Description

Northeast Bank provides an extremely rare informational arbitrage opportunity; public data suggests 20 - 30%+ near-term earnings growth that the market has not yet recognized.  A rapid ramp in SBA 7(a) loan origination - something NBN has been working on for years with a partner they’ve successfully worked with before - is now paying off, and will flow through to significant gains on sale.  While there is uncertainty about the exact magnitude and timing, there is no uncertainty about direction, and we believe this could potentially double earnings over time (although our base case is more like a 30 - 50% increase over the next several years). 

Given the lag time between A) origination of a loan, B) sale of the guaranteed portion of that loan, and C) the company’s reports of that data, we believe that investors have a rare opportunity for true information arbitrage, as this government-provided data gives an indication of significant earnings growth over the next several quarters (and years).  Data on SBA 7(a) loan originations is public, released daily by the SBA, and available for anyone to look at, but NBN has not historically had a large position in this market and has not yet discussed their explosive growth in this arena on conference calls, so we believe very few investors are paying attention. Candidly, we didn’t notice it until a friend who followed the company more closely alerted us to it.  

For background, there are three wonderful writeups by Aaron16 (2017), Altarocks (2019), and Plainview (2024), which cover the story up to today really well.  There are also literally hundreds of excellent comments on those threads by the above authors and others such as LDMR, huqiu, david101, and too many others to name.  We are indebted to all of them.  We will focus only on what is new, although we include the below three paragraphs for those who want a quick intro.

Summarily, Northeast Bank is somewhat similar to Beal Bank - less a traditional borrow at 3, lend at 6, golf at 3 type bank and more a credit fund with a banking license.  Led by Rick Wayne and Patrick Dignan, who successfully executed a similar playbook before at a company called Capital Crossing (sold to Lehman pre-GFC), Northeast Bank primarily focuses on specific niches such as purchased loans and lender finance. As discussed in previous writeups, both of these segments have protections that result in minimal credit losses.  Despite taking what we view as significantly lower risk than most banks, they have generated substantial growth in tangible book value per share:

Their unique model leads to extremely low charge-offs and extremely high NIMs despite a lack of a typical core deposit base and reliance upon high-cost FHLB/brokered CD funding.  This was initially a turnoff to us given our comfort with low-cost deposit bases (indeed, you can review some of our comments on the previous threads), but as we have interacted with management and come to understand the story over time, NBN has grown into our largest position today at almost 10% of our portfolio.  

Independent of the new development with SBA 7(a) loans, we viewed it as a compounder run by a winner which could grow earnings and TBVPS by 20%+ annually.  With this development, we think it could see much higher ROEs and a capital-light source of ongoing earnings.

Years in the Making

Northeast Bank has historically taken advantage of its small size and agility to go after opportunities that other banks can’t or won’t - this mentality extends beyond the purchased loan market.  For example, during COVID, the company opportunistically went after PPP loans, which were attractive as a source of fee income because the lenders weren’t really taking on risk.  This table (credit Altarocks) shows that Northeast Bank was the 11th-largest PPP lender in 2021, in the running with SIFIs such as JPM and BofA, as well as all the large regional banks.  To put it in perspective, NBN’s PPP originations were roughly similar in number and dollar amount to M&T Bank, despite M&T’s asset base being 100x that of NBN’s.  

So, they've proven their ability to punch above their weight class.  This opportunity obviously did not last forever, but led to significant growth in tangible equity, which the company was able to redeploy into other lines of business (purchased and originated loans).  Today, we believe that NBN has a similar opportunity, except that - unlike in the case of PPP - the opportunity is not time-bound and therefore might be worth even more.

Northeast Bank had partnered with a company called Newity during the PPP era.  Once that ended, Newity and Northeast started looking at the SBA 7(a) market, which is similar in that the government provides mostly-guaranteed loans to small businesses.  American Banker has a good article here.  At the time (December 2022), the company was starting small and trying to figure out how to book 50 loans per month.

Northeast and Newity focus on loans of $250,000 or less. A nonbank lender created in 2020 to purchase and service Paycheck Protection Program loans, Newity announced apivot to small-dollar SBA lendingin January. While putting its 7(a)-lending operation in motion took longer than expected, Newity "has made a ton of progress" over the past three months, LaHaie said.

"It definitely took us longer to get the process going than we thought," LaHaie said. "Everything is more complicated when you actually get into the nitty-gritty. " A lot of the [delay] was learning how to best approach the $250,000-and-below segment, both from borrowers and our own internal processes. Now we feel really good about the whole setup."

With its operational concerns largely ironed out, LaHaie said Newity is close to reaching its near-term goal of originating 50 7(a) loans a month. "One hundred a month is probably achievable later in 2023," LaHaie added.

From Wayne's standpoint, the more loans Newity can originate and package for his bank, the better. Newity originates loans on the front end and services them on the back end. Northeast provides the final credit approval, as well as funding.

"Newity is doing high-quality work enabling us to efficiently book 7(a) loans" Wayne said.

Northeast earns noninterest income by selling the guaranteed portion of the 7(a) loans it books on the secondary market. The residual non-guaranteed portions generate additional interest income.

The strategy "can be quite profitable with high volumes of loan production," Wayne said.

It took a long time to ramp up, but now they are on track.  After having de minimis originations in the government’s fiscal 2023 (ends in September), Northeast grew to the 8th-largest originator (by number of approvals) in Fiscal 2024.  10 days into the young Fiscal 2025, Northeast is #1 with 256 loans approved, just above Newtek’s 254 loans approved, although it is smaller on the basis of dollars since it is focusing more on small-balance loans.  (You can find the data yourself here: https://www.sba.gov/partners/lenders/lender-reports)

Newtek (traded as NEWT on the Nasdaq) is an interesting source of information because it has historically focused on this market (as have a few others like Live Oak Bank, ticker LOB).  One of the attractions of originating in this market is that the loans are 85% guaranteed up to a balance of $150K (the level that Northeast is mostly focusing on), and this guaranteed tranche can be sold on the secondary market for a premium (typically 11% or so) given its attractive yield and de minimis risk (it's government guaranteed!).  Northeast Bank would split this premium 50/50 with Newity, and retain the unguaranteed tranche on the balance sheet.  Now, importantly, this tranche would have significantly higher credit losses than Northeast’s historical lines of business, but it would also have a much higher yield (double digits), and of course have the day-1 accretion from gain on sale. 

To Northeast’s credit (pun intended), they are very focused on credit, and in fact chose to exit a different SBA vertical (related to hotel loans) in late 2019 for the following reason:

Answer – Richard N. Wayne: Probably, depending on pricing, we probably would sell them. The point I was really trying to make is previously, we had higher aspirations for that SBA business a while back when the market was different. But we've been, as you know, every quarter our originations are going down, and we probably have – this is a round number, but we probably had about $600,000 of cost in business development and marketing, and travel, and those things by having it as kind of a separate division. And with Fred, who we like very much and our departure was very amicable (00:32:39), and understood by both of us. But, we're going to still do SBA loans as we get referrals from groups currently known to the bank. But we're going to just run that as part of our – through our LASG. So it's going to save us some money on the cost side.

[...]

Answer – Richard N. Wayne: Okay. So, I mean for us it wasn't – we could live with lower rates and there we were reasonably happy with the premium. For us, it was all about credit. And we saw a lot to Fred's credit, I want to make sure that's clear on this call. We think the world many did (00:34:57) – he showed us a lot of deals. But there is a spectrum of credit quality and range from an exterior corridor or hotel that needs a meaningful what they call (00:35:12) property improvement in the tertiary market sponsored by a borrower that – owner that's worked hard and accumulated some money but post-closing doesn't have a lot of capital if there's a problem. Those are the kind of deals that we saw a lot of and turned down.

You can obviously – on the other end of the spectrum, is as the credits get better, a lot a lot of times, they're not appropriate SBA loans. We were seeing a lot of deals that we could have booked. We probably could have, if we booked everything we saw, I don't know what we would have done. We could have done $50 million or $60 million of hotel loans, and now this is going to be a complementing the team not me. But we have the discipline to say no to those because those are loans, we just felt we're getting the credits, we're going to be a problem. We could feel great on day 1 by booking those, selling those, having meaningful gains and growing our volume. But when they blow up, it's pretty unpleasant. So we just couldn't find deals that we were comfortable on the credit quality side. And that's really what happened for us.

They are owner-operators and don't want to lose their own money, so they wouldn't go after something if it didn't meet their underwriting standards.  

What is somewhat difficult is mapping the government data on loan approvals to what will actually show up on Northeast’s balance sheet.  Based on Newtek, there does seem to be a delta between what is approved and what is closed; I don’t profess to understand these dynamics exactly, although I plan to ask management after the next quarterly release.  In the interim, for purposes of triangulation, Newtek is guiding to $935 million of SBA fundings in calendar 2024.  Fiscal 2024 approvals were $2.1 billion, or a roughly 44% conversion rate.  For now, we will work with these assumptions out of conservatism, and try to get more precise once we are able to discuss this with management.   

Northeast Bank was approved for $290 million in Fiscal 2024; if we applied the same conversion rate, we would get to perhaps $130 million of closings. If we assume 80% guaranteed we get to about $105 million in guaranteed sales, with a take rate of 5.5% leading to $5.5 million of pre-tax income.  Tax-effect it and you get about $0.50 of EPS on the 8.2 million shares outstanding.  Interesting, and certainly nice, but not thesis-changing.

However, the really interesting part is that this ramp occurred late into the fiscal year.  If we flip to Fiscal 2025 (October), Northeast has already originated 256 loans worth nearly $39 million; in other words, they are at 13% of last year's dollar volume in the first 10 days.  Annualized, this origination rate would equate to somewhere in the $1 - $1.5 billion range.  I’m not saying that is what will happen (we are working off a small sample size), but if this goes on through October, it would be quite interesting - especially because monthly breakouts on SBA loan volume show that October is typically one of the smallest months of the year, which aligns with the general end-of-fiscal year dynamics you see elsewhere.  Last year, October approvals dropped sequentially from September by about 50 and 60% in number and dollar terms, so if anything, a strong October for Northeast would portend a really banner 2025.  Below is a table from the SBA website demonstrating the seasonality:

  Playing around with numbers, if Northeast did indeed get approval for $1 billion in loans and (let’s say) $500 million of them closed, using the math above (80% x 5.5%), NBN would book $22 million in pre-tax income - or something that looks closer to $2 per share - from the gain on sales alone.  Closer to $1.5B would be $3+ in incremental EPS on a stock that trades a little below $80, and of course the blue-sky scenario is that they get to the scale of something like Newtek, which books $20M+ of gain on sale income per quarter (which would equate to $7 in fully taxed EPS for Northeast Bank).  

The tranche they keep should, meanwhile, also generate at least similar NIMs (net of credit expense) to existing business, so in the scenarios above, Northeast should also see income from the piece they retain on the balance sheet - which, unlike the gain on sale, would persist from year to year and compound.

Finally, in terms of sustainability, I think this is actually the opposite of the PPP - this is an area that rather than going away in a year or two, might actually be set to significantly structurally grow.  Consider this commentary from Live Oak Bank, historically one of the largest originators, on their conference call in January 2024.  It seems that the government removing red tape (are pigs flying??) will allow 7(a) lenders to access significant unmet demand; focus on LOB’s commentary on them having to turn down $500 million per year of inbound interest:

Lastly, a comment or two on operating leverage before we move on to the most surprising development at the SBA. Since we started this bank.

[...]

As many of you know, the SBA was created in 1953 in the Eisenhower administration. It is the smallest agency in the United States government, yet its administrator holds a seat on the president's cabinet. We have recently attended two meetings at the White House to understand some very significant changes that have been put in place to give access to capital and smaller businesses and many in potentially underserved areas.

Historically, the SBA had its banks charge an origination fee and a 55-basis-point trail on each loan to fund the program. Under the revised plan, the origination fees on all loans under $1 million have been eliminated; and on loans under $500,000, all collateral requirements have been waved. Unusual. Shocking. One can use one's own underwriting standards as they do for non-SBA loans. On loans under $150,000, the Government guarantee has been increased from 75% to 85%. Traditionally, we would say that our target market would be those businesses with revenues between $500,000 and $10 million.

In that group, in 2023, there were $1.5 million such businesses in the United States. There are $5.3 million businesses that generate between $100,000 and $500,000 in revenues. As the agency's number one to lender, Live Oak's average loan over the past six years has been about $1.5 million. This will change. We are extremely excited about these changes that will enable us to put capital in the hands of deserving businesses that we have not addressed in the past.

[...]

Question – Steven Alexopoulos: Got it. Okay. If I could sneak one more in. Chip, going back to the changes to the SBA program you called out, sounds like they're smaller dollar loans, right? And you guys typically did larger dollar SBA loans. As we think about loan growth for 2024, is this a needle mover, right? If we think about where the growth has been, call it, mid-teens or so on loans, can you do better than that in 2024 because of the changes to the program? Thanks.

Answer – James S. Mahan III: Steve, I don't know. I mean, this was a tectonic change that forward us all. I mean, for the agency, career people that sit at the door (00:33:25) to fundamentally say to an entire banking industry that you can make loans under $500,000 and not take all available collateral is shocking to us. We turned down at least $500 million worth of loans under $1 million every year just from our website. So, we have no idea what this is going to be. We're doing a lot of work technology wise to see if we can scale this.

And it reminds me of the earlier days because we'll probably do is sell those smaller loans like we did when we started the company, so we'll have an even more interesting balance between gain-on-sale dollars and holding on to more of our $1.5 million average loans and just keep those loan book and sell some of the smaller ones.

But I just don't have any idea of what that number could possibly be. But we are rifle focused on – and you think about it, Steve, it's like, what person ever said to you, well, I got a $1.5 million loan from a bank and everything's fantastic. Most people say, well, I got $100,000 loan from a bank. I got a $25,000 loan from a bank and I really build my business over time. And the fact that we can reach down to some of the underserved communities and take care of them, the ones that are deserving and have good historic credit quality. So, I mean, it's a huge difference.

[...]

Question – Brandon King: So, a follow up on the changes at SBA. And I know just early stages and, Chip, you're still thinking through this, but the Live Oak is known for such a high-touch model. Do you think about kind of extrapolating that towards these smaller dollar loans as well and what could that potentially mean as far as the people you have in place and the systems and infrastructure?

Answer – William C. Losch III: Hey, Brandon, it's BJ. So, if we will still be as high touch as we have always been, but I think high tech is going to be the emphasis here on small dollars. So, what Chip talked about is first and fundamentally very important, the SBA is making it easier for borrowers to be eligible for SBA dollars, which makes it easier for us to get them approved and get them the money. The way that we're going to do that is to really automate as much as possible on the frontend for our borrowers and our lenders to be able to get the documentation that we need to make the credit decision more on an automated, not 100%, but much more than we typically would on a larger deal today. And then build out the appropriate infrastructure to service this the right way. So, it'll be much more of a technology solution than not.

The total approvals for all lenders grew from $27 billion to $31 billion in Fiscal 2024, and Fiscal 2025 seems to be off to an unusually strong start with nearly $1 billion in approvals in the first 10 days of the month - again, remember that October is usually the seasonally weakest month.  There is of course a chance that it is just holdover from September, but if it continues over the next few weeks, it would suggest pretty sizable growth for the market overall in 2025, since $1 billion in a third of a month annualizes to about $36 billion in a year, and that too from the seasonally weakest month.

Valuation

As discussed in the other threads, Northeast Bank is already a cheap stock; pro forma for the recent large loan purchase, most of us seem to be expecting $9 - $10+ in 2025 EPS at 20%+ ROEs.  Given management’s history of being able to deploy capital accretively, and their still-small size allowing them to cherry-pick good opportunities, I see no reason the company should not be valued at a minimum of 10x earnings, or say $100+ in one year’s time, just on the basis of their existing, legacy business.

Depending on your assumptions around SBA 7(a), Northeast could see an incremental $2 - $3 in EPS added this year, and given the market opportunity, the business could seemingly grow into something worth close to the entire market cap at 10x earnings.  Even if the market changes and the opportunity only lasts a few years (like PPP), at worst, the company will generate another $10+ in incremental TBVPS that they can then redeploy accretively into other areas.

We believe this is a very interesting opportunity because you can track government-released data, day by day, that are telling you significant earnings growth is coming, but it isn’t being noticed because it hasn’t shown up in their numbers - which will probably start this quarter, get much more material one quarter from now, and snowball from there.

Catalyst

Gains on sale showing up on the income statement over the coming quarters and years.