BOFI Rally Set To Unwind: Fundamentals Point To Material Headwinds Out Of Trump Election

Summary

• In our conversations, investors attribute two themes to the recent surge in BOFI: a) higher rates, and b) less regulatory scrutiny…in this note, we show both theories are dead wrong.
• The idea that BOFI will benefit from higher rates is the financial markets equivalent of the idea that Superman would benefit from more kryptonite.
• Regulatory interest into fraud allegations (established in pending litigation), do not magically disappear due to Trump’s ascension – unless you believe the rule of law no longer holds.
• No upside to BOFI from looser regulations: it already operates on the “edge”– yet market acting as if BOFI’s primary bank examiner is transitioning from Elizabeth Warren to Angelo Mozilo!
• While BOFI’s CEO has vehemently attacked short sellers, he has still yet to come out publicly and outright deny ongoing SEC Enforcement interest into his affairs, rendering BOFI un-investible.

This article covers two important and fundamental topics relating to BOFI.

BOFI shares have rallied ~30% since Trump's election, in our view due to investors mistakenly assuming that BOFI is "similar to other banks". We think this trade is likely to not only fully reverse as BOFI fundametals prove otherwise, but to ultimately result in materially negative headwinds for BOFI that punish both the company's bottom line and investors who have bought into the "BOFI is a normal bank" narrative.

The two main factors that have driven bank shares, including BOFI, are: expectation for lower regulations, and higher rate expectations.

On the former, any upside in BOFI due to looser regulations is farcical given that BOFI has already been operating as an essentially unregulated and gun-slingin' cowboy.

On the latter, we expect BofI Holding (BOFI) to not only not get any help from rising rates, but to actually get smoked by them. While it makes sense for most banks that largely fund themselves through low rate checking accounts to be bid up, BOFI is categorically and unambiguously NEGATIVELY impacted by rates, as we show in this article.

#1: How to Interpret Loosening Regulatory Environment?

In our view, BOFI has already been operating as if it was unregulated for the past seven years. The bank has (had?) a felon running its lending business, has made countless loans to people with awful credit and criminal backgrounds, made a loan to a pedophile who set up shop across the street from a school, continues to gamble on money laundering rules with aggressive loans to foreign nationals and shady LLCs, regularly rents out its charter to suspect off balance sheet boiler room operations, and has already dabbled in every predatory business line out there - i.e. structured settlements, small business pay day loans, tax refund loans (HRB) etc.

Operating as a heavily regulated entity? Yeah right!

The market is currently trading BOFI as if Elizabeth Warren was previously assigned as BOFI's chief bank examiner and is now being replaced by Angelo Mozillo.

If ANYTHING, laxer regulations on larger banks is a MATERIAL negative for BOFI. Suddenly the "niches" that BOFI alone had the guts to play in will be open season for any bank to touch.

And BOFI was already exempt from stress testing and is under $10B in assets - so it has already been incredibly lightly regulated relative to the banks that will actually benefit from any potential regulatory changes (no interchange issues, no stress test issues, etc.). This is NOT Zion. This is NOT Citizens. Loosened regulations are in fact a negative for BOFI due to the relative shift in regulation, with larger competitors now likely to face less regulation than in the past.

Some investors may also be concerned that allegations that have already been made against BOFI - and that are being actively litigated in a whistleblower lawsuit and securities fraud lawsuit against the company - may now somehow be "brushed under the rug" due to Trump's ascension. Investors now anticipate that Trump administration will provide more lax regulatory oversight going forward, particularly for big banks.

Somehow this narrative has morphed into some investors believing that under Trump, the SEC is going to turn a blind eye to claims of fraud (i.e. the "Make Fraud Great Again" narrative has made the rounds on Wall Street). We seriously doubt this claim. In fact, experts already pointed out bi-partisan support for whistleblower protections that currently exist under Dodd-Frank, suggesting these provisions are unlikely to be rolled back. As a reminder, BOFI has been accused by former employees of DOCTORING bank examination reports - a claim that if ultimately proven true could result in criminal charges. While these claims remain unproven, it is hard for us to believe that if they were true, the SEC and bank regulators would suddenly turn a blind eye to them just because of Trump's victory.

We actually think that interest in white collar prosecutions broadly may actually increase in under a Trump administration. In fact, Gretchen Morgenson at the Times recently went as far as claiming that letting crooked bankers off the hook may have tipped the election. Perp walks cater well to the populist political environment we live in.

Furthermore, according to the WSJ, Paul Atkins, advisor to Trump on securities matters and former SEC commissioner, is an outspoken critic on large civil fines. Per the article below, he appears to prefer "holding individuals accountable" which in our view suggests there is a higher likelihood of white collar prosecutions in lieu of fines going forward:

Source: WSJ

Taking a step back, and assuming rule of law remains intact under the new Trump SEC, then we look to the other burning question on investor minds - how do interest rates impact BOFI?

#2: The interest rate impact - materially negative:

Rapidly rising rates have introduced a new material risk for BOFI -deposit flight.

For years, short sellers have cried wolf about BOFI's interest rate problems. Back in 2014 it served as the basis for a negative piece from Kerrisdale regarding BOFI. Many viewed short sellers claims as premature given BOFI has continued to chug along fine. But that is because interest rates - until Trump's ascension - never showed any credible sign of going higher.

We need to take a step back and remember how BOFI became the "earnings juggernaut" it is today. Mr. Garrabrants very astutely took advantage of extremely low interest rates in U.S. to build a deposit franchise over the past few years. As rates fell, BOFI capitalized on its bank charter to attract deposits under an FDIC-backed structure. When other banks cut deposit rates to zero, BOFI leaned forward, offering higher rates in order to attract deposits. And depositors came - particularly 1031 exchange operators that play a "heads I win, tails you lose" game of getting to keep the margin they earn on client deposits.

But alas, here we are at what many believe will be the first sustained tightening cycle since the mid-2000s.

So what has changed? BOFI's net interest margin has gone from the mid-1% range all the way to ~4% since 2008, largely in our view as a result of two factors - 1) taking outsized and stupid risks on the asset side, and more pertinently, 2) betting the farm on rates remaining low indefinitely.

In fact, one could argue that BOFI's entire business model is predicated on low rates - as low rates have allowed BOFI to build a deposit franchise by attracting depositors that would have otherwise parked money with a bricks and mortar bank with a real deposit franchise.

Low rates attracted yield chasers. FDIC-backing gave BOFI deposits a sense of comfort and attracted depositors such as 1031 exchanges.

Look no farther than BOFI's own 10-K risk factor disclosures, where interest rate risk is identified as the first risk to the business. The ordering of risk factors are not by chance - lawyers set these risk factors up based on materiality. Furthermore, BOFI itself acknowledges that a large and relatively rapid increase in market interest rates (THIS JUST HAPPENED) is a material negative for its business:

Source: BOFI 10-K FY16

Given our fundamental distrust of BOFI SEC filings and investor relation presentations (that include terms such as "business checking accounts" - i.e. nonsensical terms we believe BOFI uses to mask the truth about its deposit franchise), we went through BOFI's call reports to understand when BOFI's assets and liabilities reset in terms of pricing.

Why does this matter?

As a bank, BOFI must manage its duration risk. It has a pile of deposits that it uses to fund a pile of assets (in this case, the loans it makes). It is important for banks such as BOFI to keep the duration of the liabilities roughly matched with the duration of assets.

So we compiled below a tabulation of the duration statistics that BOFI reports in its call report as of the most its F1Q17 call report filing:

Source: FFIEC call report data, BOFI SEC filings, Friendly Bear estimates

And see the bank's cumulative gap below based on our calculations - i.e. the cumulative mismatch between liabilities and assets in pictures (NEGATIVE numbers mean higher rates eat into earnings, POSITIVE numbers mean higher rates boost earnings):

Source: Friendly Bear analysis and BOFI FFIEC call reports

Here is how to read the tables above.

To arrive at the current yields we did a bit of detective work as well as talked to mortgage brokers in the market. We believe that BOFI's average yields on its mortgage book are around 4.75% - speaking to the high risk borrowers BOFI underwrites. BOFI provides yields for its overall loan book and for its securities book and for various deposit accounts above in its SEC filings (so the only place we took a guess was on the split between the rate on the 1-4 Fam resi book and all other loans, however we feel very good about our guess).

According to BOFI's call report, in the next year, BOFI has just over $1 billion of assets repricing - meaning, these loans will come due, and will either be refinanced or rolled over. As has been well established on Seeking Alpha, BOFI lends to "outside the box individuals" who opt to pay higher rates to BOFI because they facesome issue that precludes them from the traditional banking market. BOFI therefore faces an adverse selection refinancing risk as a result of higher rates. Its borrowers that are more credit worthy today may take advantage of still relatively low rates and refinance their mortgages with other banks, leaving BOFI saddled with only its less credit-worthy borrowers still in the book. BOFI itself acknowledged that pre-payments spiked this most recent quarter.

On the liability side, BOFI has a staggering amount of money market and demand deposit priced accounts that are essentially recallable at any period in time based on our analysis. In other words, BOFI is offering depositors 72 basis points on average for their deposits. Those deposits can be pulled at any time. So essentially all of BOFI's deposits can be immediately pulled should borrowers find more attractive rate propositions elsewhere.

And what is going on in the market right now?

Source: Bankrate.com pulled on 11/15/16

Rates are moving up on BOFI, and they are moving up very quickly.

You can see that even a tiny move in fed funds had a pronounced impact on BOFI's fundamentals. The fed hiked 25bps in mid-December 2015. Since then BOFI's deposit costs have risen 10bps. We think this move may also include some benefit from the HRB deal, the pass through may be even more. In the same time period, BOFI lost 16bps of margin on its loan book. Wells Fargo, on the other hand, saw essentially a negligible increase in its cost of funding driving home one simple point:

BOFI is not a regular bank. It is going to get smoked now that rates have risen. The violent increase in rates is particularly negative for BOFI.

So the rate hike is VERY bad news for BOFI. While BOFI is unlikely to see resets on its loan for a very long period of time - with its loan book not repricing on average until 3-5 years from now, it could see an immediate repricing in its deposit base which means an immediate hit to net interest margins today. It could also see far lower mortgage fee income which has been driving low quality beats recently due to less refinancing activity. It may also see refinancings away from BOFI as its best borrowers try to lock in low rates while they last - a material growth headwind that already hit in the most recent quarter.

So what does the impact of rates rising practically look like? We modeled it:

Source: Friendly Bear analysis (this table should be read in conjunction the asset/liability mismatch table above).

If the deposit rate were to hypothetically move up by 125bps (so to 150bps by next year, in-line with the range thrown out by many economists in recent days), we assume that BOFI will pass through all of that rate hike to deposit customers. We believe it would need to pass the full amount through given the taint around BOFI, its lack of branches, and our belief that it has massively underinvested in its technology capabilities for years in order to keep its efficiency ratio depressed). So rising rates are materially negative for BOFI and could result in almost $1 of lost EPS on our numbers - a huge hit to earnings - even assuming a lower tax rate than where BOFI currently sits.

This of course assumes that BOFI can even hold its house of cards deposit structure together as rates rise. 1031 exchanges and brokered deposits are not exactly the right way to build a deposit franchise and are likely to become huge issues if rates do in fact continue to rise rapidly.

If BOFI's ongoing litigation results in a negative economic outcome, or the company's purported regular and "ongoing discussions with regulators" eventually results in fines or worse, then the bank will face massive deposit flight on top of NIM pressure as depositors begin to look for alternative sources of yield in an environment where yield is yet again available.

And of course, as we previously mentioned, we think the more stable credit borrowers in BOFI's book are likely to refinance their loans due to the threat of rising rates. Sitting in an average 5/1 ARM rate of 4.75% while 30 year fixed rates are sub-4%, we think that credit-worthy borrowers are likely to move away from BOFI. This is a material headwind to growth. Will BOFI really be able to find borrowers who will be able to afford to pay 6% for 5/1 ARMs (assuming a parallel 1.25% uptick in BOFI rates) while maintaining its purportedly "disciplined" credit quality? We doubt it. As should you.

Extra Credit: Other Trump Issue Worth Mentioning - Taxes

Corporate federal taxes are likely to go down under the Republican-led administration. We have heard from sources in the tax community that investors now expect 20-25% tax rates. Let's assume the tax rate moves to 25%.

Investors need to keep in mind that California taxes represent a huge chunk of BOFI's tax base and are not going to move. So it is not as if BOFI is suddenly going to go from a 42% tax rate to a 15% tax rate. We doubt it. We could see BOFI taxes moving from the 42% range to the 30% range.

Source: BOFI 10-K

We also wonder whether the business will have income left to shield by the time the tax rates move?

Conclusion

So are lax regulations good for BOFI? No. They unequivocally are not.

Are higher rates good for BOFI? No. They unequivocally are not.

Are investors who have bought into BOFI shares thinking it is "similar to other banks" dead wrong. We think so.

We therefore offer a simple warning:

Make sure you know what you own.

Good luck to all.

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.