Goldman Sachs (NYSE:GS), the whitest of white-shoe Wall Street banks, has done a remarkable about-face within the last year. Its reputation was built on financial engineering at a very high level: mergers and acquisitions, IPO underwriting, and proprietary bond trading by the smartest guys in the room. But it has recently begun facing retail.
One aspect of this retail-facing initiative is its new foray into the personal loans business. This foray seems to be known but not understood. The threat/opportunity Goldman sees, the actions it has taken, and the speed and determination with which it has taken them, point to a bank which - although it has stumbled recently - has no intention of being pushed off the top of the Wall Street banking heap.
March 2015. "The Future of Finance: the Rise of the New Shadow Bank"
In March of 2015, the equity research department at Goldman issued a report for its clients. The report detailed the rise of "the new shadow banking sector" and its threat to incumbent banks. The report listed six areas - personal loans, small business loans, leveraged lending (to non-investment grade businesses), student loans, mortgage banking (origination and servicing), commercial real estate lending - where non-bank entities were in the process of taking market share from banks. The opportunities were opened by a combination of stricter bank regulation in the wake of the financial crisis, and new technology that made new business models possible.
(Source: GS report)
According to the report, $10.9B of annual bank profits were at risk. $4.6B of these profits were in the unsecured consumer loan sector, where Lending Club (NYSE:LC), Prosper, and numerous imitators were encroaching on market share.
At the time of the report, Goldman was not in the consumer loan business. But I believe the partners at Goldman Sachs must have seen in their equity research report a market opportunity, because after that, events began moving quickly.
June 2015. The Mosaic initiative
In June, three months after the "new shadow bank" report came out, Goldman announced a new initiative. It would go into the personal loan business, online, just like Lending Club or Prosper. The new initiative was given the project name Mosaic.
Goldman could have bought an existing company, or formed a partnership, like JPMorgan's (NYSE:JPM) partnership with OnDeck (NYSE:ONDK) in the SME lending space. However, it elected to build its own platform. To do so, in Goldman Sachs style, it hired the very best management.
Harit Talwar would head up the project. His last position was at Discover (NYSE:DFS), where he ran the U.S. cards division. Unusually, Talwar was hired as a full partner, giving some idea of how seriously Goldman took the Mosaic initiative. Abhinav Anand, head of Analytics, also came from Discover, where he was in charge of the risk division.
Boe Hartman, formerly of Barclay's credit card division, was Chief Technology Officer. David Stark, formerly of Citigroup's (NYSE:C) credit card division, was Chief Risk Officer, in charge of the underwriting. These men worked for traditional banks.
However, Darin Cline, head of operations, was formerly head of operations at Lending Club. And Greg Berry, Chief Architect, used to work for OnDeck. These officers had experience with the new online lenders. Goldman wanted the best of both breeds as it put its own product together.
August 2015. The GE Capital acquisition
In August, just two months after the Mosaic announcement, Goldman announced that it was buying the deposits and the online platform of GE Capital Bank. It would also keep on most of the employees. Goldman re-branded the acquired business as GS Bank when the acquisition closed in April. Several things about this acquisition are notable.
First, there were no physical assets purchased, just an online platform and $16B of deposits. (Total deposits in GS Bank are about $114B.) Goldman is headed into retail-focused banking, but it will be 21st-century retail-focused banking, which is to say entirely online. There will probably never be a physical bank branch of GS Bank.
Second, GS bank does not offer a checking account. Nor does it offer a lot of other ordinary retail services, like mortgages or car loans or bank checks or automatic bill paying. Goldman offers one thing to its depositors: savings vehicles. These savings accounts and CDs have premium rates. For example, the savings account offers an interest rate of 1.05%, which is one of the highest, if not the highest, savings interest rate available anywhere.
The fact that GS Bank offers premium savings vehicles, and only premium savings vehicles, means that it is not interested in making money off of fees and services (yet). Rather, the main function of these deposits is to provide a funding source for the lucrative business opportunities Goldman sees elsewhere, particularly (for our purposes) in the burgeoning online lending sector. Moreover, the premium rates indicate that Goldman wants to grow these deposits as fast as possible. On the latest call, it was quite happy with 20,000 new depositors since the close of the GE Capital acquisition.
These funds from retail savers have two important characteristics: they are sticky, and they are cheap.
The benefits of sticky capital: steady growth
When you are a lender, you need funds to lend, and when you want to grow as an online lender, you need a source of funds that won't dry up when the credit market contracts a few points. This is one of the problems Lending Club has faced recently. Its originate-to-distribute model, plus its meteoric growth (until recently), meant that it was heavily dependent on institutional funding. But it turns out that institutional funding flees quickly when credit markets turn slightly less rosy. The impacts of a recent, fairly small, capital drought have ramified into internal mismanagement, crippled growth, and a share price collapse for Lending Club.
GS Bank, on the other hand, is institutional capital, and a stable bed of depositors, lured by savings rates they can't get anywhere else, provides a platform for steady growth indefinitely far into the future.
The benefits of cheap capital: profit (with a regulatory wrinkle)
Those same depositors also provide just about the cheapest capital there is. The average interest rate on a Lending Club loan is 12.8% and 14.6% at Prosper. With a cost of capital at 1.05%, comparable rates would give GS Bank a fat interest margin of 11.75-13.55% (not counting allowances for losses).
However, the originate-to-distribute online lenders have a regulatory ace up their sleeve. Since they sell the entirety of their loans, keeping no credit risk exposure, they do not have to reserve capital against their receivables book. Banks holding loans on their balance sheet, however, have to tie up capital at about 15% rates. This places a lid on the ROEs that the bank funding model can achieve.
In spite of that, Discover has an ROE of ~20% on its consumer loan business, which is far above what GS is earning now as a bank (6.4% in Q1). Online lending stands to be a significant incremental boost to profit, even if traditional banks cannot find a way to tilt the regulatory playing field in their direction and away from pure-play online lenders.
Recently, online lenders have received more regulatory scrutiny, both about their internal controls (in the wake of the Lending Club scandal) and about their business model. On this latter front, online lenders have made some concessions, albeit so far without impact to their business. I expect that over time, traditional banks, including GS Bank, will find some way to increase their capital's competitive edge vs. the online lenders.
April 2016. The GE Capital acquisition closes. GS Bank opens to the public.
May 2016. "We expect to begin the initial phase of engaging consumers this fall."
On its most recent call, Goldman indicated that its "digital consumer lending platform" would be open for business, at least in a small way, by the fall. This is the fruition of the Mosaic initiative, which will have gone from conception to rollout in eighteen months.
This platform will compete with the numerous other players in the online lending space. It will differ from the Lending Clubs and Prospers in having a more stable and cheaper source of capital. It will differ from personal lending products offered by Discover, Wells Fargo (NYSE:WFC), and SunTrust (NYSE:STI)/Lightstream in using the highest-tech underwriting algorithm, relatively short on human labor, that the sharpest elements of the credit industry know how to provide.
It should be a very strong competitor.
Some very rough numbers
In its "New Shadow Banking" report, Goldman's researchers estimated a TAM for the consumer loans business at $258B, with an average ROA of 2.2%. That is $5.67B of profits up for grabs, and you can bet that Goldman intends to own a big piece of it. Every percentage point of that amount would add about one additional percentage point to the bank's 2015 net income.
Obviously, it will take a while to get there. However, growth rates in the online lending space are astronomical - until recently, for example, Lending Club was doubling every year.
I expect Goldman to pursue its online lending initiative post-rollout just as aggressively as it ramped it up. Initial growth rates will be very high and - since expenses are mostly already being incurred - income will be accretive to the bottom line. Initially that will be a fairly small amount. In, say, five years, however, a $5B loan book is not unlikely - SunTrust, Discover, Lending Club, and Prosper have all achieved that level in about that time frame. At 2.2% ROA, that is $110M of net income.
Outlook for Goldman
In pursuing its online lending initiative, Goldman has positioned itself well for the future. I doubt it will stop with personal loans, since the other five verticals mentioned in its "New Shadow Banking" report remain ripe market opportunities. So expect to see some or all of small business lending, student lending, leveraged lending, mortgage financing, and commercial real estate funding added to the GS Bank suite of online products in the next few years. (Small-business lending has already been mentioned by Blankfein in an internal memo, mentioned here.) All of these will be offered online-only, technologically underwritten, funded mostly by sticky deposits lured by premium savings rates, and probably very profitable.
The competitive advantages of new technology, an absence of brick-and-mortar costs, and cheap sticky capital make for a firm foundation for future profitability.
Outlook for the personal lending industry
In the longer term, though, these competitive advantages are not unique to Goldman. Any deposit-taking institution can replicate them. What made Lending Club and Prosper possible was not just new technology and heavier bank regulation, but the enormous spread between the cost of banks' capital (now close to zero) and their returns from extending credit to individuals (20+% on credit cards). Technology made exploiting that spread possible.
Personal loans are already becoming a commodity product. In the longer term, this spread will get competed away, and the cost of credit will get cheaper. That will squeeze the returns that online lenders can offer their investors, lessening their appeal, and in turn drying up their funding sources. My long-term bet would be that online personal lending migrates permanently to deposit-taking banks.
Cheaper credit probably also means more credit, in the aggregate. This will provide a demand boost to the economy, and afterwards maybe set us up for a consumer-lending crash. But all that is some years away.
Right now, Goldman Sachs is doing the right thing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.