Slump Might Turn Anti-Bank SoFi Into a Bank

By PETER RUDEGEAIR and TELIS DEMOS for WSJ

Mike Cagney, the boss at online lender Social Finance Inc., said in August that the traditional finance industry is “the second biggest waste of human capital outside the IRS” and full of “significantly overpaid people who do very little in terms of value to society.”

Now he might become more like a bank to have a better chance at beating them.

Social Finance, which calls itself SoFi, is the most heavily funded startup in the fintech sector. Since 2011, the San Francisco company has made roughly $10 billion in student loans, mortgages and other loans, using money from investors such as hedge funds. Mr. Cagney, fintech’s bomb thrower in chief, wants SoFi to be worth $100 billion someday.

Suddenly, though, the entire sector is in trouble. Growth has slowed dramatically because of deeper worries about consumer-loan defaults and shifting preferences among some investors for other kinds of debt. Some of the largest online lenders have cut jobs, with Avant Inc. and Prosper Marketplace Inc. shrinking their number of employees by more than 25%.

Confidence also was bruised badly when LendingClub pushed out its chief executive in May because of a scandal involving fabricated loan data. In the second quarter, venture-capital investments into lending startups fell by nearly half from a year earlier, according to preliminary data from Dow Jones VentureSource.

U.S. regulators are weighing tougher rules for fintech firms like SoFi, while banks are rushing to improve their online-loan products and turnaround time.
SoFi itself stumbled when consumers flooded its website after the lender ran an ad during the Super Bowl in February. Applicants who didn’t hear from SoFi for days blasted it in online ratings, and the company lacked the funding it needed to meet the surge in loan demand.

“It’s important to grow, but you need to grow in a way that you can manage,” Mr. Cagney, 45 years old, says now. “If we lose sight of that, then we very quickly become just like the whole [banking] infrastructure we’re trying to drag kicking and screaming into modern time.”

Silicon Valley’s invasion of the U.S. banking industry promised better service, broader credit access, easier use and cheaper loans. If fintech can’t pull out of its slump, though, the sector might be stuck as a bunch of small lenders with unsteady financing that do little more than try to skim the best bank customers.

Mr. Cagney is wrestling with some tough decisions that could help show SoFi has staying power.

He might seek regulatory approval for a state banking charter in Utah, which would bring more red tape but perhaps greater stability. He is considering offering credit cards and deposit accounts, considering potential partnerships with big financial institutions and recently said the former co-chief executive officer of Deutsche Bank AG, Anshu Jain, would join SoFi’s board of directors.

“Do I think I’m going to put Bank of America out of business? Of course not,” says Mr. Cagney. Just last year, he had said the entire stock-market value of the four largest U.S. banks were “vulnerable,” vowing to “go and get as much of that as I can.”

Closely held SoFi was valued at nearly $4 billion based on last year’s investment of $1 billion led by Japanese conglomerate SoftBank Group Corp. It was the single largest investment ever in a U.S. financial technology startup, according to Dow Jones VentureSource.

The premise behind online lending startups is simple. If the internet could revolutionize the way people book hotel rooms and hail taxis, say bank-bashing entrepreneurs, it ought have a field day with outdated loan bureaucracy.

Venture capitalists poured nearly $70 billion into financial technology startups from the start of 2010 to 2015, according to VentureSource. Morgan Stanley analysts predict online lenders will make about 10% of all small-business and unsecured consumer loans in the U.S. by 2020, up from about 1% in 2014.

“Silicon Valley is coming,” J.P. Morgan Chase & Co. Chairman and Chief Executive James Dimon said last year.

Mr. Cagney used to trade derivatives and still is chief investment officer at a hedge fund on the side. The son of a Michigan steelworker, he studied economics at the University of California, Santa Cruz, and started at Wells Fargo & Co. in 1994, writing computer programs for the big bank.

Later, he ran a trading desk that bet the bank’s own money, pushing Wells Fargo to take more risks. During the height of the technology boom in the 1990s, Mr. Cagney quit to try his hand at starting companies.

SoFi was born while Mr. Cagney worked on a master’s degree at Stanford University’s business school. In 2011, he and three classmates raised a fund for alumni to invest in loans to current students. The rationale was that the borrowers would flock to SoFi’s low interest rates and wouldn’t fall behind on loan payments because they were on track for high-paying jobs.

The company now specializes in refinancing student loans of roughly $80,000 at interest rates of about 6%. Borrowers apply online and usually get an answer within minutes—and money in a few days. SoFi targets graduates of elite universities such as Stanford and Harvard University, sometimes referring to its customer base with the acronym Henrys: “high earners, not rich yet.”

Mainstream banks can’t target loans so narrowly because of requirements to lend to underserved customers in areas where the banks have physical locations. Bank of America Corp., Citigroup Inc. and J.P. Morgan left the student-loan business after deciding they no longer wanted to compete with the U.S. government, which began making low-cost loans after the financial crisis.

SoFi isn’t registered as a bank and has no branches or federally insured deposits. When the company was just starting to expand, Mr. Cagney spoke with advisers about acquiring a small bank that would have enabled SoFi to make loans around the U.S. and fund them with deposits. He decided instead to lend state by state and rely on investors rather than deposits for funding.

The roughly 600 employees at SoFi try to befriend customers, including by arranging interviews or career counseling for those who lose a job, helping launch crowdfunding efforts for entrepreneurs, and setting up dates for customers who are single.

In the past year, SoFi started sponsoring cocktail parties, skydiving and other outings. Mr. Cagney says he will personally pay for the first wedding that grows out of the schmooze sessions.

By making a big push in student loans, SoFi “is getting to consumers before they are tied to a financial institution,” says Alex Rampell, a partner at venture-capital firm Andreessen Horowitz, which hasn’t invested in the online lender.

At the end of last year, the fastest-growing category of loans at SoFi was personal loans, usually smaller ones for credit-card consolidation and home improvement. Mr. Cagney also is pushing into mortgages. A SoFi billboard in Portland, Ore., encouraged borrowers to make a 10% down payment “because you’re too smart to rent.”

Through the end of May, just 22 of SoFi’s 73,000 individual student-loan borrowers had defaulted, including five who died, according to Moody’s Investors Service.

SoFi makes its profits by charging investors loan-servicing fees and by selling loans to investors for more than it costs to make the loans. The company also keeps some loans and collects interest payments.

One shortcoming of the business model is the threat of loan-funding problems. In 2012, Mr. Cagney was hoping to secure a $100 million equity investment from SoftBank to help SoFi expand its student-loan business.

Just before the deal was completed, Mr. Cagney was told SoftBank could commit only $10 million to SoFi. It was a disaster. SoFi already had agreed to make loans based on the assumption it would get $100 million.

Mr. Cagney says he worried he might be exposed to criminal liability if the funding fell through.

He held a flurry of meetings with venture-capital firms, while simultaneously preparing for SoFi to shut down, people familiar with the matter say. He averted that by raising $75 million from other venture-capital investors. SoftBank declined to comment.

Fintech firms are now facing a similar challenge. In last year’s fourth quarter, investors started to back away from online loans due to volatility in stocks and bonds, increased competition and loan-default worries.

In the first quarter, SoFi had total loan volume of $1.85 billion, far below the lender’s projection of $2.4 billion. The company doesn’t publicly report financial results, but The Wall Street Journal reviewed a letter to investors.

“We got caught a little flat-footed,” Mr. Cagney said. “Shame on us.”

Since then, Mr. Cagney and Nino Fanlo, SoFi’s chief financial officer, have been working to secure financing from banks and big investment funds that manage many countries’ sovereign wealth. Mr. Fanlo went to South Korea, and Mr. Cagney has flown to Japan a number of times. SoFi hopes to announce a new loan-funding deal as soon as this fall, says Mr. Cagney.

Mr. Cagney feels torn about working more closely with banks. “Some of my peers are perfectly content being the origination arms for banks,” he says. If SoFi follows that approach, he says, “what have I really disrupted?”

On the other hand, he adds, “our thought process has matured to the stage of we understand and appreciate how important the banking infrastructure is for our business to execute and grow and succeed.”

In February, Mr. Cagney met with J.P. Morgan’s Mr. Dimon. The meeting was set up by Arthur Levitt, a former Securities and Exchange Commission chairman who is an adviser to SoFi.

Messrs. Cagney and Dimon discussed their backgrounds and SoFi’s goals but haven’t announced a partnership. Both CEOs wanted to control the relationship with customers, according to a person familiar with the discussions.

Mr. Cagney estimates SoFi’s typical customer relationship will generate $50,000 over time, compared with $3,500 on a student loan.

As SoFi aims to expand beyond lending into other financial services, it is again considering the possibility of being regulated more like a bank.

SoFi executives have had talks with Utah and federal regulators about a bank charter that would let SoFi offer insured deposit accounts and credit cards without using the deposits to fund loans, people familiar with the talks say.

In March, SoFi told Utah officials it would create 400 jobs and invest $8 million in the state. Mr. Cagney says the lender will handle borrower phone calls and other tasks from Utah, but the operations also would be useful if SoFi decides to seek approval for a bank charter there.

SoFi seems to be weathering the online lending industry’s turmoil better than many rivals. At the end of April, the latest date for which figures are available, asset manager Hartford Funds put the same value on its SoFi shares as it had in October. LendingClub shares fell 44% in the same period.

In May, SoFi received a triple-A rating from Moody’s on a $380 million deal that repackaged loans into bonds. It was the first securitization by an online lending startup to get the top rating from Moody’s.

Other online lenders have turned to banks for more access to customers and capital. On Deck Capital Inc. announced late last year it will make credit decisions on loans to small-business customers of J.P. Morgan. LendingClub and Prosper have done deals to boost the lending businesses of small banks.

Mr. Cagney decided instead to pay $5 million for a 30-second Super Bowl ad. He says now that the ad was an example of his tendency to move quickly, sometimes too quickly. The ad portrayed the startup company as an exclusive club, with a tagline to “Find out if you’re great at SoFi.com.”

The original version of the ad ended with a twist that marketing executives thought would appeal to the sense of humor of millennials: “You’re probably not.” Other executives thought the line sent the wrong message, so it was cut.