Small Tech Bank opposes the massacre of American minnows

By Breakingviews

While it’s true that America has too many banks, the country could lose a few more after the failure of four lenders this year. But the final count is closer to 4,100. Institutions can be overwhelming, it is not always true that bigger is better. One example is the $1 billion Live Oak Bancshares (LOB), which removes many preconceived notions of what it means to be a small American bank.

In the year Founded in 2008 by ex-Wachovia banker Chip Mahan, Live Oak until recently was talking about the same thing as Silicon Valley Bank ( OTCPK:SIVBQ ) — the lender that deflated the giant and then in March. Although SVB was much bigger, they were both good teams that grew quickly: They each increased their assets between 2017 and 2022, with Mahan Bank recently reaching $10 billion.. The market rewarded them handsomely. Among the more than 140 lenders that make up the S&P US Regional Banks Index, Live Oak has a 2021 valuation of more than 5 times book value. Next on the list, crypto specialist Silvergate Capital (OTC: SICP), burned one day before SVB.

But if those failures show that rapid growth brings high risk, Live Oak is an example of the opposite. Get financial support. SVB and Silvergate have been vulnerable to bank runs as they have loaded large uninsured deposits to fuel their expansion. By the end of 2022, 90% of SVB’s customer savings were uninsured. At Live Oak, by contrast, only 15% of deposits exceed the state’s guarantee limit, according to its most recent regulatory filing. And those potentially volatile funds are more than tripled with cash and readily available lines of credit. That makes the North Carolina-based firm almost as run-proof as a small bank.

In lending and investing, too, Live Oak has zig-zagged where others have zig-zagged. Investors in US regional banks are shedding riskier real estate loans, bond portfolios and exposure to struggling tech companies. Mahan’s properties, by contrast, are positively prosaic. Live Oak has spent the past 15 years cornering the market on small-ticket loans backed by the US government’s Small Business Administration (SBA). Think dentists, veterinarians, and poultry farmers—industries with historically low default rates. It is now the largest SBA lender. Because of the way the program is structured, 40% of Live Oak loans carry a government guarantee.

Despite its low-tech clientele, Live Oak punches well above its weight in digital innovation. Mahan Bank has no traditional branches and instead collects deposits online. The company launched its cloud-based banking software division nCino (NCNO) in 2014. That company is now worth $2.8 billion, more than double the value of Live Oak. Profits from venture-type investments accounted for nearly a quarter of the bank’s pre-tax profits in 2016, according to Refinitiv data.

The question is that live oak, for all its advantages, is prone to relative fragility. Huntley Garriott, a former Goldman Sachs banker, estimated that it would grow its assets 15% a year and command a 15% return on equity — compared to JPMorgan’s ( JPM ) target returns. At that rate, Live Oak could double its balance sheet in five years. But even then, it would only be the nation’s 85th largest lender, based on Federal Reserve data. Rising interest rates have led to an optimistic view of the bank’s outlook. Refinitive said that while it once traded at 5 times book value, it is now close to 1.5 times. The focus on small businesses may not be as strong in a recession — analysts at Truist ( TFC ) expect bad loan losses to look even worse next year than at its community and regional bank peers.

That more earthly assessment may reflect Live Oak’s biggest danger: that it starts to look like the rest of the pack. Since 2016, the bank has quadrupled the number of industries it provides under the SBA category, with some sectors such as self-storage showing rapid, sometimes predictable, growth. If it has sold most of its loans to other investors, it now keeps most of them on balance sheet, and from time to time it also makes regular and unsecured loans. And it needs live oak deposits to keep growing. Those aren’t cheap anymore, especially for a bank that doesn’t have branches or decades of customer relationships.

An impatient owner may spy a simple answer: sell to a bigger rival. A large group—Trust Financial, PNC Financial Services (PNC) or Citizens Financial (CFG)—could build Live Oak’s loan book by financing it with cheap retail deposits. Still, analysts at Keefe, Bruyette and Woods expect the bank’s standalone net interest income to rise by a fifth next year, even without such help. And Mahan, who owns a 15% stake in Live Oak, shows no signs of being a seller. If he didn’t cash out when the shares were around $100, it’s hard to see them being a quarter of that level now. A live oak can therefore remain a sapling surrounded by redwood. There is room for both.

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Editor’s Note: Bullets for this article’s summary were selected by Search Alpha editors.