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Hedge Fund Reverses Course On Hugely Successful Internet Bank Bet

NEW YORK (TheStreet) - Kerrisdale Capital has reversed a long-standing trade in internet banking player BofI Holding, Inc.  (BOFI), turning one of the hedge fund's biggest long investments into its biggest short position. The short trade is based on BofI Holding's valuation and Kerrisdale's expectation the firm's margins may be peaking.

Those views, while they don't reflect a wider recommendation on the financial sector, come at a turning point for many banks. The looming prospect of rising short term interest rates amid U.S. economic growth could dramatically alter the earnings environment for many banks. Depending on the business model, some may be poised for an earnings windfall, while others could see their performance slump.

BofI, according to Kerrisdale's analysis, sits in a vulnerable position. The bank, which has approximately $3.6 billion spread across its brands, doesn't have a single bank branch and instead relies upon its internet presence to draw in deposits. That means BofI has brought in depositor money at a low cost. BofI's efficiency ratio of 35% is almost half that of larger lenders with nationwide bank branch networks such as Wells Fargo (WFC), Bank of America (BAC), and JPMorgan (JPM).

BofI also has been one of the top performing banks after it identified an opportunity to buy distressed mortgage bond securities in the wake of the crisis, driving industry-leading interest margins. A high-yielding loan book versus low-cost deposits also means BofI's net interest margin -- the difference between what it earns on loans and what it pays to fund them -- has sat at above 4% in recent years, far above the industry average.

That business model performed admirably in the years since the crisis. BofI took in deposits and was able to invest them in distressed assets. At the same time, the firm's funding costs fell as the Federal Reserve entered years of unprecedented easing efforts.

On both fronts however, Kerrisdale believes BofI Holding's best days may have passed.

The hedge fund said in an April report that it believes BofI's net interest margins could fall 40% as the company's opportunity to buy distressed residential mortgage backed securities (RMBS) fades. Meanwhile, BofI's low-cost deposit taking structure may turn from a competitive advantage to a weakness, as short term interest rates rise in coming years.

"[We] believe the main driver of BOFI's recent earnings has been a large gamble on low interest rates and a once-in-a-lifetime opportunity in distressed MBS. It has managed to rapidly grow its profits in a mature and commoditized industry by chasing fickle, price-sensitive depositors and investing their funds in unusually long-dated assets," Kerrisdale said in its report.

Banks have had to pay little to draw in deposits amid near-zero interest rates, however, the prospect of rising savings and money market yields could impact internet-based banks like BofI more than they do those like Wells Fargo that have branch networks.

"To retain its hot-money deposits in the future, BOFI will need to pay up, while still holding onto legacy assets earning below market yields," Kerrisdale said in its report.

Not Another Savings & Loan

In a Tuesday interview with TheStreet, Kerrisdale chief investment officer Sahm Adrangi said that the hedge fund had gone short BofI shares as a result of valuation concerns specific to the company.

Currently, BofI trades at about 3.5 times its tangible book value, about double its peers according to Kerrisdale, after shares in the company more than doubled over the past 12-months. BofI shares have gained over 1,200% over the past five years. Adrangi said that, at one time, BofI was Kerrisdale's biggest long investment, and the bank was a top five holding between 2009 and 2010.

"It turned out to be a great investment, and then the stock got carried away," Adrangi said.

While language in Kerrisdale's report included worrying analysis on a potential rise in BofI's non-performing assets, a duration mismatch between the asset and liability sides of the bank's balance sheet, and regulatory concerns, Adrangi said potential issues aren't comparable to the savings and loans institutions of yesteryear.

Adrangi also said that Kerrisdale's turn to a short on BofI doesn't mean the hedge fund sees bigger issues for the financial sector. "I don't think we are bearish on banks generally or financials," he said.

Kerrisdale disclosed its short recommendation in BofI earlier in April at the Value Investing Congress in Las Vegas. At their peak above $105 a share in mid-March, BofI shares were up roughly fourfold from where they traded at the end of 2012. Since then, however, they are down some 25%, and they are down over 2% for 2014.

-- Written by Antoine Gara in New York

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