Editor’s note: During the credit crisis, we learned that making loans to over-indebted consumers could be a very bad business. Although it’s tough to directly attribute causality, 487 banks have failed in the United States since 2008. A healthy portion of those failures almost certainly has to do with making subprime loans.

But that’s the past. One of the things we learn in investing is that the same thing, done in different times and different ways, can give shockingly different results. The report below is a bull case for the equity in a subprime lender formerly owned by AIG.

 

David contends that the company may be in for a bright future because of a confluence of factors that would have seemed unlikely just a few months ago, including the return of the asset-backed securities (ABS) market and the credit quality of subprime borrowers. As you read, imagine how you would have reacted to these same words written just a few years ago.

Springleaf Holdings (NYSE: LEAF) combines a number of major themes emerging from the recent credit crisis, including the changing focus of ”too big to fail” banks, the overall deleveraging of household credit, and the falling and reemergence of the securitization markets, fueled in part by the portfolio rebalance effects of quantitative easing.

Springleaf sits right in the middle of all these themes as it funds its balance sheet through both securitizations of loans and the unsecured debt market — both areas revitalized with ZIRP (zero interest rate policies) and the chase for yield. Maybe most interesting is that this unit was previously owned by AIG, only to be sold in a fire sale to private equity firm Fortress in 2010. Piecing together these factors, Springleaf presents an interesting opportunity for equity investors that I believe will be rewarded over the coming years.

Executive Summary:

  • Conducive environment in which the Fed is accommodative and the credit cycle isn’t deteriorating. Typically, these factors don’t occur simultaneously.
  • A pure play on the subprime consumer lending segment in which most big banks have left the market because of tighter regulations.
  • Improved funding mix benefiting from a continued return of ABS securitization and refinancing of high-cost legacy debt in the unsecured market.
  • Springleaf’s credit quality will improve, and costs will fall as the legacy real estate segment runs off.
  • Use of the “push through” accounting method has held the real estate segment  at ~$1.5bil below the unpaid balance, providing a strong cushion.
  • The company’s newer servicing platform is scalable, which provides meaningful fee income potential.
  • Strongly incentivized and experienced management team.

Company Overview

Springleaf is a consumer lender providing two to four-year fixed rate loans for the purposes of family-related issues, medical issues, loan consolidation, and home improvements. Springleaf has 834 branches in 26 states. The average customer borrows $3,500 and has an income of $47k and a FICO score of 599; 85% of loans made are collateralized by the borrower’s personal household property, as well as hard goods, such as boats and autos. Interest rates that the company extends borrowers average about 25.5% as of June 2013.

springleaf

During 2010, Fortress Investment Group (FIG) acquired an 80% stake in Springleaf (at the time, it was American General Finance) from AIG for $125mil.

With the securitization market largely dried up, there were questions regarding how Springleaf was going to fund its balance sheet. Many distressed debt traders viewed Springleaf debt largely as a liquidation play, but Fortress obviously saw more.

The company’s $3bil 6.9% coupon senior unsecured notes due in December 2017 traded as low as 33 cents on the dollar in March of 2009. These bonds now trade at a price of over 109 cents on the dollar, or a yield of 4.38%.

After taking the company public in October 2013 and selling a small percentage of shares, Fortress remains the largest shareholder at roughly 75%. Wesley Eden,s who runs FIG’s private equity business, is Springleaf’s chairman.

Macro Overview

Consumer balance sheets have contracted since the credit crisis in 2008. As shown in the Federal Reserve Bank of New York (FRBNY) chart, the contraction in household liabilities (with the exception of student loans) has been broad, spanning mortgage debt and autos, among others. Consumer finance is no different, with the outstanding amount of debt falling as well.

Unfortunately, the Fed does not break out consumer finance balances on a granular level but instead lumps it in the “other” category along with department store cards.


Evolution of the Consumer Finance Market and Competition in the New Landscape 
Prior to the financial crisis, big banks — including Wells Fargo, HSBC, Citigroup, and others — competed in the subprime consumer lending segment. Because of a tighter regulatory climate since the crisis, most big banks have shut down or sold these nonbank consumer finance units.

The exception is Citigroup’s OneMain Financial unit, previously known as CitiFinancial. Vikram Pandit aggressively attempted to sell the unit after the crisis, but potential deals involving Centrebridge and Berkshire Hathaway fell through. HSBC exited its business by selling a $3bil portfolio of consumer loans to a group including Springleaf, which now owns a 47% interest.

Today, without the participation of large banks, a gap exists in the market to serve these nonprime or subprime borrowers. As shown by the FDIC survey below, nearly 43% of Americans are deemed “under banked,” and according to its S-1, Springfield pegs this number at 51 million Americans. With Springleaf’s average borrower FICO score at 599, it ranks just below the first quartile of borrowers, according to the FRBNY Consumer Credit Panel chart.

Said another way, Springleaf serves the borrowers with the lowest 25% of credit scores in the market. Springleaf notes that outside of the few national competitors (such as Citi’s OneMain Financial), competition is very fragmented in the installment loan space among 5,000+ individually licensed finance branches.


What Are Its Assets?
Springleaf has three major segments of finance receivables: consumer, acquisition (SpringCastle), and legacy real estate. The consumer segment is now its core business and will be the source of future growth.

SpringCastle is a recently completed asset purchase from HSBC in which Springleaf owns a 47% interest. The real estate segment, although still the biggest, currently generates the largest amount of interest income but also the highest amount of costs and will continue to be run down over time.

The SpringCastle Acquisition
On 1 April 2013, Springleaf acquired a 47% equity interest in the portfolio it now refers to as the SpringCastle Portfolio from HSBC. It was purchased through a three-way joint venture with an entity controlled by Newcastle Investment Corporation and with an affiliate of Blackstone Tactical Opportunities Advisors. The portfolio is a consumer loan portfolio with more than 400k loans and an unpaid balance of $3.9bil, purchased for $3.0bil (~77% of unpaid balances).

The SpringCastle Portfolio is consolidated on Springleaf’s financial statements. I believe this acquisition is a huge win for Springleaf, with particular upside in the credit-impaired portion. At purchase, this segment was put on the books with a fair value of $755mil, but management estimated (in the prospectus) that it would have an expected lifetime cash flow of $1.2bil.

Remember: “Credit Impaired” Does Not Mean Delinquent
Springleaf’s financials segregate between “performing loans” and “credit-impaired” loans. Credit-impaired

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