Saturday, April 30, 2016

Equity-financed banking

My dream of equity-financed banking may be coming true under our noses. In "the Uberization of banking" Andy Kessler at the WSJ reports on SoFi, a "fintech" company. The article is mostly about the human-interest story of its co-founder Mike Cagney. But the interspersed economics are interesting.

SoFi started by making student loans to Stanford MBAs, after figuring out that the default rate on such loans is basically zero. It
has since expanded to student loans more generally and added mortgages, personal loans and wealth management. Mr. Cagney says SoFi has done 150,000 loans totaling $10 billion and is currently at a $1 billion monthly loan-origination rate. 
Where does the money come from?
SoFi doesn’t take deposits, so it’s FDIC-free. ... Instead, SoFi raises money for its loans, most recently $1 billion from SoftBank and the hedge fund Third Point, in exchange for about a quarter of the company. SoFi uses this expanded balance sheet to make loans and then securitize many of them to sell them off to investors so it can make more loans
Just to bash the point home, consider what this means:
  • A "bank" (in the economic, not legal sense) can finance loans, raising money essentially all from equity and no conventional debt. And it can offer competitive borrowing rates -- the supposedly too-high "cost of equity" is illusory.
     
  • There is no necessary link between the business of taking and servicing deposits and that of making loans. Banks need not (try to) "transform" maturity or risk.
     
  • To the extent that the bank wants to boost up the risk and return of its equity, it can do so by securitizing loans rather than by borrowing. (Securitized loans are not leverage -- there is no promise of your money back when you want it. Investors bear any losses immediately and without recourse.)
     
  • Equity-financed banking can emerge without new regulations, or a big new Policy Initiative.  It's enough to have relief from old regulations ("FDIC-free").
     
  • Since it makes no fixed-value promises, this structure is essentially run free and can't cause or contribute to a financial crisis. 

More. SoFi does not use the standard methods of evaluating credit risk:
Instead of relying on notoriously inaccurate backward-looking FICO scores, SoFi is “forward-looking.” That means asking basic questions—“Do you make more money than you spend?”—and calibrating where applicants went to college, how long they’ve been employed, how stable their income is likely to be over time.
Why can’t banks do this? Because if you use depositor money for loans, as all banks do, you fall under the jurisdiction of the Federal Deposit Insurance Corp. and the Community Reinvestment Act,...
And Basel and the FSOC and the Fed and so forth. FICO score based mechanical lending standards are also demanded by government-backed securitizers Fannie and Freddie.

Yes, bank "safety" regulations demand that banks purposely lend to people that one can pretty clearly see will not pay it back, and demand that they do not lend money to people that one can pretty clearly see will pay it back.

Now, what will the regulatory response be to this sort of innovation? The right answer, of course, should be hosannas: You have introduced run-free banking, that solves all the financial-crisis worries that 90 years of bank regulation could not solve. Let this spread, and the army of bank regulators, lobbyists, lawyers, and associated politicians can all go, well, drive for Uber.

Somehow I doubt that will be the response from foresaid army. And SoFi might well want to invest in its own lawyers, lobbyists and politicians in today's America.
Rather than by the FDIC, SoFi is monitored by the Consumer Financial Protection Bureau. The overbearing regulator that was Elizabeth Warren’s brainchild thus far hasn’t come down on SoFi—the CFPB is perhaps too preoccupied with using “disparate impact” analysis of old-school auto-loan businesses to focus on a relatively exotic, app-based form of banking. But Mr. Cagney should watch his back.
Indeed he should. In today's rather rule-free environment, the CFPB -- or Department of Justice -- might just discover it doesn't like the demographics of Stanford MBAs as target borrowers.
He’d like to get a national lending license, but that would entail federal-oversight entanglements he’d rather avoid.
If he can.

A little puzzle crops up at the end. For now, I gather SoFi does not issue public equity. The plan for expansion is
insurance companies and sovereign-wealth funds might rent him their balance sheets. 
I'm not sure what "rent a balance sheet" means, but it sounds a lot like private equity or long term debt.  It would be even better for stability and low cost to issue public equity, which is liquid -- investors who need money fast can sell. But public equity comes with its own regulatory scrutiny, and perhaps even that is too much for innovation these days.

21 comments:

  1. Very interesting. A few minor points…

    1. “The supposedly too-high "cost of equity" is illusory.” Yes: Google has a 90% capital ratio and is doing OK!!!

    2. “Banks need not (try to) "transform" maturity or risk.” Advocates of the bank status quo (i.e. the revolving door brigade) will argue that maturity transformation (MT) creates liquidity / money (which it does). And that’s supposedly “good”. The quick answer to that is that if MT is banned, the deflationary effect of doing so is easily countered by having the state print and spend extra money into the economy (and/or cut taxes).

    3. “Equity-financed banking can emerge without new regulations..”. I doubt that debt financed banking would totally disappear without a complete prohibition on the practice. To that extent, “new regulations” will be required. But the rules of equity financed banking are so simple they can be written on the back of an envelope almost. So no big problem there.

    4.I just wonder whether SoFi’s success is down to low interest rates – i.e. if and when higher rates return, will SoFi have problems? Given low rates, investors are desperate for yield. They get next to nothing from deposits, so they crowd into equity in the hopes of something better. That might reverse.

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  2. Would other institutions be allowed to make leveraged investments into these new banks? If so then you still get the same conventional risk, if you get a few of these new banks to be large enough, than if they make a series of bad loans and their equity price collapses, other institutions invested in them could collapse along with them, resulting in the same kind of chain reaction as we saw in 2008.

    Secondly, it doesn't solve the core problem banking is meant to solve, matching savers with borrowers. If only these kinds of equity banks exist, most people with spare cash wouldn't have the risk appetite for them, which means a huge amount of 'funds' aren't getting matched with increased loans - this would be hugely contractionary.

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    1. Re your first para, I agree: that supports my point No3 above, namely that unless all banks are FORCED to abide by the rules of equity funding, there'll always be some who are tempted to fund themselves via debt, in which case, as you say, the risks won't be disposed of.

      Re your second para, clearly an enforced "equity funding only" regime would be contractionary, as you put it, but as I pointed out in my point No2, that's no problem because there is no limit to the amount of stimulus that the state can impart (if we can just get those economically illiterate politicians out of the way!!).

      In short, there is a choice between two regimes. 1. The existing regime, which involves a relatively small amount of base money in the hands of the private sector and relatively large amounts of debt. 2. A regime where households and the private sector in general has a larger amount of cash (base money), and thus doesn't need to incur so much debt.

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    2. I can't imagine Cochrane, who's libertarian leaning, favouring a scheme so dependent on central bank/state stimulus.

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  3. I think that this scheme is doomed, because consumer credit is a heavily regulated product. I know, because once upon a time, in a previous millennium, I designed consumer credit compliance programs for a living. It is difficult work because the rules are both state and Federal, and encompass several overarching ideas, e.g. disclosure, usury, and unfair practices. The laws were written over many generations and have lots of exceptions and loopholes. Consumer credit regulation will not be changed by Congress or State legislatures any time soon.

    Some examples: the Federal Truth in Lending Act is mostly enforced by the CFPB, but it also has heavy civil liabilities, which have lead to much litigation, and many court decisions, but that law is seldom overlapped by state laws. OTOH, The Federal Trade Commission enforces consumer credit rules under its maddeningly vague ability to prohibit "unfair and deceptive trade practices". Many states have overlapping UDAP ("unfair and deceptive practices") laws. They are not preempted by the Federal law, are enforced by many different state authorities, and often have civil remedies such as treble damages, and class actions. The California law is notorious in that way.

    Another class of state regulatory laws are the usury laws that limit the amount of interest a lender may charge. In the current environment of ultra low rates, not much attention is paid to usury laws. In 1980 when the so-called prime rate hit 20%, compliance was a real issue. New York, where I then worked, had a law making an interest rate over 25% a crime. We were concerned.

    The California usury law is a particular trap. It is embedded in their constitution as Article 15. The limit on general, non-real estate, consumer loans is 10%. Exceptions to the rule are granted to certain specific classes of lenders. Needless to say UBERized lenders are not a class of excepted lenders. Another immunity to usury laws is granted to National Banks, which only need to comply with the law of the place where they are chartered.

    You note another set of regulatory laws, those prohibiting discrimination. You correctly perceived that looking at colleges attended by the borrower could be a problem under those laws. But, you mocked FICO scores. The reason for the popularity of FICO scores though is that, long before they were used to monitor safety and soundness, they were more or less immune to charges of racial bias. National Banks may be immune from usury law problems, but they are subject to the most onerous anti-discrimination law, the Community Re-investment Act. Incidentally, there is no national lending license other than being a National Bank, which has its own, onerous regulatory issues.

    All of the issues about consumer credit regulation have little to do with how lenders are financed. Before the big banks moved into the consumer lending space, much consumer lending was done by non-bank lenders such as finance companies and retailers. They did not fund their operations with callable debt contracts, although they often used bank loans, commercial paper, and bonded debt as part of their funding mix.

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  4. A bank is a financial institution that accepts deposits from the public and creates credit. www.orchardbank.co

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    1. Agreed, but that doesn't prove it's a good idea to continue with banks as per the traditional definition of the word (if that's what you're saying). In fact, as this Bloomberg article explains, full reserve or "equity funding" means tearing up the whole traditional idea as to what a bank is, and starting again.

      http://www.bloombergview.com/articles/2013-03-27/the-best-way-to-save-banking-is-to-kill-it

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  5. John, I share your excitement about equity-financed banking being realized by companies like SoFi or LendingClub, but worry that as they scale, such companies will do little to reduce the risks of short term debt to the financial system. At the end of the day, products created by SoFi are sold to investors, who may choose to finance them as they please. Nothing stops banks or bank like institutions from buying SoFi's products and financing them with all the short term debt they please.

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    1. That all depends on how well regulated "bank like institutions" are. One of the big mistakes that caused the 2007/8 crisis was not regulating shadow banks. As the former head of the UK's Financial Services Authority (Adair Turner) put it: “If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safeguards,”

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  6. When this institution securitizes its loans, we don't really have equity-based banking, it is merely equity-based *origination* of loans - which is nothing new. As Rex points out above, the buyers of these securities provide the ultimate source of funding, which might be shadow money instead of bank-issued money. The system will still find cheap funding for the loans, but regulations will add on some compliance and transaction costs as the risk is transferred from regulated balance sheets to unregulated balance sheets. And as we saw in the previous crises, the resulting system is not run-free.

    You can try to ban all of this within US borders, but then bail out the global system by offering swap lines to other central banks during a crisis. Really what we want is to reduce agency costs and systemic risks by finding a way to let banks keep the loans they originate, while funding themselves cheaply with a loss-absorbing form of money, i.e. a super-liquid short-term senior claim, not an information-sensitive residual claim (equity).

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  7. The article also brings me back to an important policy question, one that was acutely raised by an recent article:

    "The Secret Shame of Middle-Class Americans: Nearly half of Americans would have trouble finding $400 to pay for an emergency. I’m one of them." by Neal Gabler in the Atlantic Magazine for May 2016.
    http://www.theatlantic.com/magazine/archive/2016/05/my-secret-shame/476415/

    The author, could be justly criticized for many of his personal choices, but I fear that the larger issue has been avoided. We are worried about financial institution debt and you want to replace it with equity. Most rational adults are worried about governmental debt. You live in a state that is about to be dragged under by its debt. And the federal debt is very worrisome, as well.

    Why are we not equally concerned about consumer debt?

    We have pumped money into financing the acquisition of houses by people who cannot afford to own them unless everything goes right.The national median income is now about $57 thousand per household, but the median sales price of a new home is pushing $300 thousand. The ratio of price to income is way above what used to be considered a prudent upper limit of 3X. Incidentally it is back in the range it was in ten years ago. Remember how well that worked out?

    Credit card debt has provided risk capital for a few famously successful entrepreneurs, but it has allowed many more people to spend a lot more than they will ever be able to pay back. Credit card companies routinely advertise that their cards will finance Caribbean vacations and luxury goods.

    Student loans are a device of the devil. They have not made college more affordable, they have made it more expensive, and the lives of an enormous number of borrowers miserable.

    I would not favor banning consumer credit. That would only drive people in trouble into the arms of loan sharks. OTOH, I would do a lot to limit the availability of consumer credit.and ease the plight of distressed borrowers.

    Mortgages should only be issued in situations that meet the the old fashioned criteria of 20% down and income > 3 x piti. 2nd Mortgages should be limited to home improvement contacts and supported at 25% equity. So should cash out mortgages.

    Credit card issuers that are regulated financial institutions should be required to obtain security for credit card limits unless the borrower is has a large non housing net worth. Their ability to sue should be limited by shorter statutes of limitations. 4 years is more than enough. They should be required to obtain actual personal service of process before suing, and be required to provide debtors with work out plans.

    Student loans should be limited in amount at all levels, not just undergraduate. Colleges should be required to reimburse the federal government if the loans are defaulted. And all loans must be dischargeable in bankruptcy.

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  8. Dr. Cochran apparently does not understand the difference in capabilities between a single lending institution ('bank') and a banking SYSTEM. Of course a single lending institution can operate with equity only (no debt). The banks in a banking system, however, must also take in deposits so that monetary policy (adjusting the growth of the real economy) can be implemented.

    Where does he think the hedge funds and purchasers of securitized loans get the money that SoFi lends out? Answer -- they draw on their deposits in the the banking system.

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    1. Ed R,

      Sofi is not entirely funded by equity. See:

      https://en.wikipedia.org/wiki/SoFi

      "The $151 million in debt includes a $60 million line of credit from Morgan Stanley, and a $41 million line of credit from Bancorp."

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    2. So the great Ed R thinks he knows better than “Dr Cochrane” (who is a professor, BTW, not a doctor).

      Ed, you claim that “The banks in a banking system, however, must also take in deposits so that monetary policy (adjusting the growth of the real economy) can be implemented.” Well if you’d studied John Cochrane’s system in more detail, you’d have discovered that banks, or bank like entities do indeed “take in deposits” under that system.

      The only difference between that system and the existing system is that under a Cochrane / Friedman system, deposit takers keep the relevant money in a totally safe manner: i.e. they don’t lend it on to mortgagors or businesses.

      But that doesn’t stop monetary policy influencing demand or growth. That is, if government or the central banks wants to expand demand, it just to print money and spend it direct into the economy, or do helicopter drops, etc. The latter would result in more money in everyone’s account, which tend to increase household spending. There are a variety of options there.

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  9. A letter to the WSJ article:

    Forgive my skepticism, but I want to see how these loans, and this company does after the first recession they go through. .02% default rate and they've been in business 4 years, with I'm sure the vast majority of their loans less than 12 months old--with this very steep growth rate the default rate is not a surprise. How many are even in the repayment phase? FICO notoriously inaccurate? I don't think so. Time on the job? Income stability? That's been part of FICO for decades. What is good is that today their risk is on their balance sheet--but wait, they are securitizing to make new loans--be careful of these securities. As others have said cherry-picking is not a new financial idea. The big risk is not the CFPB [although that rouge agency is a real problem] but Mr Cagney's ego and self-serving promotionalism, and sycophants like Mr Kessler.

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  10. It seems that decreasing investor appetite caused in part by FDIC FIL 49-2015 is making it a lot harder for these New lenders to sell their structured loans. In fact Lending Club set up an offshore hedge fund to buy their own loans, which does not look like a healthy thing to do...

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  11. "Renting a balance sheet" is what's known in the insurance business as "securities lending" - lending out those longdated boring Treasury bonds insurers have to keep to match their longer liabilities. The borrowers pay a few basis points to the insurers and then turn around and borrow against these securities, pledging them as collateral, in order to deploy the funds at what they hope will be higher margin investments. Too many moving parts with deep trouble potential if the securities cannot be returned to the original insurer on the last day of the lending period. See AIG securities lending 2008.

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  12. John,

    "SoFi uses this expanded balance sheet to make loans and then securitize many of them to sell them off to investors so it can make more loans."

    And so who is the buyer for these repackaged loans? My guess would be:
    https://www.salliemae.com

    If and when these loans go bad, the taxpayer is on the hook again? How is this any different than what happened with Fannie Mae / Freddie Mac?

    "A bank (in the economic, not legal sense) can finance loans, raising money essentially all from equity and no conventional debt. And it can offer competitive borrowing rates -- the supposedly too-high cost of equity is illusory."

    I don't believe this has ever been disputed. Now try operating a bank that retains all of the loans that it makes and funds those loans with equity.

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  13. John,

    Helps to read the fine print:

    "Where does the money come from?"

    https://en.wikipedia.org/wiki/SoFi

    "On October 2, 2013, SoFi announced that it had raised $500 million in debt and equity to fund and refinance student loans. This total funding amount came from $90 million in equity, $151 million in debt, and $200 million in bank participations, with the remaining capital from alumni and community investors. The $151 million in debt includes a $60 million line of credit from Morgan Stanley, and a $41 million line of credit from Bancorp."

    I am not sure how "bank participations" should be qualified (debt / equity?), but it's clear that SoFi is not 100% financed by equity.

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  14. Never realized this:

    http://www.usnews.com/education/best-colleges/paying-for-college/articles/2015/07/01/3-things-to-know-about-the-new-student-loan-interest-rates

    2014-15 2015-16
    Direct Subsidized Undergraduates 4.66% 4.29%
    Direct Unsubsidized Undergraduates 4.66% 4.29%
    Direct Unsubsidized Graduate or Professional Students 6.21% 5.84%
    Direct Grad PLUS Graduate or Professional Students 7.21% 6.84%

    Federal loan rates for graduate students are significantly higher than for undergrads. This is somewhat striking given that higher default rates are tilted towards undergrads - primarily those that don't finish school.

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  15. Ed, you claim that “The banks in a banking system, however, must also take in deposits so that monetary policy (adjusting the growth of the real economy) can be implemented.” Well if you’d studied John Cochrane’s system in more detail, you’d have discovered that banks, or bank like entities do indeed “take in deposits” under that system. What are Mortgage Loans

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