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This Bank Stock Just Soared After Earnings -- But Could Still Be A Great Buy

Just Soared After Earnings -- but Could Still Be a Great Buy

There is a lot of investor pessimism surrounding the lending industry right now, and it certainly makes sense. After all, soaring interest rates have caused demand for loans to decline, and if a recession hits (like most experts are predicting), it could cause a rise in loan defaults.

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However, Ally Financial (NYSE: ALLY) just showed investors that things might be going better than anticipated. The bank recently reported its year-end 2022 results, and shares soared by as much as 20% the day after the announcement. Here's a rundown of Ally's fourth-quarter numbers, why the market reacted so favorably, and why the stock could still be a great buy for long-term investors.

Ally handily beat expectations for the fourth quarter

Let's start with the headline numbers. Ally beat expectations on both the top and bottom line. The bank generated $2.2 billion in revenue, $150 million more than expected, and $1.08 in earnings per share (EPS) was 8% better than analysts had been expecting. And it's worth noting that expectations were likely even worse right before the report, as Discover (NYSE: DFS) reported disappointing results and high charge-off rates the day before.

Looking beyond the headlines, Ally originated $9.2 billion in auto loans during the quarter at an average yield of 9.57%, a staggering 260 basis points higher than a year ago. And impressively, net financing revenue was slightly higher year over year, despite the challenging economic conditions.

Ally also did a great job of returning capital to investors and taking advantage of the decline in its stock price. In fact, Ally spent $1.7 billion on repurchases in 2022 -- that's 18% of its entire market cap. And that is in addition to the roughly $350 million the bank stock paid in dividends.

An extremely profitable business model

If you aren't familiar, Ally was spun off from General Motors (NYSE: GM) after the financial crisis, so it shouldn't be a surprise that its primary business is auto loans. About 77% of the bank's loan portfolio is automotive in nature.

However, it's important for investors to realize that the company has evolved into a full-featured online bank with a massive deposit platform. The bank has $137.7 billion in retail deposits, providing a low-cost source of capital for nearly all of its $146 billion in loans.

Here's why that's important. Because deposit interest rates are much lower than other types of financing, Ally's average cost of funds in 2022 was just 1.71%. Meanwhile, the average yield of its new auto loans for the full year was 8.24%. Even with administrative costs and a reasonable default rate, it's not hard to see how this combines for a huge profit margin. In fact, Ally's net interest margin of 3.65% in the fourth quarter is one of the best in the banking industry.

Should investors worry about a rise in defaults?

Ally set aside $480 million during the quarter, more than double than it did in the fourth quarter of last year, but this is still largely in line with pre-pandemic norms and isn't a cause for alarm.

For the full year, Ally's auto loan portfolio saw a 97-basis-point (0.97%) annualized charge-off rate, but this had increased to 166 basis points (1.66%). However, this isn't cause for alarm. This is a bit higher than the 1.33% default rate Ally saw in 2018, but the bank has about 3.6% of its loan portfolio in reserves. The situation is certainly worth watching, but the charge-off rate is still quite manageable.

Ally could still be a great stock for patient investors

Despite the post-earnings pop, Ally still looks extremely attractive from a long-term perspective, especially if you believe the fears of a spike in defaults are overblown. After all, Ally trades for just over 5 times trailing-12-month earnings, and for a 12% discount to its book value per share. The stock is still 40% below its 52-week high.

To be sure, Ally isn't without risk. However, with an extremely profitable business model, an excellent history of returning capital to shareholders, and a cheap valuation, Ally is a bank stock that could pay off very well for patient long-term investors.

Best Personal Loans Of January 2023

Upstart has made a mark on the personal loan space because of its artificial intelligence- and machine learning-based approach to borrower qualification. In fact, Upstart estimates that it has been able to approve 27% more borrowers than possible under a traditional lending model. With competitive APRs, Upstart is not a top lender for borrowers who can qualify for more competitive rates. Even so, the platform’s minimum 600 credit score makes it an accessible option to those with fair credit.

Upstart also offers a pretty flexible range of loan options, with amounts ranging from as low as $1,000 so you don’t have to borrow (or pay interest on) more than you really need. And, while Upstart’s loans cap out at $50,000—lower than some lenders—this is likely to be enough for many prospective borrowers.

Even though Upstart’s three- and five-year loan terms are more restrictive than other lenders, it’s likely to be an acceptable tradeoff for applicants who might not be approved in a more traditional lending environment. Plus, it’s available in every state except West Virginia and Iowa, so it’s as widely available as many other top lenders.

Eligibility: Upstart stands out because it uses an AI-based platform to consider a range of non-conventional variables when evaluating borrower applications. And, while the platform advertises a minimum credit score of 600, Upstart may even accept applicants who don’t have enough credit history to have a score. When evaluating prospective borrowers, Upstart considers college education, job history, residence, debt-to-income ratio, bankruptcies and delinquencies and the number of credit inquiries.

Borrowers also must have a full-time job or offer starting in six months, a regular part-time job or another source of regular income—with a minimum annual income of $12,000. Co-signers and co-applicants are not permitted.

Loan uses: Upstart’s personal loans can be used for credit card and other debt consolidation, special events, moving and relocation, medical and dental costs and home improvements. In contrast to many other traditional and online lenders, Upstart also lets borrowers use personal loan funds to cover educational expenses (except in California, Connecticut, Illinois, Washington and the District of Columbia).

Upstart borrowers cannot use personal loans to finance illegal activity or purchase weapons, firearms or illegal drugs.

Turnaround time: Upstart provides next-business day funding for borrowers whose loans are accepted before 5 p.M. Eastern time Monday through Friday. Loans that are approved after 5 p.M. Are typically funded the following business day, or the day after that. That said, Upstart reports that 99% of loan applicants receive their money one business day after accepting their loan terms. Loans for education-related expenses may take up to an additional three business days after loan acceptance.

Bailout Or Business As Usual? Home Loan Bank-crypto Ties Raise Red Flags

The use of Federal Home Loan Bank advances to offset crypto deposit losses has raised questions about banks' reliance on the quasi-governmental funding mechanism for liquidity.

La Jolla, Calif.-based Silvergate Bank and New York-based Signature Bank, arguably the two traditional banks with the greatest exposure to the digital asset industry, have both tapped Home Loan Bank advances following the collapse of the cryptocurrency exchange FTX.

Of the two, Silvergate, which has pivoted the bulk of its operations toward digital assets during the past decade, was more significantly impacted by the volatility in the wake of FTX's demise. The bank received $4.3 billion in advances from the Federal Home Loan Bank of San Francisco in the fourth quarter of 2022 to offset $8.1 billion of drawn down deposits. Advances now account for more than 60 percent of Silvergate's wholesale funding.

Silvergate Bank availed itself of billions in advances from the Federal Home Loan Bank of San Francisco in the fourth quarter of 2022, raising questions about whether the Home Loan Bank system should be acting as a critical source of liquidity for the banking system.

SOPA Images/Photographer: SOPA Images/LightR

The episode puts a spotlight on both the supervision of crypto activity in the banking sector and the use of advances to support institutions that do little to support housing finance.

"The fact that this bank, which was exposed to steep crypto losses, was entangled with a Federal Home Loan Bank, that's the first suggestion that the real financial system and crypto could be in some ways interconnected," David Zaring, a legal studies professor at the University of Pennsylvania's Wharton School of Business, said. "That it's interconnected with … a pretty hidden avenue for banks to cover their liquidity needs is, in my view, a little worrisome."

At the heart of the debate is whether the Federal Home Loan Bank of San Francisco, in providing advances to Silvergate, was merely sticking to its mandate to provide liquidity to a member bank, or if it was providing a de facto bailout to a firm engaged in a risky and unproven line of business.

Advances are intended to be a first-order liquidity source for member banks, said Ryan Donovan, president and CEO of the Council of Federal Home Loan Banks, an organization that serves as a voice for the entire Federal Home Loan Bank System. As long as a member is in good standing and can provide the proper assets as collateral, the Home Loan Banks are inclined to provide liquidity, Donovan said.

"Home Loan Banks aren't an emergency source of liquidity. There's this perception that if an institution has a need for liquidity they are in some way troubled, but liquidity issues could arise for a number of reasons in the normal course of business," he said. "We were established by Congress to meet the needs of banks in those situations."

Indeed, advances are often the first place many banks will turn for liquidity in a pinch. In the Fed's latest senior financial officer survey, the results of which were published last week, more than three quarters of Home Loan Bank members said they would be "very likely" to tap advances should their reserves fall below their desired level. Home Loan Bank advances were by far the most preferred liquidity source included in the questionnaire.

There are several reasons why banks tend to favor advances, Zaring said, including their cost relative to other funding sources as well as the lack of stigma from industry analysts, investors and peers about using them. Meanwhile, turning to other facilities, such as the Fed's discount window, tend to be viewed more negatively, he said.

Julie Hill, a law professor at the University of Alabama who specializes in financial regulation, said the regulators are aware of this preference for advances and would have to sign off on their inclusion in banks' liquidity plans. She said this was most likely the case between Silvergate and its primary regulator, the Fed.

"The Federal Reserve absolutely knew before FTX that crypto presented unique liquidity risks, Silvergate absolutely knew that, too, that's part of why their balance sheet looked so much different than a traditional community bank of a similar size," Hill said. "You know Silvergate had a liquidity plan, you know part of that plan was securities and it would surprise me very much if borrowing money from places like the Federal Home Loan Bank of San Francisco wasn't part of that liquidity plan."

Silvergate and the Fed Board of Governors declined to comment for this article.

Hill said there is an argument to be made that regulators did the right thing by allowing Silvergate to fall back on Home Loan Bank advances because it enabled the bank to withstand the run and avoid failure. On the other hand, she sees the concerns that the use of advances to hold off a run is needlessly creating more risk for the Federal Deposit Insurance Corp.'s Deposit Insurance Fund.

The 11 Federal Home Loan Banks were created as government sponsored enterprises by an act of Congress, but they are privately capitalized by member banks, credit unions, thrifts and other financial institutions. They enjoy certain advantages, such as preferential tax treatment and fundraising costs. They are also given first lien priority, meaning they are repaid first in instances of bank insolvency. That means the FDIC could be on the hook for a potential future bank failure.

Zaring said this is concerning because the Home Loan Banks' incentive to support their members could be in conflict with broader financial stability considerations.

"The Fed sits on [the Financial Security Oversight Council], Home Loan Banks do not, so the Fed has a sort of financial stability mandate that is important when you're thinking about contagion and bank bailouts in provisions of liquidity," he said. "It's just not clear that the Federal Home Loan Bank Board has that kind of systemic view of what's going on in the financial ecosystem."

Donovan said in the case of Silvergate, as with all advances, the member bank's regulators — in this case the Fed and FDIC — could have blocked the liquidity provision if it felt the bank presented a threat to financial stability.

"In the case of Silvergate and others, the FDIC, the Fed and state bank regulators are in constant contact with the Home Loan Banks," he said. "If they had safety and soundness concerns about a bank, they could ask that the advance not be made."

Hill said the episode demonstrates how the regulators themselves have been taking a trial and error approach to managing the counterparty risks presented by crypto firms.

"It's not like regulators let all banks or thousands and thousands of them do this," Hill said. "Regulators let a handful of banks experiment in this space and now they might be rethinking what sort of experimentation they'll allow."

Alison Hashmall, a banking and regulatory lawyer with the law firm Debevoise & Plimpton, said she expects the Fed to take a tougher tack with banks that seek to do business with crypto firms moving forward. She pointed to a joint letter from the Fed, FDIC and Comptroller of the Currency issued earlier this month, in which the regulators pledged to a cautious approach to supervising digital asset exposure.

"[Regulators are] advising banks that in order to pursue a safe and sound practice, you need to be mindful and consider how much of your deposit base is coming from these types of [crypto] companies," she said. "Examiners are going to be looking at that and wanting banks to make sure they're not over exposed. I don't think they'd like to see that [type of run] happen again."

Founded in 1988 as an industrial loan company, Silvergate began as a commercial real estate specialist before transitioning to a single-family mortgage lender and then a multifamily lender. In 2013, it began building its digital asset business. Today, the bulk of the bank's business centers on providing payment, lending and funding services to crypto firms. Much of this is done through its Silvergate Exchange Network platform.

Meanwhile, Silvergate's presence in the mortgage industry has dwindled. Late last year, it exited its mortgage warehouse lending product, citing rising interest rates and falling volumes of mortgages.

The fact that Home Loan Bank funds are being used to support banks that do little in the home finance space has frustrated some housing advocates. As the Federal Housing Finance Agency, which oversees the Home Loan Banks, conducts a comprehensive review of the system, some are calling for stricter provisions that will force the banks to focus on their core mandate.

Caroline Nagy, senior policy counsel for housing, corporate power and climate justice with Americans for Financial Reform, said if the Home Loan Banks are going to provide subsidized funding for banks, the government should ensure that activity is leading to the creation of more housing.

"If we think that promoting liquidity for the largest banks and insurers in the country is a valid use of public resources, and I'm talking specifically about the privileged lien status and the tax free status of the system, we really need to see a public benefit," Nagy said. "Frankly, we have massive needs for the kind of investment that this banking system could produce. We desperately need affordable housing, we are in an affordable housing crisis."

The FHFA declined to comment for this story.

Where Silvergate's advances are seen by some as an abuse of the Home Loan Bank system, Signature's use of the funding source is more typical.

One of the largest multifamily lenders in New York, Signature frequently taps the Home Loan Bank of New York for advances to support that activity, and took out $11.3 billion of advances in the fourth quarter of 2022. And while it has launched a similar network for digital payment processing, its falling deposits — which were $88.6 billion on Dec. 31, from $106.1 billion a year earlier — are the result of conscious effort to pull back from the digital asset space.

"We are truly the quintessential example of what the Federal Home Loan bank was put in place for because any borrowings that we do have from the FHLB are supporting our lending in the multifamily sector," Eric R. Howell, Signature's chief operating officer, told American Banker. "It's really just part of our overall funding equation. We use these advances to fund our businesses."

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