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BOFI: Will The FDIC Stop The Music?

Summary

BOFI's recent 10-K filing has been promoted as being a de-facto "all clear" siren and shares have surged.

Closer examination reveals that BOFI's 10-K actually issued an entirely new warning to investors concerning the risks of "material and adverse" consequences from potential regulatory sanctions and business restrictions.

The FDIC recently issued sweeping new proposed guidance that is likely to have enormous implications for BOFI's profit-fueling partnerships and financing of non-bank operators.

Court rulings call into question the legal validity of the hundreds of millions worth of bad BOFI-originated "C&I" loans while introducing potential liabilities related to the tactics of the loan-brokers.

"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 The Internet (NASDAQ: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 now 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...


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