SoFi: The End Of The Student Loan Moratorium

I previously discussed student loans last year when the moratorium was expected to end on December 31, 2022. This article updates that analysis.

SoFi (NASDAQ:SOFI) was founded in 2011 on the mission to provide more affordable options for students who were taking on debt to fund their education. Student loans were their first product, and the company became synonymous with the student loan refinance business (just ask Bernie Sanders and Elizabeth Warren). They also provide in-school loans, but refinancing existing loans has made up the bulk of student loan originations since the company was founded. After Anthony Noto came on as CEO in 2018, SoFi began to significantly expand its offerings. In 2019, the company launched SoFi Money (now Checking & Savings), Invest, Relay, and Home Loans (a relaunch of their previous mortgage business) to supplement their core student loan and personal loan business.

The deal to increase the debt ceiling has codified into law that student loan payments will resume in September and there are a lot of questions of what that means for SoFi. I'm going to do my best to answer them. First, I'm going to go through the history of SoFi's student loan business to give this article the proper context. Next, I'll discuss the implications of forgiveness, income-driven repayment (IDR), and the fed funds rate on student loan refinancing. Finally, we'll look at how it will affect SoFi's top and bottom lines. Feel free to skip to the juicy part at the end if you don't care about the rest of it, but I think it provides really useful context for the analysis that follows.

From Hero to Zero

Throughout all the new product rollouts, student loans remained SoFi's hero product. In 2018, 99.5% of SoFi's revenue came from lending, with student loans comprising 55.6% of their originations. In 2019, lending was still 98.9% of their revenue, and student loans had grown to 59.7% of originations. We don't have detailed quarterly data from before 2019, but if you look at the data available, the trend is clear. Student loans were becoming an increasingly large piece of the SoFi lending pie, and therefore an increasingly large piece of SoFi's revenue.

By the end of 2019, the lending business was firing on all cylinders and student loans were leading the way, representing 68.2% of all originations in 4Q19 and growing at a very fast pace. Then COVID-19 hit and the CARES Act paused all federal student loan payments and set interest rates to 0% effective March 13, 2020. This moratorium on payments and interest has been extended ever since, and federal student loan borrowers have not been required to make payments for over three years. The student loan refinance business decreased to $2.1B in originations in 1Q20 and predictably fell off a cliff thereafter. Turns out it's really hard to compete with free.

What SoFi pulled off by pivoting has been nothing short of incredible

Remember, 99% of revenue in 2019 was from lending and 68% of originations were student loans in 4Q19. Imagine any other business with a product that represents ~65% of its revenue getting cut down 60% due to an emergency act of Congress, sitting there for two full years, and then getting cut in half from that depressed level for the next year and a half because people were convinced payments were never coming back. This is the equivalent of Apple (AAPL) losing 75% of their iPhone sales since March 2020 and then 100% of iPhone sales from March 2022 through today. What do you think Apple's revenue and profits would have done?

Some other comparable revenue drops would be Nike (NKE) losing 60% and then 80% of their shoe revenue, Starbucks selling 63% and then 85% less coffee, Tesla (TSLA) selling 46% and then 61% less cars, or Disney (DIS) losing 100% of their Parks, Experiences and Products revenue for 3.5 years, and then another 18% of their total revenue from other sources for the last 1.5 years of that. People say Disney was hard done by the pandemic, but it doesn't hold a candle to what happened to SoFi. How did SoFi fare over that time period? Just fine, thank you.

In 2019, SoFi did $451M in revenue. In 2022, they did $1.54B. They more than tripled their revenue without their hero product.

Now this is obviously an unfair comparison. I wanted to use examples of companies and products that everyone is familiar with, so all the businesses mentioned are well established. Tripling revenues that already measure in tens or hundreds of billions is different than tripling revenues of $451M. However, in terms of percentage of total revenue, it is not an exaggeration at all. The chart above clearly shows student loans were just as important to SoFi's business as those products are to their companies. That SoFi made it through the last three years at all is fairly surprising. The fact that they've thrived and excelled in these conditions says everything you need to know about the execution of the management team.

The moratorium is coming to an end

As I stated in the intro, the deal to increase the debt ceiling has codified into law that student loan payments will resume in September. That means that regardless of what the Supreme Court decides in the pending student loan forgiveness trial, payments are going to restart, and that is by far the most important thing for SoFi investors. In the meantime, however, Biden has also modified student loan plans. Additionally, rates are much higher now than when SoFi was lending before. Let's take a minute and discuss how all of this will affect SoFi.

Forgiveness

The Biden administration just announced $10,000-$20,000 in federal student loan forgiveness for eligible borrowers making less than $125,000 per year if single or $250,000 for households. In the recent 1Q23 earnings call, CFO Chris Lapointe stated "Our student loan barrower's weighted average income is $173,000 with a weighted average FICO of 769." CEO Anthony Noto stated previously that, "Prior to the pandemic, our student loan refinancing business had an average loan size of about $70,000." From this, we can gather that most of SoFi's target customers for their student loans actually won't qualify for student loan forgiveness if they are still single. Approximately 65% of people with a bachelor's degree or higher are married, and roughly 50% of married households have dual incomes. That gives us a rough estimate of something around 35% of SoFi borrowers would still qualify for forgiveness. On the average 30% of borrowers get Pell grants. That means average loan size probably goes down to about $65,500 from $70,000 if you assume that tuition has remained stagnant in the last three years, which it has not.

In other words, for SoFi borrowers, the average loan size is large enough that student loan forgiveness may make a small dent, but does not remove the need for refinancing. Most of these people will still have significant debt to pay off after targeted forgiveness is done, even if they get $20k forgiven.

Income-driven repayment

The Biden administration also revamped the income-driven repayment plan to make it so that more people would qualify. Under the new IDR plan, monthly student loan payments are capped at 5% of discretionary income for undergraduate loans and 10% for graduate loans. So if you don't make a lot of money, you do not have to make your full payment every month.

So how does this affect SoFi borrowers? Discretionary spend is defined as income above 225% of the federal poverty guidelines. I've posted the table here for quick reference:

You can run as many scenarios as you want, but the math shows that most potential SoFi borrowers will not qualify for IDR. Average US family size rounds down to 3. The federal poverty line for a family of 3 is just under 25k. So for the average family, discretionary spend is anything they make above $56.25k. Again, SoFi's borrowers average salary is $173k, so that would leave them with $113.75k in discretionary income. That means their payment has to be over $488/month to qualify for IDR as an undergrad or over $975/month if they have grad loans. For a single person, those numbers are $584 or $1168, respectively.

Federal student loan interest rates can be seen in the chart above. Direct loans are the lower of the two graduate loans and PLUS loans are the higher. Graduate students qualify for around $20k/yr in direct loans, after which they can get a PLUS loan to any limit to cover attendance for their program. Federal student loans have a 10-year term. A $70k loan even at a 7.9% interest rate results in a monthly payment of $846, so even with a family of 3, the average SoFi borrower doesn't qualify. A single person would need loans over $100k to qualify. In essence, some potential customers will qualify for IDR, but most of them will not. If it's a dual-income family, you can completely forget about IDR.

Higher rates mean less refinancing

The primary source of student loan originations is refinancing existing loans. Increasing rates decrease the amount of people that will benefit from refinancing and will result in a lower total addressable market (TAM) and in lower student loan originations than if rates had remained low. Anthony Noto addressed this directly in the Credit Suisse conference on November 30 by saying "We still think there's a really big TAM with rates up as high as they are now. It's a $200 billion of TAM that people would save in student loan financing in our credit box today." Student loan rates move approximately with treasury yields, which are still in line today with where they were in November, so that TAM should be very similar today.

There is also one more thing to consider. Most people care way less about what their rate is than what their monthly payment is. If SoFi can refinance a loan at a higher rate but a longer term than what borrowers are facing, many will do it anyway.

What do student loans mean for SoFi's business?

We'll cover this in multiple sections. Buckle up, this is the fun part.

Member growth

SoFi's target demographic are Millennials and Gen Z HENRYs (high earners, not rich yet). What better way to get those people into their ecosystem than to find people who have federal student loans and offer to save them money by refinancing? Once they are in the SoFi app and ecosystem, you can cross-sell them on SoFi Money, Invest, Relay, offer a credit card with 2% cashback on all purchases, and make them a customer for life. That's a great business model. That was the business model until 2020. They have over a decade of experience marketing to this exact cohort. They get to return to their core business, and it should result in even better member growth moving forward.

Originations

Ok, now for the meat. How much business are we talking here, and what is the effect on SoFi's top and bottom line? We'll start with comments from CEO Anthony Noto from November. I quoted a portion of this above, but here is the broader context:

As I mentioned, we were doing about 2.4 billion in the fourth quarter of 2019. We still think there's a really big TAM with rates up as high as they are now. It's a $200 billion of TAM that people would save in student loan financing in our credit box today. And so, we think we can get back to the high ones low twos on a normalized basis when payments resume.

I'll reiterate that student loans are priced mostly based on the 5-year and 10-year treasuries and that those 5-year and 10-year yields are very close now to where they were on November 30 when he gave those remarks, so what he stated then still holds true today.

I am certain we will get more details on this during this week's investor conference, but based on this, they expect to get back to around $1.7B-$2.2B in originations once payments resume.

Revenue

Net Interest Income

Historically, SoFi has made a pretty good interest margin on their student loans. However, their cost of capital is now much higher than it has been for the entirety of their existence since they were founded in 2011. If you look at their weighted average interest rate earned over time, you'll see it bottomed in early 2022 and rose quickly during the last two quarters as rates increased. Keep in mind that that number is the gross interest earned. You can also see that the rate that SoFi is paying their depositors has increased much faster than the interest rate they are getting from their student loans. The difference between these two lines is their net interest margin, or NIM, which is how much they make in interest.

As you can see, the net interest margin between the interest they take in and what they pay to depositors has been squeezed from about 3.5% in 1Q22 to just over 2% by 1Q23. SoFi's Savings account. APY sat at 3.75% on savings accounts for all of 1Q23 until March 16, when it went to 4%. They then raised it again to 4.2% on April 24, so deposits costs will probably increase by a maximum of 0.4% in 2Q23. The actual cost will probably be less than that because the increase in savings rate will be offset somewhat by the decrease in APY for SoFi Checking accounts that also happened on March 16.

From the best I can calculate, it looks as if the loans originated in 1Q23 had a weighted average interest rate of 6.88%, meaning that is what they are charging for student loans now. Average deposit APY was 3.4% in the quarter, so they should be getting at least 3% NIM, on all newly originated loans. Since the Fed is very close to pausing hikes, APY, which is a cost for SoFi, should not rise much from where it is right now. I would expect NIM to expand back to 3.5% in the long term on new originations as rate cuts happen in the back half of 2023 or 2024.

Noninterest Income

Ok, this one is a little harder. Student loans are longer-term assets, and historically SoFi has gotten somewhere around 4% gain-on-sale margin (GOSM) on their loans. That means if they sold $100M of student loans to another bank, the other bank paid them $104M for them. However, as the banking crisis proved, rising rates have hammered the value of long-term assets. Who wants to buy loans with a 4% APR and a the risk of defaults when you can get 5% risk free from the Fed? Nobody. Their loans that were originated during the ultra-low-rate times of 2021 and 2022 are going to be very hard to sell until rates come back down.

There is one silver lining here, which is that SoFi management was prudent enough to hedge their loans. And thank heavens they did. SoFi knows that their costs are variable, even though their student loans are almost entirely fixed rate loans. So, when SoFi originates a loan, they also buy hedges. Those hedges mean that while the nominal interest rate they are collecting on the loans might only be 4%, the amount they earn from the hedges compensates for the loss in fair value of the loans as interest rates have risen. I'll do another article and explain this more in depth, but for now, realize that they have made a lot of money on those hedges that offsets the drop in value to sell those loans on the open market. They unfortunately do not break them down between the different loan types, but they had $359M of gains on their hedges in 2022.

The average principal they hold on the balance sheet in 2022 was around $8.7B. That means they made about 4.1% on average in 2022 through their hedges. Why is that important? The gains from hedges are noninterest income and count toward their GOSM. If SoFi has already gained 4% through their hedges, then they could sell the loans at cost and still have a 4% GOSM. That's why they buy the hedges. If Silicon Valley Bank, Signature Bank, or First Republic would have bought similar derivatives on their assets like SoFi, they never would have gone into receivership. Another feather in management's cap for excellent management.

In fact, this is exactly what SoFi did last year. They unfortunately don't always get asked in every earnings calls what their GOSM is, and it is impossible to back out since we don't have enough detail to know which loans with which hedges were sold in which quarter. However, we do have all of the quarters in the last year when they sold student loans, and the hedges have absolutely been doing their job. In fact, the scenario I outlined above actually happened in 2Q22, where GOSM without the hedges was actually -0.2%, but with the hedges it was still 4%. Notice that despite the huge move in interest rates between these quarters that their actual GOSM has stayed rock steady.

The loans that they sold in 3Q22 were unhedged (it's possible these were variable rate loans, since there were only $74M loans sold that quarter), which is why the hedged and unhedged bars are equal.

EBITDA

The best part about the student loan business coming back is that it's already fully built and ready to go. There are minimal scaling costs here and the entire product is already fully integrated onto their in-house tech stack. The student loan business is like a Porsche that has been stuck in bumper-to-bumper traffic for the last three years. It's a well-tuned machine that was built for a scale of at least 10x where it has been operating. That means that the incremental cost to go from $400M-$500M originations per quarter to $2B-$4B is almost nothing. SoFi's student loan Porsche is finally within eyesight of the autobahn. The margins on this are going to be very high, and should be easily above the 60% contribution margin that the lending segment has been delivering through the past few quarters.

A Bearish, Baseline, and Bullish Simulation

Ok, so using all this information, let's construct what we think will happen to the company's bottom line moving forward. For a bearish scenario, I assume that they only get to $1.5B in originations in 4Q23 and only grow originations by 6% each quarter, which is lower than their typical member growth. I also assume and that the balance sheet stays stagnant at $5B of student loans, which is where it was in 1Q23, that they only earn 2% NIM on the loans, and that they only get a 2% GOSM, which is half of their historical marks. Finally, I'm also assuming only 50% contribution margin.

For the baseline scenario, I assume a starting point of $1.9B of originations in 4Q23, which is the midpoint of what Anthony Noto guided above. I assume 8% QoQ origination growth, which is in line with their member growth and assumes no benefits from any movement downward in rates. For the other variables, I assume 3% GOSM, 2.75% NIM, 60% contribution margin, and a small growth in the balance sheet from $5B to $6B by the end of 2024.

The bullish scenario assumes $1.9B in 4Q23, 10% QoQ origination growth, 4% GOSM, 3.5% NIM, 65% contribution margin and the balance sheet grows from $5B to $7B. The 10% origination growth and higher NIM and GOSM would be the expected result if there are rate cuts in 2024 as the market is predicting. One last assumption is that I assume that 70% of contribution profit hits the bottom line EBITDA numbers, as management has guided. This applies to all three scenarios.

I'm taking my calculated numbers and comparing them to what I calculate we got from student loans in 1Q23, which was 0 gain-on-sale revenue, since we didn't sell any loans, and 2% NIM on a $5B loan book. Here are the results:

So even in the case where NIM doesn't expand at all, they get 50% of their historical GOSM, they get nowhere near their origination targets, and rates stay high for all of 2024, we are looking at an extra $30M/$40M qtr in revenue and $11-13M in EBITDA. Every one of those assumptions are virtually impossible, but even if they happen, that's a free 7% growth rate in revenue and 15% EBITDA growth based on 1Q23 numbers. Most banks would kill for those numbers.

The baseline numbers, which I'd argue are still very conservative, would result in an incremental $470M in revenue for FY2024 and $40M per quarter in EBITDA (and hence, net income). As a reminder, SoFi is expected to only be at $2B in revenue for FY2023, and had only -34M in GAAP net losses. Analysts are forecasting $2.46B in revenue and an EPS of 0.00 for all of 2024. In other words, with the baseline scenario, student loans alone would result in SoFi beating analyst expectations for 2024. Yes, you could freeze growth in every other business line for the entirety of 2024 and beat analyst targets just from the bump in student loans. Student loans returning are not priced in. Revenue and EPS estimates below are courtesy of Yahoo Finance.

The bullish numbers would result in 50% revenue growth in 2024 and about $0.40 EPS in FY2024 on their own, without any help from personal loans, home loans, the tech platform, or financial services. Remember, the bullish scenario basically just assumes they get everything back to historical run rates of 3.5% NIM and 4% GOSM. In the declining rate environment people expect for 2024, these numbers may prove to be not bullish enough. People don't understand what is about to happen to SoFi's growth. Analysts don't understand what's about to happen to SoFi. No scenario is going to follow a model exactly, the real world doesn't look like that, but these give a pretty decent range for what's possible. Analyst expectations are woefully bearish for both revenue and profits. The picture the simulations paint is clearly brighter than what's been priced in.

Conclusion

Most people have no idea how SoFi operates, what they've been missing out on in terms of their business with student loans, and what they are getting back when the moratorium ends. This is their bread-and-butter business and it's going to be a huge catalyst for the company. I invest in businesses, I don't buy stocks. Specifically I like to invest in businesses that are misunderstood, because the difference between actual performance and Wall Street expectations is where you make the most money. SoFi is deeply misunderstood and the implications of the return of their student loans refi business is misunderstood. The best part is that you still have 6 months to take advantage of this discrepancy because the revenue and EBITDA won't even start trickling in until the end of this year at the earliest.