July: Credit Blowups are Already Here
Evolve fallout review, Credit risk transfers, Newtek and the bank risk horizon, Homestreet's merger, what banks looked like in 2007.
In this edition:
Brief notes about a New Orleans conversion, another unusual Japanese bank, and a different way to think about the compulsion to spend time on NVDA.
The 5 Points:
5 Points is 6 Points today because of the Evolve Bank catastrophe. Some takeaways from this situation.
“Wait and see, bank credit will crack.” Have you looked at non-agency mortgage REIT credit metrics lately?
The Homestreet & First Sunflower merger - a meaty spread for this merger given some overlooked incentives to close.
Newtek (NEWT): Trying to simplify the story of this poorly understood bank.
Credit risk transfers can be a valuable capital tool for banks, with Merchants Bank (MBIN) as an example.
Do you remember what banks looked like in 2007? Not Lehman or Merrill but little ones like Ameris. Through the lens of 2024, you might not believe how extended they were. ABCB
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Brief notes:
5th District: This New Orleans mutual is beginning a community offering, suggesting it may convert at the low end of the range at 43% of tangible book. If it comes at the minimum, I am told this would be the lowest multiple for a conversion since Magnolia & Rantoul each about 30 years ago.
Many mismanaged, sub-scale conversions in bad markets have come since then!
I take this as a mildly constructive contrarian indicator, and will be watching for signs that the board truly supports return of capital. Early indications are management has more of a pulse than some think. A share repurchase all the way to book value, as occurred for example at William Penn (WMPN), would mean 132% upside, for dreamers. As cigarette butts go, 5th District pricing is interesting.
Two new Believe it or not! museum entrants for this edition:
If 2009 was a credit crisis, and 2023 was a rates / liquidity crisis, I would argue we have been in a small-scale compliance crisis in the banking sector, with an assist from BaaS and crypto. To wit:
Zelf was until late 2022 a fintech program partnered with Evolve Bank. More below on Evolve. Zelf funded anonymous, or “unverified” debit cards for customers. The potential to launder money in broad daylight upset regulators, and so Evolve was ultimately asked to shut down their partnership with Zelf:
Zelf protested this, saying they were more restrictive than cards bought with straight cash. However if you want to launch a card program with anonymity as a feature, it begs the question of “why be hidden from the rule of law?”
SBI Sumishin Net Bank. The second museum piece was in front of us all last edition with the Japanese bank screen but one reader pointed it out to me. A BaaS bank making 17% ROE, with 1/3 of revenue from fees. Interesting.
Peeking at the presentation was tricky due to my inability to read conji, but a few slides made sense. The Japanese characters for BaaS and ROE are fortunately “BaaS” and “ROE”:
Next, ROA is…0.26%. 0.26% ROA and 17% ROE is a problem. This bank carries $1bn in equity against $70bn in assets.
STI return on risk adjusted assets is closer to 1.5%, because in Japan, BaaS assets are apparently adjusted down for risk weighting and STI has only $12bn of risk-weighted assets. This is closer to sanity.
Here I will admit my analytical limits for understanding the risk sharing between Japanese BaaS banks and their partners, and whether that shelters STI’s $1bn capital base as much as the risk weightings imply it would. In other words, it’s possible STI won’t actually fail at the first sign of asset impairment.
Just for fun (I’m not suggesting STI is about to follow this precedent), it reminds me of the old days like when the bank below carried $16bn in tangible common equity at year end 2007 against $695bn in assets. Can you guess which bank? Hint - not Bear Stearns.
So while I wish management well in getting to their 20% ROE target, and this bank may end up continuing to perform at a high level, I hope they have their BaaS systems and risk management in much better shape than say, Evolve Bank and Trust so that their 1.2% capital ratio is never truly tested, nor their reserves at 0.05% of loans. 5bp reserves, believe it or not!
Stick to your knitting.
Today there is a lot of discussion of NVDA moving the entire equity market.
I have heard that in 2000 most value fund managers became growth managers because they wanted to remain employed. This reminds me of the old Dos Equis ad for career advice:
Very few people have any competitive advantage in forecasting outcomes at Avago or Nvidia. However they don’t always have the discipline to admit this.
To prove this to yourself, consider thinking for 3-5 minutes about how you historically have generated returns.
For me, much of the answer is intimate knowledge of the quality and thinking from management at microcap financials. It is not from any understanding of crowd psychology in large-cap tech.
When fund managers play veer out of their lane to gamble on GPU demand they begin charging money for a bait and switch, and clients should allocate elsewhere.
1. Evolve Bank has hijacked point 1) of this latest 5 Points with its catastrophic issues.
Evolve Bank and Trust is working through a cease and desist order, a massive and troublesome cybersecurity event, and missing ~$85 million of funds with partner Synapse.
Who should care about Evolve, a $1bn bank with no ticker in Memphis that nobody banks with?
Everyone. Evolve is the primary bank funding lender Dave’s 10 million customers. Also much of lender Affirm’s 11 million customers. In addition, Earnin’s 2.5 million customers. Who knows how many people are affected at Bond, Alloy, Tabapay and the hundreds of other programs Evolve administered. Evolved allowed these firms to use its balance sheet and payments rails.
If forced to guess I would estimate Evolve touches at least 50 million people, which is about 8x as many customers as say, $150bn Regions Bank, and reports are that every one of them has their social, account balance, account number and ID on the dark web now.
Jason Mikula of Fintech Business Weekly believes that the hack may include everyone making a payment to an Evolve program, which means much of the US financial ecosystem is caught up.
This is in the midst of a separate disagreement about where $85 million went in a court case that left a judge flabbergasted.
Regulators saw this coming, with Evolve’s recent Cease and Desist, but could not act fast enough.
Beyond using life lock, what does it mean?
Fintechs closed at worst and redirected at best. At fintechs heavily dependent on Evolve, like lender Dave, a new way forward is needed immediately. It’s not clear there is room at the inn however - CCB takes months or years to target only Fortune 500 companies, and TBBK and CASH don’t need lenders making 10 days loans on 400 FICOs. Few others are properly compliant. CASH is the best possible option for many, possibly including DAVE.
This is not evidence that “BaaS is done for”. What’s done for is recklessly opening programs, misrepresenting capabilities, using third parties to scale BaaS, and hoping software will catch discrepancies to save money on compliance. Evolve has been a bad actor making these mistakes for some time now:
There are no shortcuts in banking
It seems a while ago now that Evolve CEO Lenoir and I were having lunch and the topic of an IPO at 3x book came up. He wanted to accomplish in a few years what Coastal had been working on for 3-5. This Icarus tale reminds us why PNC adopted the slogan, “Brilliantly boring since 1865”.
As for whether Evolve survives, it’s a bit of a moot point now.
2) The credit fireworks is already here, if you know where to look.
Many non-agency mortgage REIT balance sheets are now severely impaired.
Don’t take my word for it, look at the numbers below. 5 Points readers already know about Sachem, Granite Point and Arbor but in the next edition of 5 Points it will be interesting to look also into Great Ajax, Ares and Claros.