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December 14, 2016

#Fintech: SoFi + HENRYs

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SoFi is a #fintech platform specializing in student loan refinancing and personal loans. Thanks to a unique strategy and a membership model, they have raised more than $1B in equity capital and made more than $10B worth of loans in the US.  While the company is not without its own set of potential problems down the road (ie. Wall-Street securitized student loans), their success up to this point can act as a beacon for anyone who believes that the days of relationship-banking are behind us.

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As of earlier this year, fewer than 15 of SoFi’s 100,000 clients have defaulted on their loans, and half of those were because the borrower died. Unlike other institutions that try to extend credit to the masses, SoFi has created a membership model where they lend to the top end of the market, such as HENRYs and MBA students.

Their model started innocently enough, making loans to ‘surefire credits’ ONLY, students at the Stanford Graduate School of Business. After witnessing the chaos of the ’08 financial crisis, CEO Mike Cagney decided that student loans were a good place to start:

“Student loans were interesting: $1.3 trillion market, 65% of business-school students borrow, paying at the time 6.8%-7.9% with a cost of capital of 4.5% as long as you could manage the risk.” The Uberization of Banking

He got a lending license and found a group of 100 students to loan $20,000, pocketing the difference on the spread between the cost of borrowing (5%) and the interest rate paid by the students (6.25%). He began to realize that, beneath the surface, there lay a model for finding good credits:

“Instead of relying on notoriously inaccurate backward-looking FICO scores, SoFi is “forward-looking.”The Uberization of Banking

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+ SoFi

The company has done 150,000 loans totaling $10 billion and is currently at a $1 Billion monthly loan-origination rate. They have expanded beyond student loans into mortgages, personal loans and wealth management. Because SoFi doesn’t take deposits, it is not regulated by the FDIC; however, this requires the company to continually raise large amounts of capital and securitize their loans. Earlier this year they started their own hedge fund – the SoFi Credit Opportunities Fund – and raised $15 Million in capital with a 25/3 management fee.

What is a HENRY?

A HENRY is a  “high-earning, not yet rich millennial.”

“HENRYs are still young—between 25 and 34—and are still moving up the career ladder. They represent the top 20 percent of households in terms of income, earning anywhere between $100,000 and $250,000 a year. Because they earn more than the middle class, HENRYs have more spending power and could afford more expensive purchases.” Vision Critical – HENRYS

According to Vision Critical, this demographic is important for brands at all levels of the pricing spectrum:

“HENRYs are the next mass-market for brands both up and down the pricing spectrum,” marketing expert Pam Danziger tells Luxury Daily. “The fact that the middle-class has lost so much spending power, the importance of HENRYs to mass brands is growing by leaps and bounds.” Vision Critical – HENRYS

And they are not limited by geography, this is a global generation that is up and coming in markets North and South:

“The phenomenon of HENRYs isn’t just a Western thing. In fact, emerging markets like China are seeing more and more people becoming HENRYs.” Vision Critical – HENRYS

From SoFi’s perspective, the HENRY’s are invaluable because they give lenders the lowest risk and the highest reward as a segment in their consumer loans portfolio:

“While defaults on consumer loans are rising across the marketplace lending industry, SoFi’s funders have the benefit of holding paper backed by top-tier borrowers.” Fin Revolutionist

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SoFi has been criticized for this ‘exclusive strategy,’ which could cause regulatory problems in the future:

“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. 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.” How SoFi can ruin Fintech for Everyone

And while we can’t comment on what will happen next to SoFi given the challenges of their model and potential regulatory hurdles should the Consumer Protection Bureau (headed by Elizabeth Warren) decide to intervene, it’s clear that they have found a valuable niche in the market and unlocked insights that will inevitably lead to complete disruption of the banking business model as we know it today.

Why Banks are Vulnerable …

Banks cater to the middle of the pack ‘near prime, consolidate-your-debt-kind-of-customer’ which Mr Cagney has said is ‘not for me.’ The problem is that they don’t do it well:

“This is why banks are so vulnerable. “People can copy our underwriting model,” he says. “This is about recategorizing what the business is. It’s not transactional banking. It’s all about money, career and relationship.” The Uberization of Banking

Across the spectrum, the younger generation is waking up to the reality that the big banks have done nothing for them other than try and push new products down their throats with a nice bow on top.   The problem all along has been that there have been no alternatives.  With SoFi, there is a clear move to a more relationship-driven way of banking where the long-term health of the customer is taken into consideration:

“We do things like career resources, help you with your résumé. We’ve gotten people new jobs over 170 times now.”The Uberization of Banking

And this is why banks are vulnerable.  SoFi’s business model may get derailed in the future as they try to scale to the size of the big boys:

“SoFi would need to go from $10 billion in consumer loans to $100 billion if it’s going to take on the big banks the way Amazon ate into retail and Uber into taxis. Skeptics say that’s unlikely, especially when the economic cycle hits a downturn—banks are safer because depositors stick around and are happy to under-earn in exchange for free checking and ATMs.” The Uberization of Banking

But they have proven something important. That relationships matter and focusing on the individual’s needs and their future pathway, instead of segmented statistics and transaction volume, will create lower default rates and a loyal customer base. Their strategy to dominate a niche has clearly proven successful and it’s unclear whether they will be able to scale into the mainstream and avoid the challenges that other financial institutions face in relation to liquidity, security and regulation. Maybe if more financial institutions looked after customers as ‘members,’ we could reestablish trust, confidence and relationship-based business models to the financial sector.