Note from the future (Sept 2020): This post was originally published in TechCrunch on April 1, 2016 and caused quite a ruckus. Shortly after publishing, I joined some of the smartest people I’ve ever met to build a direct to consumer mortgage lender from the ground up at Clara Lending.
In an ironic twist of fate, ~18 months later we were acquired by SoFi. During the two and a half years I spent at SoFi this article was the gift that kept on giving. It caused headaches while negotiating my employment agreement, inspired some exciting conversations with regulators, and became the number one source of questions during recruiting conversation. And now I own a bunch of SoFi stock, go figure.
I’m going to start by saying I’m actually a huge fan of SoFi. I think they have a great product, they’ve built an incredible business and their growth in a regulated and complex industry is impressive.
And I say this even though I’ve had my student loan refinance denied by them — they still provide a great experience.
However, some recent strategic choices at the company give me cause to worry.
There are three things that, individually, seem innocent enough. But when considered together, I think SoFi is at a tipping point, and, if managed incorrectly, it could create a chain reaction that will seriously hurt the company and the fintech market at large.
Recent marketing campaigns are exclusive
SoFi’s recent “Don’t Bank” campaigns are provocative. Especially when you consider the fact that the millennial generation watched the housing collapse from the sidelines, it makes sense that SoFi would want to distance themselves from the old-money banks and mortgage lenders in the market.
However, their ad campaigns are borderline exclusive. Not the cool “the new iPhone just launched and the line is long” type of exclusive. More like the mean girls’ “you can’t sit with us” type of exclusive.
Sure, the company takes great care of its customers, who they call “members.” Members receive perks, like investor introductions for entrepreneurs or career planning services — which are totally awesome benefits, but only if they accept you into this exclusive club.
It’s this exclusivity that’s a problem. Watching one of their video ads, one line in particular struck me: “We can’t accept everyone, and we make no apology for that.”
“We hope that by getting a little education they can be great in the future.” I’m sure the spot was well-intentioned, but the underlying tone is, “We aren’t for everyone.” When you’re a financial services company that’s growing toward a $30-billion valuation, that’s a problem — especially if you offer mortgages.
You don’t have to read the Equal Credit Opportunity Act to know that this probably isn’t a great stance to take as a company. Marketing to a certain group is one thing — discouraging people before they apply is another.
SoFi has a history of targeting the high-end customer. Starting as a student loan refinance lender, they focused on customers with degrees in specific fields or from certain schools.
You need consistent access to money if you want to lend money to others.
Imagine what would happen if Wells Fargo or Bank of America came out and said “We can’t accept everyone, and we make no apology for that.” What if these other major institutions only targeted the top end of the market? The Internet would explode and stock prices would tumble.
In a way, SoFi’s “Don’t Bank” campaign feels like a small- scale version of redlining. They get away with it because they are a fresh, innovative disruptor — but this only buys them so much runway.
The campaign opens the possibility for increased regulatory attention from groups like the CFPB (Consumer Financial Protection Bureau). You can be sure Quicken Loans’ disastrous super bowl ad caught the attention of the regulators, and I’m afraid the current SoFi campaign will do the same.
Nice Save Quicken.
Newly established hedge fund tips their hand to the real customer
The “Don’t Bank” campaign alone isn’t overly troublesome. But consider the fact that SoFi recently created their own hedge fund to buy the loans they originate. There is even talk of SoFi starting their own REIT, which they could use to buy the mortgages they write, as well.
I understand their thinking in creating these funds: You need consistent access to money if you want to lend money to others; that money has to come from somewhere.
When SoFi started, they tapped a marketplace investor network that encouraged alumni to help recent grads from their alma mater. Helping grads refinance their student loan debt was almost an act of school spirit.
SoFi needed access to cash to continue lending money.
From there, demand outpaced their available capital, so they turned to venture and debt financing. According to CrunchBase, SoFi has raised $301 million in debt financing in addition to $1.37 billion in venture capital. This includes a $1 billion Series E completed in September of 2015, firmly planting SoFi in the unicorn club.
With an IPO likely being delayed, and business booming, SoFi needed access to cash to continue lending money.
This hedge fund creates a new dynamic — their debt products must satisfy hedge fund investor demands. If they have to focus on their risk/return profile, there is a good chance they will have to be selective about to whom they lend money.
This creates an interesting situation and a potential conflict of interest. Maybe the investor was their true customer all along? What if the borrower was just a means to an end? It also leads me to question a potentially bigger issue.
Problems scaling the business
There is a large market for personal and student loans — but the holy grail for online lenders is mortgages. They come with higher loan balances, consistent cash flow and larger fees — plus, they are asset-backed.
SoFi has not been shy about wanting to own the mortgage lending space. The problem is that mortgages have a much higher balance than student loans or personal loans, and SoFi is already outpacing its financial capacity.
Fairy tale…or nightmare?
Traditionally, mortgage companies bundle up their loans and sell them to a third party. These loans must meet certain criteria, which is determined by regulators like Fannie Mae, Freddie Mac or the FHA. Loans that meet the criteria are guaranteed by the government, which makes investors comfortable and creates a liquid market. This process is called securitization.
SoFi regularly securitizes student loans. Mortgages are a different beast entirely because they are asset-backed.
To me, it seems that starting a fund to buy their loans is an alternative to securitizing and selling the loans through existing mortgage investor channels.
If the company cannot nail the mortgage securitization process, they will never be able to leverage revolving credit and will constantly need to raise money to grow. If SoFi can’t get these loans off their balance sheet, they will eventually hit a wall.
What happens going forward?
When you consider these three recent developments together, there are two stories you can tell.
The story of the innovator: SoFi wants to work with everyone, and they want to be different than the old-money banks, so they’ve created a member services component to their product. Their product fills a valuable gap in the market, and their explosive growth requires more and more capital.
They find the mortgage securitization process, so they’ve created an innovative way to access capital that eliminates costs and complexity. Eventually, when the time is right, they’ll IPO and be on the path to gain even more market share and grow into other services, like checking accounts.
But there’s another story that can be told here, a cautionary tale: SoFi targets the top end of the market, which is lucrative, and discourages all others to apply. Their explosive growth has tapped their capital resources, and they haven’t perfected the process of securitizing loans or using revolving credit.
Cash-constrained and without a favorable IPO window, they double down on exclusive customer practices. These marketing efforts, in addition to some consumer complaints, attract the attention of the CFPB, which takes action against the company. After regulators discover issues in any number of business areas, SoFi is subjected to hundreds of millions in fines and customer refunds.
If SoFi goes down the fairy tale path, everyone wins — and it lays the groundwork for other innovative fintech companies like it. But if their growth story turns into a nightmare, it could be a huge setback for the entire industry.