BofI: Risky Loans To Undisclosed, Off-Balance Sheet SPEs Found Disguised Within Mortgage Warehouse Portfolio

Summary

• BOFI's large mortgage warehouse business is widely believed to be extremely safe. Footnotes, however, reveal that $297 Million of far riskier lender-finance loans are disguised as belonging to this category.
• The article examines BOFI's undisclosed relationship with Center Street Lending which specializes in highly suspect, single family "fix and flip" loans requiring "no doc", "no FICO", and "no income verification".
• The apparently unlicensed Center Street was recently accused of "Enabling And Assisting" the perpetuation of a ponzi-scheme that was shut down by the SEC earlier this year.
• Documents confirm that BOFI is funding Center Street via another undisclosed, off-balance sheet, special purpose entity that is also the subject of a recent lawsuit.
• BOFI's sponsorship of Center Street appears to contradict management's public statements and introduces enormous potential risks.

We continue to maintain our conservative underwriting criteria and have not loosened credit quality to increase loan volume"

BOFI's CEO, Greg Garrabrants. October 29th Earnings Call

Introduction

Last week, I published an article on Bank Of The Internet (NASDAQ:BOFI) titled, Boiler Rooms, Bad Loans, And Off-Balance Sheet Maneuvers Underpin Poorly Understood Risks. The article exposed how a network of boiler rooms and undisclosed lending relationships has facilitated hundreds of millions worth of highly suspect, BOFI-originated, small business loans that have flooded the courts with defaults. Furthermore, the article examined how BOFI's financing of at least one undisclosed, off balance sheet, Special Purpose Entity ("SPE") appears to have boosted (short term) reported profits while obscuring the risks of BOFI's fast growing C&I business from investors. For additional background and context, I would direct readers first to that article which essentially serves as a "Part 1" to this piece.

This writing examines BOFI's large Mortgage Warehouse credit book which is widely believed to be ultra safe. Apparently the opposite, the article examines how BOFI has disguised nearly $300 Million of risky lender finance loans (amounting to nearly half it's tangible common equity) within it's mortgage "warehouse and other" portfolio. While Mr. Garrabrants has repeatedly assured investors of BOFI's extremely disciplined credit standards, BOFI appears to have directly contradicted his public statements by clandestinely funding "hard money" single family lenders making highly suspect "fix & flip", "no doc", "no FICO", "no income verification", type loans. Structured as facilities to newly discovered and undisclosed, off-balance sheet Special Purpose Entities, BOFI has reported "zero" credit delinquencies while earning high yields. Led by a senior management team that has collectively been involved in two of California's largest bank failures (Imperial & Indymac), BOFI has set aside only minimal loss reserves. It appears that BOFI's increasingly insatiable appetite for growth and yield has led the bank into potentially disastrous waters.

This article examines BOFI's undisclosed and poorly understood single family lender finance activities. A likely "Part 3" will share additional recently discovered findings.

Note: All information for this article was derived from publicly available information. The article makes no representations or judgments as to BOFI's compliance with any applicable laws. Investors are encouraged to conduct their own due diligence into these factors.

The Traditional Mortgage Warehouse Business

The traditional mortgage warehouse business, if executed properly, can produce attractive yields with minimal risks. Mortgage warehouse loans are short term credit lines extended by banks to mortgage companies for the funding of loans. The mortgage company is able to draw on the credit line to originate a new mortgage and fund it before it has sold the mortgage to a permanent investor. Typically, the mortgage company will only hold the mortgage for 10-20 days before it is able to sell the mortgage to a permanent investor and pay off the associated credit draw.

An American Banker article authored by a former BOFI warehouse lending executive explains how the risks can be limited in this business. Among other factors, the author explains that "No mortgage is funded without a firm takeout commitment, indicating the home loan is "clear to close," from a major investor such as Wells Fargo. A warehousing client must have at least two approved take out investors with similar underwriting guidelines. Due diligence is performed on site for every prospective warehouse client". This is exactly what the mortgage warehouse business is commonly understood to be.

BOFI's Mortgage "Warehouse & Other" Business

So, at least on the surface, BOFI's mortgage warehouse business appears to be an ultra-safe lending category that harnesses the bank's mortgage relationships to produce attractive yields. BOFI's own description of it's single family and warehouse activities in it's most recent investor presentation appears to echo this understanding (Below).

This has been further bolstered by continuous reassurances from BOFI's CEO, Greg Garrabrants, regarding the bank's conservative underwriting posture, especially in regard to it's single family lending activities . As recently as the October 29th earnings call, Mr. Garrabrants commented that "We continue to maintain our conservative underwriting criteria and have not loosened credit quality to increase loan volume". This has been further supported by the bank's stated single family underwriting metrics and credit performance statistics. I note that BOFI currently reports "zero" delinquencies in it's $431 Million warehouse lending category.

A new mystery recently emerged, however, when a key BOFI executive was observed speaking at a November 10th Las Vegas Conference on the topic of making risky "Fix And Flip" Loans. This is quite strange because, as far as I'm aware, no mention of "Fix And Flip" loans has been made in BOFI's rosy investor pitch-books. If BOFI is committed to stringent credit discipline, as Mr. Garrabrants contends, why would BOFI also have been exhibiting at a booth in an apparent effort to expand into this far riskier lending category? Also, if BOFI is involved in these loans, why aren't they showing up in the bank's reported credit metrics and/or delinquency statistics?

BOFI's Footnotes Indicate That Nearly $300 Million in Risky Single Family Lender Finance Loans Have Been Disguised Within BOFI's Mortgage Warehouse Lending Category.

In it's single family loan category, BOFI reports having $431 Million in mortgage "warehouse and other" loans outstanding as of the most recent quarter. A close review of the filing, however, reveals that this balance comes with a very important footnote that most investors likely missed.

On page 24 of the most recent 10-Q, in font so small that it's barely legible (I had to zoom my browser to read it), BOFI discloses that "The balance of single family warehouse loans was $133,058 at September 30, 2015..The remainder of the balance is attributable to single family lender finance loans". So in other words, nearly $300 Million (70%) of BOFI's mortgage warehouse category actually consists of single family lender finance loans. A better title for the category is "Single Family Lender Finance Loans And Other". Instead, in my opinion, BOFI has titled this category as "warehouse and other" so as to disguise the existence and significance of it's risky lender finance activities.

The distinction between warehouse and lender finance loans may seem trivial. After all, mortgage warehouse loans are loans to a lender (albeit highly secured and extremely short term), and it would be easy for investors to mistakenly conflate the two. In the case of BOFI, however, the distinction between these two categories appears enormous.

Recall that last week's article explored the large apparent risks behind BOFI's C&I lender finance loans made to off-balance sheet SPEs collateralized by highly suspect loans (which BOFI itself had originated). Research suggests that BOFI's single family lender finance loans actually may be the predecessor to those relationships.

The Rise Of Center Street Lending

In addition to the previously examined Quick Bridge Funding, another Irvine, California based operation, Center Street Lending, has been growing quickly in recent years. A true flashback to California's subprime days, the company's website advertises "easy money" residential loans with "24-hour funding", "minimal documentation", and "flexible underwriting".

Center Street's website makes clear that it caters primarily to home flippers and property speculators that lack income, a meaningful down payment and/or both. The business appears to be expanding rapidly and Center Street declares itself "one of the largest private money lenders to the residential investor community". Previously operating in six states, Center Street announced this September that it would expand into three additional states. The operation's marketing materials also reveal that it has expanded into rental property loans with "flexible structures". By no means a tiny operation, Center Street advertises loan sizes up to $40 Million. The company's marketing materials also indicate that it provides credit lines as well as construction loans for "investors who plan to build homes on vacant land".

It appears that the majority of Center Street's Loans come through a team of internal loan originators as well as external brokers. Much like Quick Bridge, it is immediately apparent that Center Street is actively originating very bad loans that appear certain to result in disastrously high loss rates. The LinkedIn profile of one of Center Street's "Senior Loan Originators" contains a variety of marketing materials (sample above) that advertise "No Doc", "No FICO", "No Income Verification", "No Property Limit", "Easy $", loans.

A section of a separate advertisement (above) states that realtors and lending officers can "charge your fee on the loan under our name" apparently so that they can deceive customers. The Senior Loan officer also states this practice is "No Respa Violation", because Center Street is a "hard money" private lender.

Any reasonable person should conclude that the underwriting (or lack thereof) at Center Street appears to be totally out of control. I believe that it is exactly the type of behavior that facilitated the most recent housing crisis. Certainly, "no doc"/ "no fico" / "no income" is the opposite of BOFI's stated "disciplined" underwriting characteristics. In direct contradiction to Mr. Garrabrants public comments, BOFI has been clandestinely financing Center Street's bad loans through yet another undisclosed, off balance sheet, Special Purpose Entity (more on that later).

Large Potential Legal Risks Of BOFI's Partnership With Apparently Unlicensed Center Street

Center Street's advertisement of it's apparent ability to skirt RESPA is especially interesting. RESPA Laws were tightened after the financial crisis with the intent of prohibiting the kickbacks that helped facilitate the housing bubble. A California Real Estate Lawyer explains that:

Anyone criticizing the kickback and fee-splitting prohibitions should remember the excesses in lending to unqualified home buyers that led us to the situation the financial industry now finds itself.

Entities who are found to have formed sham joint ventures for the purpose of evading the Section 8 prohibitions risk potentially millions of dollars in damages and attorney fees as well as criminal charges and imprisonment.

As a result, BOFI's sponsorship of Center Street may have significant legal consequences. Complicating this further, Center Street appears to be operating without a lending license in California. Searches in California's large public database, return no results (below).

The state of California explicitly states that "any person engaging in the business of a finance lender of finance broker is required to obtain a California Finance Lenders license". Center Street, however, considers itself a "hard money" private lender and apparently believes it is exempt from regulation. As it states on it's website "the hard money industry has largely been unregulated by state or federal laws". While a detailed discussion of California's lender laws is beyond the scope of this article, BOFI's sponsorship (as a federally chartered bank) of Center Street may eliminate any regulatory exemptions that Center Street believes it is entitled to. Further reading can be found in a recent California State Senate background paper on the topic.

Readers are also directed to a series of Sacramento Bee investigative articles exposing the pervasive fraud in the "hard money" lending industry (here, here, here, here). One of the articles describes the experience of Citizens Bank of Northern California who, "extended millions of dollars in credit to the local hard money industry". These bad loans subsequently led to disastrous losses and sent bank officials to prison.

The fact that BOFI's "advanced data analytics" have apparently directed it to partner with Center Street should be astonishing to investors who have been seduced by BOFI's investor relations narratives. Even worse, Center Street itself has recently been linked to fraudulent activities that could have potentially severe credit and legal consequences for BOFI.

Center Street Is Accused of "Enabling And Assisting" A Recently Collapsed California Ponzi Scheme

In June, the SEC shut down yet another ponzi-scheme, this one related to a California "flip and fix" real estate fund named Capital Cove Bancorp. Similar to the ETIA ponzi scheme (which was the subject of an alleged SEC subpoena issued to BOFI), the operator changed his name from Christopher Lee to Rashid Khalfani.

Importantly, a recent lawsuit was filed on November 10th by Capital Cove's Receiver against Center Street and it's web of related Special Purpose Entities (numbering over 9). The lawsuit alleges that, over a multi-year period, Center Street was "enabling and assisting" the perpetuation of the Ponzi scheme. The details of the complaint have grave implications for BOFI (as Center Street's sponsor) and speak volumes regarding BOFI's own underwriting and asset quality.

Despite obvious red flags, the receiver alleges that Center Street (likely with BOFI provided funds) "lent money to Capital Cove on at least 86 occasions over the course of about 4 years, almost all of which were in default throughout the vast majority of the lending relationship". The receiver makes clear that the loans had no economic basis and that Center Street:

could have and should have known that Capital Cove could not turn a profit on the properties that it was purchasing when considering all of the liens placed against the properties, the cost of refurbishment, the carrying costs for the properties including insurance, taxes and interest, as well as the closing costs, commissions, late fees, and taxes to be paid upon the sale of the properties.

Despite most of the earlier loans being in default (total loans valued at over $20 Million), and it being obvious that Capital Cover had no means to pay, Center Street continued to issue new "flip and fix" loans to Khalfani. The receiver alleges that Center Street continued to make new loans in an effort to help Khalfani perpetuate the scheme and attract fresh capital from unsuspecting investors so that the proceeds could be used to pay Center Street.

The receiver goes on to allege that Center Street began making "flip and fix" loans to Khalfani despite running a background check which revealed Khalfani's criminal record includes a 2003 five-count felony grand theft conviction which resulted in a two year prison sentence and $1.2 Million in restitution. Furthermore, while doing business with Center Street, Khalfani pled guilty to November 2013 forgery charges, but Center Street continued to make new loans to Khalfani.

The receiver further explains that "In May 2014, the Securities and Exchange Commission contacted [Center Street], asking questions about Capital Cove....Despite receiving no reassurance from the SEC, [Center Street] nevertheless entered into at least seven new loan transactions after that time and collected payoffs and other interest payments exceeding $3.3 million." Ignoring additional red flags, it is possible that Center Street itself may the subject of an ongoing SEC investigation. The SEC's complaint states that Khalfani later solicited an undercover FBI agent to invest in the fund. If Center Street is indeed complicit in the scheme, there likely would be significant legal and financial penalties that, as Center Street's sponsor, could have a potentially severe impact on BOFI.

California Records Confirm That BOFI Is Financing Center Street's Highly Suspect Loans.

The below documents offer incontrovertible evidence that BOFI is financing Center Street. UCC statements obtained from California's public database are included below. Both pages clearly state that BOFI is funding the SPE named "Center Street Lending Fund IV, LLC". I note that this SPE appears to be the "master" SPE as public record searches reveal various transactions amongst the elaborate web of Center Street SPEs. I also note that this SPE is a named defendant in the earlier referenced lawsuit.

Large Credit Risks Appear To Dwarf BOFI's Paltry Loss Reserves

As mentioned, BOFI's footnotes indicate that it's single family lender finance exposures approach $300 Million (nearly half it's tangible common equity), not counting unfunded commitments. Despite strong evidence of large credit risks in this portfolio, BOFI has set aside a paltry $2 Million of loss reserves. The corresponding risks, in my opinion, are self evident.

Note: All information for this article was derived from publicly available information. The article makes no representations or judgments as to BOFI's compliance with any applicable laws. Investors are encouraged to conduct their own due diligence into these factors.

Disclosure: I am/we are short BOFI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.