SoFi Deep Dive, Revolutionizing Loan Underwriting

Welcome to the 98th Pari Passu Newsletter, two weeks away from an amazing milestone!

In the last non-restructuring edition of October, we’ll delve into the story of SoFi, the firm that disrupted legacy financial service providers with its unique approach to data analytics.

Under the leadership of CEOs Mike Cagney and then Anthony Noto, SoFi has provided an all-in-one solution for clients, at costs that are significantly below competitors. Additionally, SoFi’s strategic acquisitions, product expansion, and use of artificial intelligence (AI) in customer acquisition have increased its market penetration and raised the firm to a household name. 

While SoFi is one of the largest firms in financial technology, the company’s history is rocked with scandals and at times questionable decision-making. Let’s explore how SoFi overcame these initial challenges to acquire the brand name it has today!

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Section 1: History

Early Financial Services

In order to understand SoFi, we need a bit of background on the predecessor technology. Banking technology was historically built on outdated programming languages such as COBOL and Fortran. This aging technology has proven to be costly and has hindered banks' ability to innovate and adapt to changing customer needs. For reference, a report shared that 75% of banks struggle to integrate new technologies with their legacy systems [1][2]. While understanding the technicalities behind COBOL and Fortran is not essential, here is a very short summary.

• Common Business Oriented Language (COBOL) is a programming language developed for business applications for processing large data sets. COBOL's limited data types and lack of modern programming constructs make it difficult to integrate with newer systems. Its verbose code and outdated programming paradigms lead to increased development time, higher maintenance costs, and limited scalability. 

• FORmula TRANslating system (Fortran) is a programming language developed in 1957 for scientific/engineering applications for numerical computations. Fortran's outdated limited support for modern data structures makes it inefficient for modern software development. Its lack of modular programming and limited support for parallel processing hinders its ability to handle large-scale computations and big data. 

The implication of this lack of innovation not only impacted the internal operations of financial services but also inhibited their ability to generate revenue. Particularly, the loaning operations that drive the revenue in traditional banks had low predictability. As the traditional credit scores of banks didn’t take modern data analytics into consideration, there was a clear opportunity for a new entrant.

Enter SoFi Technologies

SoFi, originally known as “Social Finance” was founded in 2011 by four Stanford graduates: Mike Cagney, Dan Macklin, James Finnigan, and Ian Brady. Noticing the illiquidity of the student loan market and the lack of data analytics used by legacy banks, these four students launched SoFi as a student loan refinancing platform [3].

In the middle of 2011, these founders started their inaugural loan program where they sought $2mm from forty Stanford alumni and then dispersed it to eighty-five students on campus. Due to the confidence of the alumni in the student borrowers, the founders were able to offer a lower interest rate on the debt than what was available in traditional student borrowing programs [4][9].

While this will be explained in more detail in the overview section, these founders were able to overcome many of the traditional issues with legacy lending practices.

• Cash Flow Assessment: Traditional systems based credit scores on a client’s current cash flow, rather than their future cash flow. This was ineffective because students who would graduate and pursue high-paying careers would be denied a loan due to their current minimal cash flow. SoFi took future cash flow into consideration, which allowed them to provide financing to the student loan market and charge lower interest rates.

• Online Crowdsourcing: The traditional fees of banks are passed on to customers, but SoFi removed these as they were an online platform. This allowed them to charge a 6% interest rate, which was 0.4% lower than private loans offered by banks [9].

With this loan program, the founders realized that by using information outside of credit scores they could provide attractive financing rates for students. By 2012 SoFi expanded to 40 universities and offered $150mm in student financing. It was from this point that SoFi began its period of rapid growth.

SoFi Begins Its Expansion

While SoFi started off strong, there were many critics of the firm’s business model. However, as the firm scaled, SoFi was able to come up with various solutions [14].

• Critics questioned the risk of bypassing conventional banks. SoFi’s approach deviated from the traditional lending model, where banks act as intermediaries, and critics worried about the potential consequences of disintermediation. To address concerns around credit risk, SoFi leveraged data analytics to assess creditworthiness. 

• In addition, critics questioned the reliability of these metrics, worrying that they might not accurately capture credit risk and they raised concerns about biases in the algorithms used to evaluate borrowers.

• Finally, many were unsure about SoFi’s ability to navigate the regulatory environment around financing.

There were two ways that SoFi could expand: vertically and horizontally. Vertical expansion consisted of enhancing the firm’s lending capabilities, and horizontal expansion meant expanding into new financial services. Mike Cagney, SoFi’s first CEO, decided to pursue the horizontal expansion strategy by growing the firm’s offerings [4][6].

• In 2012, SoFi introduced its student loan system to refinance federal and private student loans. SoFi attracted users with lower interest rates, smaller monthly payments, and only single repayment terms. Their “edge” was that data analytics allowed them to charge these low rates while keeping default rates low.

• By 2014, SoFi expanded its product line by introducing personal loans and an MBA loan program

• With the growing real estate market in 2015, SoFi decided to enter the home loan market. The same year, they introduced the Parent PLUS Loan Refinancing product, which allowed parents who had taken out loans for their children’s education to refinance at lower rates. 

• Then, in 2016, SoFi launched SoFi at Work, an initiative designed to provide student loan repayment benefits to employees. They also introduced SoFi Protect including life insurance and eventually expanded to other types of insurance products.

The horizontal expansion was getting realized and Cagney made the decision to expand into other financial services outside of lending. Between 2016 and 2017, Cagney helped launch SoFi Money, SoFi Relay and SoFi Invest [3]. These financial service products will be explained in more detail in the “Overview” section. 

The CEO Transition

While SoFi was externally a powerhouse in financial services with a $4bn valuation, internally the company had many issues. Reports described the company culture under Cagney’s leadership as a “frat house” with a free-for-all ethos that fostered a toxic work environment. Cagney in particular faced many sexual assault and misconduct allegations, which eventually led to his resignation in September 2017 [6][7].

SoFi was caught in a troubling position as they urgently needed to restructure the organization, while also pursuing growth. After sorting through various CEO candidates, SoFi’s board found a strong choice: Anthony Noto. 

Noto was the best candidate for SoFi, as his background and past experiences provided the best leadership values for SoFi to restructure its operations [9]. 

• Noto received an MBA at Wharton and then left to work at Goldman in 1999, where he became a managing director in 2004. Noto’s period at Goldman would bolster his passion for acquisitions, an important tenet of SoFi’s future growth prospects.

• Then, Noto became the COO and CEO of Twitter from 2010 to 2017, where he helped the firm monetize its user interface. This monetization process interested SoFi, as they were looking to expand their financial services, and return more capital while outperforming their peers.

• Noto then resigned from his position at Twitter to join SoFi in 2018 when SoFi was filled with media controversy from Cagney’s management and had an Apple Store rating of 2.9 stars. Despite the poor position of the firm, Noto set out on achieving his goal of making SoFi the one-stop-shop for all financial services.

One of Noto’s significant contributions to SoFi is his expansion of the firm’s vertical expansion strategy, which first started by targeting medical students [3][4].

• As we all know, the process of becoming a doctor is very long with students spending four years as an undergraduate, four years in medical school, four years in residency, and then three years in a fellowship. In total, the process takes around eleven years and therefore requires lots of financing.

• Many medical students prefer to take out loans for medical school, and the interest for these loans is negotiated to be paid-in-kind (PIK) which allows the borrower to take out loans to not pay cash interest payments on a recurring basis, and instead pay a higher principal payment at maturity.

• Due to the loans being PIK a student might take out a $150,000 loan, and then it accrues to $250,000 by the time they become a doctor (yes, a lot of interest).

SoFi started to issue low-rate loans to medical students in residency, acquiring market share from their legacy competitors [3][4].

• SoFi found that medical students in residency earning $60,000 annually were forced to accept high loan rates. Their credit score was judged on their current cash flow, rather than their future $500,000 salary. Additionally, 97% of students in residency become doctors which means that lending to these borrowers would have a very low default rate.

• While banks treat these borrowers as debtors with no job experience, limited credit profile, and inadequate salary, SoFi used a different forward-looking approach that allowed for differentiated underwriting.

• SoFi also gave borrowers the opportunity to pay off amounts of their loan during the lending period at $2,000 a month. This prepayment option severely de-risked SoFi’s lending practice, as they were able to get more cash upfront.

The alternatives simply couldn’t compete with SoFi’s offering [9].

• Medical students could keep taking federal loans at ~7% interest rates or they could pursue private loans at ~9% when SoFi was charging sub-6%

• There was the option for loan forgiveness which meant that students had to work for non-profits or in government institutions for ten years. These options would require lots of time, and sacrifice, and hurt the medical student’s recruiting options into hospitals

• Finally, there were income-based repayment options. However, these require users to reapply every year and they were only for students that displayed financial hardship.

Noto also executed other initiatives to expand SoFi’s operations to become his ideal “super app” for financial services. The three main steps that Noto aimed to pursue included executing the financial services and lending segments, starting a new segment in enterprise AI, and then building brand awareness. These topics will be explained more in-depth in the overview section

• Financial Services Execution: SoFi introduced the SoFi Credit Card which had rewards to pay down loans. Additionally, the firm introduced SoFi Home Loans, SoFi Protect, which provided insurance solutions, and then Lantern which was a marketplace for third-party lending [5].

• Enterprise AI with Galileo: In 2020 Noto led SoFi’s acquisition of Galileo Financial Technology for $1.2bn in cash. Galileo is a software platform that leverages AI to help fintech firms to manage their services such as digital banking, payments, or managing card issuing [9].

• Building Brand Awareness: In September 2019, Noto secured a twenty-year agreement with the National Football League (NFL) for a “SoFi Stadium” in Inglewood, California. The contract required that SoFi pay $30mm per year, however, Noto found the deal attractive, as it would expand its brand awareness. Additionally, Noto would pursue a marketing campaign to expand SoFi’s presence, which will be explained in further detail in the next section [9].

IPO through SPAC

After SoFi’s many rounds of private financing in the 2010s, the firm eventually decided to conduct an initial public offering (IPO) through a special purpose acquisition company (SPAC).

On May 28th, 2021 SoFi merged with the SPAC Social Capital Hedosophia Holdings Corp. V (NYSE:IPOE). Yep, if you had heard of this name you are right. This is the SPAC led by the real Chamatha Palihapitiya…

The SPAC approach provided various two benefits to SoFi, which is why many believe Noto ultimately chose to pursue this approach [15][16][17][18].

• Conversion Benefits: Before its IPO, SoFi had $1bn in preferred equity, which functions similarly to debt but does not require principal repayment at maturity, instead providing consistent dividend payments. US regulations mandated that SoFi obtain a banking license to sell this amount of preferred equity prior to its IPO. However, SoFi's status as a "bank" was contested due to its technology-driven approach, which regulators did not view as fitting the traditional banking model. Therefore, Noto opted for a SPAC as a strategic maneuver to navigate regulatory challenges and convert the firm's preferred equity.

• Ability to leverage retail enthusiasm: the ability to include future projections and tell a story that resonated with many of its customers (as SoFi primarily targets consumers vs other B2B businesses), enables the company to take advantage of very positive financial markets and minimize dilution. On the other end, performance has not been great since then.

Section 2: Overview

Company Overview

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