"As long as the music is playing, you've got to get up and dance. We're still dancing,"
-Chuck Prince, Former CEO of Citigroup
Last Thursday, Bank Of Internet (NYSE:BOFI) made its annual 10-K filing, which the sell-side predictably and immediately touted as containing "no new regulatory news". BOFI's stock has subsequently surged as investors have rushed to buy shares based on the aggressively promoted notion that an "all clear" siren has sounded. A closer inspection of the 10-K, however, reveals that the regulatory clouds long-believed to be circling BOFI have never appeared darker. In the filing, BOFI itself has actually now confirmed that new material risks of regulatory sanctions have recently developed.
Investors need to ask why BOFI is now warning them of potential "material and adverse" consequences of regulatory penalties?
Previous research has shown that BOFI's profits have been increasingly fueled by the bank's unique willingness to use taxpayer guaranteed deposits to finance and partner with an assortment of non-bank lenders that make a broad variety of risky loans. Most visibly, BOFI has continued to originate hundreds of millions worth of "C&I" loans, brokered through a network of boiler rooms, that have flooded the courts with defaults and led to the bankruptcies of small business owners across the country. This activity, of course, invites regulatory scrutiny which appears to have manifested in sweeping new proposed FDIC guidance that has major implications for BOFI.
At current market prices, investors are dancing as if "the music" of BOFI's profit fueling loan origination engines will continue forever. Mounting evidence, however, indicates that regulators, principally the FDIC, appear increasingly likely to bring this party to a sudden halt.
(Note: All information for this article was derived from publicly available information. The author has had no contact of any kind with either of the bank's whistleblowers or their attorneys.)
BOFI Is Now Warning Investors That Regulatory Sanctions Have Become A Material Risk.
In its 10-K filing, BOFI added a lengthy and completely new body of text warning investors of potential regulatory penalties and business restrictions. By definition, BOFI included this text because it now considers these items material risks that are legally required to be disclosed:
Source: Factset's indispensible BlackLine Report. Green Text indicates new content.
BOFI, for example, is now warning investors of "changes in the interpretation" of statutes or new laws that could "substantially restrict growth", restrict the "ability to originate or sell loans", and restrict "the amount of interest or other charges or fees earned on loans". Burying the most ominous new language in the end of the paragraph, BOFI is now warning of risks from potential "sanctions by regulatory agencies" or "civil money penalties" which could have a "material and adverse effect on our business...and the value of our common stock".
Importantly, because the above risks weren't included in last year's filing, these factors must have only recently become material. So, what changed in just the last twelve months that now make the risks of potential regulatory sanctions so material?
I believe the answer lies in BOFI's prominence as a major financier of risky non-bank lenders and the recent entrance of the FDIC into the growing assembly of regulators scrutinizing third party banking partnerships.
The FDIC's Sweeping New Proposed Guidance
On August 21, the Wall Street Journal reported that the FDIC is scrutinizing the third party partnerships of banks and has proposed sweeping new regulatory guidance related to these activities. The overarching theme of the FDIC's proposed guidance is that bank partnerships with third parties will be evaluated by the FDIC "as though the activities were performed by the institution itself":
The entire premise of BOFI's lender finance strategy, in my opinion, rests on BOFI earning outsized yields and fees from partnering with third party lenders, in a broad variety of categories, that the majority of other banks have simply been unwilling to touch. BOFI's bulls defend this strategy as occupying a "niche" and have asserted that the bank is removed from both the activities of the lenders BOFI finances and the loans BOFI originates and sells prior to default.
I believe the proposed FDIC guidance, if adopted, would completely undercut BOFI's lender finance business as it presently exists because BOFI would become responsible for the activities of its numerous non-bank partners. In my opinion, this has several major implications:
1) There is a high risk that BOFI's activities are violating regulatory safety and soundness principles.
The FDIC's proposed guidance states that "credit risk should not be disregarded if loans are sold" and that third party agreements "do not insulate the institution from its ultimate responsibility to conduct lending activities in a safe and sound manner". This language directly applies to BOFI's ongoing origination and sale of hundreds of millions worth of profit fueling "C&I" loans that public records tie to at least four primary undisclosed partnerships in this arena:
- Quick Bridge Funding
- National Funding (which reportedly has the same ownership as Quick Bridge)
- Small Business Term Loans ("SBTL") also known as BFS.
- OnDeck (NYSE:ONDK) (The contract of which has not been renewed.)
While the bad loans originated with both Quick Bridge and OnDeck have been examined at length in previous articles, the BOFI-originated loans from all four of these partnerships appear to share common characteristics: suspect underwriting and documentation, enormous interest rates and penalties, and defaults that often occur within weeks or even days of origination. My review of the defaulted loans associated with National Funding and SBTL indicates that they appear to be equally bad as the Quick Bridge and OnDeck varietals. National Funding, for example, is not even able to locate some borrowers:
Source: Case No. BC612380 Los Angeles Superior Court- Central District
It is indisputable that these loans have defaulted at high rates and resulted in ruinous bankruptcies of hard working (and oftentimes minority) small business owners across the country. With the FDIC making clear that BOFI's responsibilities extend to these loans, I believe it is self evident that the bank is at a high risk of violating safety and soundness principles.
2) BOFI may have massive potential liability for the activities of the boiler rooms and brokers referring the loans it originates.
Bloomberg News has already reported in detail on the criminal loan brokers and boiler rooms that have helped feed OnDeck's loan referral engine. BOFI's partnership with Quick Bridge and SBTL also relies on brokers and the FDIC's proposed guidance specifically calls out that:
"agents or employees of third-party lenders may misrepresent information about the loans or increase credit risk by failing to adhere to established underwriting guidelines".
I believe BOFI could be exposed to massive potential liability in this regard because an increasing number of defaulted borrowers are reporting that they were the victim of deceptive practices of unscrupulous loan brokers that "closed" the loan for BOFI. For example, a small business owner who defaulted on a BOFI-originated loan with SBTL, argued earlier this year that he had been deceived by a fast talking broker named "Tony". In court filings, the small business owner describes how he was cold called and offered "fast cash" and persuaded to agree to an egregious loan he didn't understand:
Source: Case: 5:16-cv-00022-FL
The facts of this loan resemble many others and there is increasing evidence that, in turn, this activity has caught the attention of regulators. State regulators, such as Illinois, have begun specifically targeting predatory small business loans and Bloomberg reports that the CFPB has now turned its attention to small business lending practices (perhaps helping explain the new CFPB risks BOFI described in its 10-K filing).
This has led to significantly increased "chatter" regarding serious regulatory investigations on an industry website (Daily Funder) that is frequented by loan brokers. One Senior Member is now reporting that a long-term federal investigation has "already pinned down top fraudsters" and that "arrests and indictments may be imminent":
When questioned, the member ties brokers to banned former subprime mortgage lenders and explains that "you can literally be in prison one day and start an ISO [loan brokerage] the next".
While it's impossible to know if BOFI affiliated brokers will be ensnared in any government action, I believe that the massive fees being paid to loan brokers (reminiscent of the subprime-era) for BOFI-originated loans increases the probability that nefarious or illegal activity has already occurred. A schedule that was filed as part of litigation of an east coast broker against National Funding and Quick Bridge, illustrates the enormous compensation at stake:
Source: Case No. 30-2016-00829489 Orange County Superior Court
With up to 15 points being paid to the referring brokers, these dealings would appear to violate California's prohibition on lenders paying referral fees. However BOFI, as a national bank that is the actual loan originator, may not be subject to the state law. By extension, this calls into question if BOFI is also helping its non-bank partners circumvent state laws that would otherwise prohibit the loans from being made? At minimum, investors should expect that regulators will scrutinize BOFI's liability (if any) for the behavior of the brokers that continue to feed its origination engines.
3) BOFI's non-bank partners appear subject to FDIC examination.
The FDIC's proposed guidance specifically states that "examiners will conduct targeted examinations of significant third-party lending arrangements and may also conduct targeted examinations of other third parties where authorized". This could be extremely bad for BOFI because, in my interpretation, the FDIC will likely be inspecting the non-bank third parties that BOFI finances. In addition to small business loans, BOFI has financed high risk outfits in categories such as tax liens, trust deeds, "hard money" and "fix and flip" loans, leveraged bridge loans*, as well as various private equity and hedge fund vehicles.
This means that, for example, the FDIC could decide to examine a BOFI-funded outfit that has solicited investors via "guaranteed returns on money invested" through agents that report finding investors over the internet:
I note that public records reveal that BOFI has also financed a lender accused of "enabling and assisting" a recently collapsed Ponzi-scheme as well as a lender that regulators have previously sanctioned for a failed house flipping scheme. As a result, I am convinced that this exercise is likely to produce significant regulatory discoveries.
*I have identified BOFI's numerous lending partnerships through easy and inexpensive public state UCC filing records.
Are The BOFI-Originated Loans Even Legally Valid?
While regulatory pressures challenge the ongoing viability of BOFI's lender finance activities, my review of court records indicates that an increasing number of borrowers are now contesting the legal validity of their BOFI-originated small business loans. I believe this explains why BOFI's 10-K now reports that the bank is subject to "claims involving the origination and servicing of loans":
Source: Factset's BlackLine Report.
As a representative example, a Massachusetts borrower who defaulted on a BOFI-originated loan, recently argued they were the victim of "unfair and deceptive practices" and specifically alleged that BOFI "was no more than a conduit for the purpose of avoiding the Massachusetts Usury State Statute":
Source: Civil Action No. 1:16-cv-10454-DLC
While the vast majority of these legal challenges appear to have either settled or been halted by bankruptcy, a California judge recently ruled against National Funding's attempts to seize collateral from a local dentist on a BOFI-originated loan:
Source: Case No. 30-2016-00856464-CU-BC-CJC Superior Court Of California
This ruling, which cites discrepancies in the documentation of the loan, may have broader implications for the legal validity of the thousands of other loans that BOFI has originated. This introduces serious questions, including:
- Does BOFI have liability if the courts determine the loans it originated are legally invalid?
- Could a subprime-era style class action suit against BOFI develop for deceptive and/or predatory origination practices?
In addition, the judge's above ruling seems to imply that BOFI may be the actual economic holder of this loan. This finding would be consistent with changes other lenders have made in response to the recent Madden v Midland decision (background here) which also threatens the legal viability of these "rent a charter" arrangements. Lending Club (NYSE:LC), for example, restructured its contract with its originating bank, WebBank, so that WebBank now maintains an economic interest in the loans.
A switch to this model would have significant implications because BOFI is believed to have previously sold the majority of these loans to others (including SPEs it finances). Considering that BOFI originated over $700 million in C&I loans last year alone, being forced to "eat its own cooking" would likely result in a massive increase in loss provisions. In fact, in light of the above cited National Funding case, I question if BOFI has perhaps actually already followed WebBank in taking an increased economic interest?
Investors are encouraged to conduct their own due diligence into these factors
BOFI's 10-K filing is being widely touted as a de-facto "all clear signal" when, in fact, the bank issued new warnings to investors of the material risks of potential regulatory sanctions. The FDIC has followed a growing collection of regulators by issuing sweeping new proposed guidance that, if adopted, would likely have major implications for BOFI. Meanwhile, mounting legal challenges threaten the legal validity of the hundreds of millions of bad small business loans that BOFI has already originated which potentially exposes the bank to liabilities stemming from the deceptive practices of the affiliated loan brokers.
The parallels of the current small business loan epoch to the subprime era, in which originators and dubious brokers earned outsized profits for originating bad loans they sold to others, are striking. With mounting defaults and increasing regulatory scrutiny, the music is (temporarily) still playing. The question then, as it increasingly is now, is who is holding the bag when it all implodes? In the meantime:
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.
Additional disclosure: I am/we are short BOFI. All information for this article was derived from publicly available information. Investors are encouraged to conduct their own due diligence into these factors. Additional disclosure: This article represents the opinion of the author as of the date of this article. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article represents the opinion of the author as of the date of this article. This article contains certain "forward-looking statements," which may be identified by the use of such words as "believe," "expect," "anticipate," "should," "planned," "estimated," "potential," "outlook," "forecast," "plan" and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this article and undertakes no duty to update its contents. The author may also cover his/her short position at any point in time without providing notice. The author encourages all readers to do their own due diligence.