There is a new short report from Muddy Waters on SoFi. Candidly, it sounded like it was recycled from all of the 2022 short reports I read on this firm. I'm going to walk through each point they made in their lengthy report and why it doesn't change my bullishness on the investment going forward. I do not plan on adding to my stake today, but I would accumulate more shares if the correction continued. Max readers, I will keep you posted in real-time.

Exact same note here on how closely banks are regulated based on GAAP accounting rules that SoFi has consistently followed since going public. Muddy Waters is again complaining that fair value markings shadily & artificially lower charge-off rates. They offered an alternative methodology to argue that fair value isn't honest.

I do not agree for a few reasons. First, I find fair value to be even more transparent and just than CECL. Companies have to incur losses on the income statement more frequently than they do under CECL. Losses are realized quarterly under fair value. That lowers the risk for unrealized losses, which was the root of the most recent regional banking crisis.

Next, as already mentioned, Capital Market Partners confirm that markings are justified (too low, if anything) every single quarter through capital market transactions. Every. Single. Quarter. Muddy Waters can talk about thinking SoFi should use a different approach in their valuation methodology... but massive institutions with actual information on these loans are telling us consistently that the markings are entirely fine. SoFi has never sold a personal loan pool at a marking even on par with the fair value level. Every single sale has been in excess.

Next, SoFi uses third-party auditors and a hedging system to double-check the fairness of markings and to ensure fluctuations aren't noisily propping up or hitting profit on a quarterly basis. They don't want an artificial profit sugar high stemming from fair value help. That would simply mean harder comps in 4 quarters for a team that consistently takes the long view. And we've already seen them drain fair value when market conditions demanded it while continuing to meet their financial promises.

The report talked about conflicts of interest throughout it. I would argue that SoFi has worked very hard to eliminate conflicts of interest that are prevalent in other banking models. Fair value is more fair.

Next, Muddy Waters thinks EBITDA is overstated by roughly 90% because of shady accounting practices. This is partially due to the charge-off and fair value marking notes above, but there's more to it. The following begins to get into the weeds on some accounting rules, but I will keep it surface level and easy to understand.

Muddy Waters is arguing that SoFi's LPB doesn't qualify under the GAAP accounting rule for "True Sales" and should be included in the balance sheet, rather than considered liquidated and counted as fee revenue. To Muddy Waters, this effectively means they're hiding $312M in debt. They argue that SoFi is not actually transferring credit risk when they offer loans through LPB and should therefore deduct provisions from EBITDA and remove the fee revenue they recognize from these sales. That would also greatly harm their capital ratios and capacity to originate.

Additionally, Muddy Waters seems to think they're hiding a lot credit ownership off balance sheet and without any disclosure, rather than selling the credit through LPB. They think SoFi is unfairly avoiding risk-sharing agreements and securitization deals because the company is not actually transferring ownership to other credit partners. They claim that SoFi is practicing off-balance sheet seller-financed transactions and retaining a large portion of the credit risk post-LPB sales. I think the onus is on them to offer a lot more concrete evidence of this actually being the case, as that evidence does not exist. SoFi is locking in billions in funding agreements from these partners, and it is transferring ownership to them. that's why they're not getting some massive cash influx when LPB securitizations happen. If the seller-financed claims were legitimate, SoFi would be getting a lot more money back when these deals happen.

There is a healthy secondary market where SoFi is leading securitizations alongside partners to help them offload any loans to more partners for profit. That is considered a piece of evidence pointing to SoFi retaining all of the LPB credit risk. I'd just point out that handling the process doesn't mean SoFi owns the loans. It just makes Fortress and others more compelled to buy more of SoFi's loans because they see an easy way to offload the credit if need be. And it's a small portion of overall LPB volume as well (under 25% of total LPB volume).

And finally, Muddy Waters also takes issue with SoFi selling loans that are in late-stage delinquency. This, the Muddy Waters, is leading to charge-offs being understated. They're not wrong about these transactions taking place. The transactions are also just very normal activity for a bank. If they're giving SoFi criticism for this, they should be criticizing many more financial institutions as well. And SoFi explicitly offers charge-off ratios excluding these maneuvers in the name of transparency. They're not hiding anything like this seems to indicate. They're being blunt as always.

All of this is again accusing a consistently blunt and candid team with a fantastic track record of flat out lying and fraud. It's accusing regulators of being incompetent. It's accusing SoFi's auditor (Deloitte) of being incompetent as they signed off on these transactions and the coinciding fee revenue for years. It's accusing the auditors for every single LPB partner institution (BlackRock, Fortress etc.) of being incompetent as well. If Muddy Waters is right, that's a lot of world-class institutions and federal regulatory bodies being incompetent. I'll take the other side of that bet. I'd also like to point out that SoFi has very little incentive to be hiding this debt right now. Their capital ratio cushions are currently massive, and there are no lending origination bottlenecks, as they now have an LPB business that allows them to grow originations, without boosting their balance sheet size. I realize some of the debate nerds in this subscriber base will view this as a fallacy, but I am comforted by the idea that this honest team, existing in one of the most strictly regulated sectors on the planet, has no reason to be risking their reputation and company, like Muddy Waters is claiming they are. There's so much risk and so little reward.

Most importantly, SoFi is following GAAP accounting rules. I'll keep saying it. Don't hate the player... hate the game. And by the way, the game is not changing. There is zero momentum at any part of SoFi's regulatory web to change GAAP accounting rules in a way that would force them to abandon their current accounting approach. Zero.

Muddy Waters talked about lower whole loan sales as a red flag for this company, and as a sign of capital market interest waning. Again, if demand was worsening and supply was struggling to find partners, pricing for these loans would not look as good as it consistently has. If there are fewer buyers for your assets, pricing will fall. That is Econ 101 and that is not happening here.

Next, maybe they should consider that the whole loan sale volume is shrinking because LPB volume is exponentially growing at such an impressive clip. They ignored part of overall origination traffic through partners and decided to conveniently focus on the whole loan portion. Total originations across all channels rose by 46% Y/Y last quarter and total volume moved through whole loan deals, securitizations and LPB rose well in excess of 100% Y/Y.

In terms of LPB partner concentration in private credit issues, I think SoFi is in better shape than most. Blue Owl and others that are dealing with certain issues are looking to lean more heavily into the relationships with high-quality borrowers like SoFi. Blue Owl cites SoFi explicitly in earnings calls as evidence of them working with high-quality loan vendors. Private credit deterioration within subprime (which is where it has mainly happened) should help prime demand as private credit firms are forced to get more picky while still allocating dollars quickly enough to appease stakeholders.

The issues we've seen with subprime lenders are also likely partially tied to immigration policy under the administration; Tricolor for example had a lot of undocumented immigrant loans on their books. That should not mean SoFi's ultra-prime niche is also in trouble. This bucket of credit is always more resilient. Not immune... but more resilient. They've spoken about LPB demand and interest broadening to many more partners, and these partners coming back to SoFi looking to do more business, not less. That's what you earn by demonstrating strong cross-cycle underwriting trends and fixating on higher-quality applicants. 

We've addressed this a few times. Why do we hate dilution? Because it lowers profit per share, which is the single most important variable in determining forward returns. SoFi's capital market raises over the last couple of years did not harm profit per share. In some cases, the raises were neutral; in other cases, they were actually additive to both tangible book value (TBV) and EPS. How is that possible? SoFi's profitability is not suddenly artificially high. It was artificially low. The balance sheet optimization they've done via the capital raises in question fixed that. They were paying far more in interest expense than comparable banks, and have now fixed that. The effect did grow share count, but it lowered interest expense enough to eliminate any headwinds to diluted EPS or TBV. 

With the raises completed, they've normalized their profit and added a ton of cash to the balance sheet. They've vastly bolstered capital ratio flexibility and allowed themselves to get far more aggressive in originations if they choose to do so. They've added exponentially more capacity to fund any M&A they may choose to do, or to keep investing in promising growth areas like stablecoins. 

I usually do not like cap raises. These did not bother me for these reasons. They were strategically savvy.

The core ideas laced throughout all of these items is that Muddy Waters thinks SoFi is shady. I think that's bs. And? We now have several years of public operating history across violently fluctuating cycles to offer concrete evidence of this being the case. Nothing that I read in this report alarmed me in the slightest pertaining to my future expectations for this company.

It is worth noting that this doesn't mean SoFi is immune to credit cycles. We need to split this part of the conversation into micro-level risks and macro-level risks. Starting with Macro (not part of the Muddy Waters report). If private credit crashes, unemployment spikes, or macro falls off a cliff for any other reason, their loan business will suffer just like every competitor. I am not saying I expect these things to happen. I'm just saying if they do, SoFi will be hit just like every other creditor. At the same time, they're more insulated from these risks because of their skew towards ultra-prime borrowers and because they're still taking market share at a material clip. Both of those things buffer (not eliminate, buffer) exposure to these macro cycles. This is the main risk I see for SoFi's business.

Micro-level risks for this company are quite moderate, and the ones that Muddy Waters spoke about are not things that keep me up at night in the slightest.

As long as the potential challenges for this firm remain macro-level, I will remain a confident shareholder. That would mean SoFi's struggles during any period of macro souring turn out to be very temporary. It would mean they exit that period with higher market share, strong profitability, and a readiness to step on the gas pedal. This is why I trimmed when the multiple sharply expanded and it reached the low-$30s in recent months. Taking profits like I did makes me more comfortable with holding through any bad parts of cycles. And it gives me more flexibility to take advantage if those things play out.

I actually have a lot of respect for Muddy Waters, and I understand why some of the less familiar parts of SoFi's business model would prompt a piece like this. Muddy Waters is good at what they do, and they've made a lot of great calls in the past. Shorting is extremely hard and their batting average is better than most. I just think they're very wrong here. Time will tell. 

For now, my opinion on this company did not change today. I guess Noto's opinion didn't change either, as he placed another $500K purchase after hours.