoted sentences above give much to digest. But there are lessons to be learned, which can be applied to any credit-centric company:
- Lending generates income slowly over many years through a spread. That's boring. Fees offer the dangerous concoction of quick and immediate income on a practically as-needed basis.
- A lender can boost fee income by pulling forward interest income. A high fee replaces a higher interest rate on the loan, effectively mortgaging the future to save the present.
- Because fees correspond with loan origination, fee income requires growth. Growth often means accepting a greater percentage of potential borrowers, which inherently means accepting worse-priced risks.
- Fees are an incentive to write new loans, good or bad.
I probably don't need to tell you that the lending practices of the S&L boom led to bust. The allure of immediate fee income encouraged excessive growth and excessive risk-taking at many institutions.
When an S&L fell behind on income, there was always a new loan to underwrite for income right now, even if the end result would be massive underwriting losses in the years that followed. It was a recurring theme. No troubled lenders, from California to Texas, could escape the temptation.
The Foolish perspective
Some of you will read this and scratch your heads. Some might take to the comments to explain how silly it is to compare business development companies to the S&Ls of 30 years ago.
But if you'd made it this far, I want you to notice the corollaries. And while I'm not stating in no uncertain terms that origination fees are forcing Prospect Capital to take undue risks, I am suggesting that incentives matter. And I think it would be prudent for everyone to take a simple look at what percentage of a BDC's income stream comes from fees. The lower the better, both for the dividend's sustainability, and the incentives that quietly govern management decisions.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.