Merging Traditional Banking with Tomorrow’s Technology

[00:00:50] Vince: Welcome everyone to 22 Minutes in Lending. I am your host, Vince Passione, and our guest this week is someone I’ve been privileged to know for close to 30 years, Chip Mahan, the founder, CEO, and chair of Live Oak Bank Shares. Chip is a serial entrepreneur who’s built his career around revolutionizing the banking industry.

[00:01:00] Vince: He’s founded four banks  in  his career, including Live Oak Bank Shares and Security First Network Bank, which was the first internet bank. He has a unique model I like to call the Mahan Move. Where he builds out new technologies  to run these banks, later markets that platform to other bankers once he’s  demonstrated his own  success. Both S1 Technologies,  one of the  first internet banking platforms, and Encino, one of the first small business lending platforms. We’re successfully IPO out of chips, DeNovo banks. Chip has also co founded and invested in dozens of successful FinTech companies, both personally  to his banks. And since 2018 via  canopy ventures that he co founded with Jean Ludwig, the former controller of the currency and founder of the promontory financial group, chip successes come from making bold decisions and taking decisive actions. He is a unique investor operator that truly walks the talk. So without  further delay, let’s  kick off these 22 minutes in lending chip. It’s great to have you on the podcast. Thanks for coming on.

[00:01:56] Chip: Delighted to be with you again for all these years.

[00:01:59] Vince: It is awesome. So chip, let’s start off with, I always enjoy listening to your earnings call and hearing sort of your view on FinTech and here was some excerpts from your call.  You’re SVB 43 billion went out the door in a matter of hours.

[00:02:14] Vince: Bank tech has changed. We’re more efficient and AI will fuel that fire. Liquidity reigns, and I’ve been waiting for this moment for 28 years. What did you mean? And what was the message to your shareholders,

[00:02:27] Chip: Well, let’s think about what has gone on. That is incredibly unusual since March, right? So, a year earlier, the number one rated bank analyst in the country at JP Morgan Chase. Invited three banks to the JPM private bank area in downtown San Francisco, Silicon Valley Bank, First Republic Bank, and Live Oak Bank. Number one on his list, right?

[00:02:58] Chip: The brand that those banks had, the respect that they had, you know, as niche banks, as extremely well run banks was off the charts and then they’re gone, right? So we had a situation where social media in a matter of minutes, if not. Maybe a little bit longer, a few hours caused a run on SVB. And as you said earlier, if we sit on there, it’s called 43 billion went out the door right away.

[00:03:25] Chip: Right. So let’s back up and let’s think about what happened here. Right. So the FDIC  saved the banking business in 1933. The first deposit insurance at that time was 1, 500 from 1933 until today. The average uninsured deposit in all commercial banks averaged 60, 60 percent and 95 percent for SVB  and for First Republic.

[00:03:53] Chip: So we had uninsured deposits at Live Oak Bank at that time of 18%. The average in the United States, when those banks went down, was 44 percent uninsured. So in the abundance of costing, what we were talking about here in that earnings goal was we basically created American legal tender of four times that amount.

[00:04:14] Chip: So if all, if every one of our customers that had whatever that 18 percent was, whatever that dollar amount was, wanted their money back, we had it times four in the bank. Because we operate this business, as you know, Vince, on a very thin tread of confidence and the business in general basically gathers deposits from the butcher, the baker, the candlestick maker, and lends it to the same, right?

[00:04:38] Chip: So most banks, community banks, if you will. Are more or less a real estate play, we’ve kind of lost the credit card business, the big guys, we’ve lost the indirect automobile business and so, and so on it goes, right? So, at the core of all that is a distribution system, the distribution system of branches.

[00:04:57] Chip: So what we tried to do at Security First Network Bank say, you really don’t have to go to a branch. You can bank this way. You write your bills, pay your bills online, do a stock trade online. And now these 30 years later, we got this little wicked fast pipe, evidence of social media and those banks going down.

[00:05:13] Chip: We have the ability. To eliminate what is about 2 percent cost. So if you add up all the branches, all the heat, light, utility and taxes, all the tellers, all the, CSRs, then you end up with about a 2 percent cost there.

[00:05:26] Chip: So our cost of funds with no branch is about 11 basis points for the people to gather our deposits that actually pay a market rate.

[00:05:36] Chip: And this is what drives me crazy in this business, right? So we have a saying around my boat that treat every customer like the only customer in the back and you alluded to that earlier.

[00:05:45] Chip: Well, that means everything that means service, that means price, that means full service. I mean, self service.

[00:05:52] Chip: And as you know, this deposit beta in the bank business is analyzed by every analyst on the planet.

[00:05:57] Chip: So what is your deposit beta? What is your deposit beta events? What is your deposit, John? What is your deposit beta chip, right? Well, what does that mean? That means that if rates go up a hundred basis points and you can screw the customer and say, I’m only going to raise my rates, 35 basis points. And your deposit bait is 35.

[00:06:16] Chip: If you meet the market like we do, if rates go up, we pass that along to our customer, you’re fine. Right?

[00:06:22] Chip: So there’s a dilemma out there we’ve never seen this before. Rates go up 550 basis points, and if you just examine the top fivebanks in this country, Which is 50 percent market share or you analyze the top 50 banks in this country that have 80 percent market share.

[00:06:38] Chip: Go and look at what they’re paying for savings and money market accounts. It’s probably 50 pips, right?

[00:06:43] Chip: So if you want a special deal, you can call and maybe they’ll give you a better rate,but it’s fundamentally time to get over that. We’re going to have to pay. What the market is and take care of these customers and take care of them in an electronic way, in a digital way where you can get everything that you need.

[00:07:01] Chip: You know, we’re trying to build this out on next generation core processors to build a community bank of the future and embedded banking product that if you’re a veterinarian, then if you can have payments and loans and your bank. Fundamentally, digitally tethered to everything that is really important to you, like your practice management software, like your tax prep, like your payroll, all in one single sign on.

[00:07:30] Chip: Now you’ve done something that’s a little bit different, and it’s impossible to do that, as you well know, way better than I, on these ancient core processing 40 years old.

[00:07:39] Chip: So, I mean, I covered a lot of different things there, but, you know. I never really understood why you needed to walk in a bank branch to get stuff done.

[00:07:47] Chip: This is a one in zero business, a bunch of ones and zeros and moving money around.

[00:07:52] Vince: So Chip you touched on deposits and if I look at your earnings results and you’re always great with the numbers, but you produce 39 cents of earnings per share, which beat expectations. Your loan book was up 18 percent year over year and your deposits were up over 20 percent year over year.

[00:08:07] Vince: I think I got that right. Thank you. on the loan side right now, we’ve all been through these cycles, right? People are very concerned about loan quality. Most of your competitors are pulling back some on purpose, others because of liquidity. They’re very concerned about these bars and their ability to pay it back.

[00:08:24] Vince: And God knows there’s a lot of pressure on these small business owners.When you think about the health of these small business owners, how are they right now?

[00:08:32] Vince: Are they healthy enough? And have you changed your underwriting to make sure that you’re managing the risk?

[00:08:38] Chip: Yeah, that’s a really good question.

[00:08:39] Chip: You know, we get asked that all the time because, you know, we’re the number one SBA lender in the country. So you’re lending the money to people that have no capital. And that’s true. You know, we’re a.

[00:08:49] Chip: We’re a cashflow lender and obviously 75 percent guaranteed by the United States government gives you a 75 percent loan to value ratio that’s actually real if you compare it to commercial real estate or anything else.

[00:09:00] Chip: But we don’t see advance. I mean, you know, our non accruals, our 30 day past dues, you know, our watch list is so far in line you know, what’s around the corner you know, I don’t have any idea.

[00:09:10] Chip: I think the interesting thing about our situation compared to anybody else is if you think about a, again, a normal bank, it doesn’t make any difference, whatever bank, they’re an in footprint lender usually.

[00:09:21] Chip: Like if you look at a bank. Call it the Bank of North Carolina that only does business in the state of North Carolina with branches in North Carolina. So that’s all they do, right? So they’re fundamentally a real estate play using those deposits in those branches from those areas to push out capital of folks like that.

[00:09:40] Chip: We’re in all 50 states, so we lend to 35 separate industries that the SBA allows you to lend to out of 1, 100 total. And we identify those industries by virtue of the data that we get from the SBA, like who pays you back on time.

[00:09:56] Chip: And then we do a couple other things.

[00:09:58] Chip: One, we like to have a domain expert who is either an employee or a director that knows and understands how to operate that business.

[00:10:10] Chip: So an example historically would be a fun example. Actually Don Jackson used to be the CEO of Pilgrim’s Pride.

[00:10:17] Chip: So we’ve made 2 billion of loans to chicken farmers.

[00:10:21] Vince: Don’t play chicken, Chip.

[00:10:24] Chip: Well, I mean, you know, if you think about it, these great big chicken companies fundamentally provide the birds to those folks that have six chicken houses that are, you know, a 3 million investment.

[00:10:34] Chip: They provide them the feed and they come pick up the birds.

[00:10:37] Chip: Well, if I’ve loaned money to them, they’re sending me the flock check. So the fellow, usually it’s a fellow, not a gal, it’s a fellow that’s babysitting those chicks because that’s fundamentally what they’re doing. He gets whatever’s left.

[00:10:50] Chip: So I think if you look at things like that and you say, well, Here’s how you would lend money to that, and what is the risk you’re taking? Is it on a 28 year old in the middle of nowhere, Georgia, or is it really the full faith and credit of Pilgrim’s Pride or Tyson’s or somebody like that?

[00:11:06] Chip: So if you find little niches like that, and you find people that can advise, credit people that sit at the door of the vault, now you’re on to something.

[00:11:14] Chip: Now, phase two, almost every SBA lender in the country is paid on commission. You make a loan, you sell a loan, you give a third of the profit on the loan sale to the lending officer in your way.

[00:11:26] Chip: We rather think that’s not the right way to go, that we want to make sure that the relationship between the credit person and the lender is one of we’re all pulling on the same rope.

[00:11:37] Chip: Because if you’re at the door of the vault, and I’m the lender, Vince, you’re thinking, if I’m getting a commission on every loan sale, did he tell me everything? Well, let’s just forget that. We’re not going to do that. So I think. By saying that we’re all in this together and paying lending officers what they made at other banks, if they came from another bank to us and having a domain expert that describes the credit box to our credit people then you get to the end story, which is

[00:12:06] Chip: what does a borrower want?

[00:12:07] Chip: So we’re lending money in Anchorage, Alaska, Honolulu, San Juan, Puerto Rico.

[00:12:13] Chip: So, we don’t have a brand in that particular state. But they want to know two things, am I approved and when are you going to give me the money? So, if we can do things like we’ve done with Encino to make sure that ability to look at the documents between the lending officer, the underwriter, the closer, and the servicer is all in one place, now we can outperform our competition.

[00:12:33] Chip: And that’s what we’ve done.

[00:12:35] Vince: And Chip, culturally, there’s got to be such huge differences between when I first met you and you launched Live Oak, you started with, I thought it was equine vets,right? I think I remember your, stepdad was an equine vet. He was on the board S1 at the time, right?

[00:13:14] Vince: That is correct.

[00:13:15] Vince: So you, started with equine vets and then. I remember the next time I saw you, which is probably three or four years later, you’re talking about, you know, chicken farmers, big difference. How do you build a relationship with these folks?

[00:13:27] Vince: I mean, your staff, I mean, you talk about, you have somebody there that actually knows the business, but does every underwriter sort of they assigned by verticals and that’s how they know, and that’s how they build those relationships over time?

[00:13:39] Chip: Well, what we found in each industry, whether it’s, you know, lending money to funeral directors or dentists or chicken farmers, it’s a very small world. So you go to these trade shows, we go to 450 trade shows a year.

[00:13:51] Chip: And one thing that is essential to credit quality is after we make these loans, after these lending officers go to a veterinary trade show, and then we’re financing somebody that’s buying somebody down the street or building a new building.

[00:14:04] Chip: We have a separate group of underwriters that know and understand that space, a separate group of closers that know and understand that space, because closing an SBA loan with 140 documents with a bunch of real estate involved in construction and contractors and paralegals is, you know, not for the lighthearted, but I think one of the keys to our success in terms of the credit quality is what we call our business advisory group.

[00:14:28] Chip: So we have about 65, 22 year olds. They get financial statements every 90 days on all 6, 000 customers.

[00:14:37] Chip: So it’s the job of the lending officer to sit around the dining room table to go over the budget because we know that the budget is going to change and it’s job of the 22 year old to go over that budget and report back.

[00:14:49] Chip: And so SBA lender. Usually loses about two and a half percent on an SBA loan. And our charge offs have been about 39 bibs per year over the past 16 years.

[00:15:02] Vince: That’s impressive. Really impressive.

[00:15:04] Vince: So Chip, hot topic is deposits. We talked about, I guess it was about eight months ago when we talked about deposits flowing out and how to capture thosedeposits. And you were in the American Banker, I guess in July, and you were quoted talking about your deposit growth. And in your earnings call, you talked about it was up about 21%. So I think it was over close to half a billion dollars of incremental deposits came into Live Oak Bank. How’d you do that? I mean: competition’s watching, right?

[00:15:32] Vince: I mean, I’ve got credit unions, my clients, and they’re struggling with liquidity. How’d you make it happen?

[00:15:38] Chip: That’s the short answer is we paid up, right?

[00:15:40] Chip: So we are not at the absolute tippy top of the market for consumers, but we are at the tippy top of the market for business savings. and then we have a call center that has today about 30 folks.

[00:15:51] Chip: So I’ll tell you this quick story, man. So you and I have known each other all that. So I’ve been with the same woman for 61 years. We met at 11, I married her at 22. We just celebrated our 50th wedding anniversary.

[00:16:06] Chip: So Peggy goes and works out with a bunch of these old women and this young guy that runs this workout thing at the club said, I saw that Live Oak Bank is paying 4 percent on a savings account. So I called, somebody answered the phone immediately. I got unbelievable customer service, opened everything online, and  then I put them to the test the next two days.

[00:16:31] Chip: I called again, 11 seconds. I called the third day, 12 seconds. So it’s got to be both. It’s got to be fully digitized. It’s got to be a great user interface and all those things I remember you sent in. 18 PhDs to security first network back during your city bank days, 30 years ago to look at the, you know, the UI of this and the blah, blah, that, and the workflow of this and all that stuff.

[00:16:56] Chip: So, I mean, it takes it all.

[00:16:58] Vince: And if you think of what you talked about, depositing the loan directly into a business checking account.

[00:17:06] Vince: Now, that reminds me of SVB, right? I did business with SVB, they had my operating account.

[00:17:12] Vince: How’s that working and is that somehow a risk for you?

[00:17:16] Chip: Well, again, this gets back to Embedded Banking.

[00:17:18] Chip: We’re trying to build a bespoke bank in each vertical that we’re in. Knowing and understanding how do we connect to that practice management software on Offense. Core. And building products on top of that, that you can only deal with when you have a next generation core like FinTech and, you know, Amazon web services and ultimate scalability and, you know, up nine nines and all those other things that, that, you know, so well.

[00:17:40] Vince: Got it. let’s go back a little bit to our days when we first met and the founding of security first network bank. And I was going back and I was showing you some of those articles and it reminded me that when you launched security first network bank, dial up was probably 28, 000 bits per second.

[00:17:58] Vince: And yet you did it anyway. And you made a huge investment. You IPO that company eventually. What are you thinking? I mean, that was a pretty small market share back that you know,

[00:18:10] Chip: we got really lucky. You know, it’s just those things like in life, Vince, you’ve done it too. It’s like, We’re going to go do this.

[00:18:15] Chip: And then you sit down, you put down the positives and you put down the negatives and you stare at your wife or you stare at yourself in the mirror and say, Oh, I can’t stand it unless we give it a go. And you tear the paper up and throw it in the trash can.

[00:18:28] Chip: So that’s what we did there. And we were very fortunate and you know, I had worked for the Wachovia bank for 10 years and the Huntington bank was a pioneer in retail banking at the time. This is in the mid to late nineties. So we were able to get them as investors and test the software and be the guinea pig. We did the same thing with Encino with the SunTrust company and had them invest in the company and test the software. And we’ve just found that, you know, the bell cow effect, when you have somebody that believes in its next generation product to actually use it with you, and then people will follow them with the reputation of a Wachovia, the reputation of a SunTrust, you know, that gets you off to the races.

[00:19:08] Vince: Now it’s like a city, that’s how we met, right? We used to call them Barney deals, right? I love you. You love me. It really does work, especially when we invest. So let’s talk about that. Let’s talk about Canopy. So you launched Canopy, I think, back in 2018.

[00:19:22] Vince: And you jokingly said, I thought, once listening to you, you said, I had to launch this because I ran out of money at the bank and making investments in some of these fintechs.

[00:19:30] Vince: Well, can you talk about sort of the idea behind

[00:19:32] Vince: Canopy? I think you have 40 banks.

[00:19:35] Vince: To invest in the fund, it was like a 700 million fund, which is an amazing sort of beginning fund for any venture fund, you know, talk about the thesis and how’s it going,

[00:19:44] Chip: right? So that’s actually true. So we had made like six or seven different investments at live Oak bank shares, you know, a tiny bank with limited resources,pay retails, fins act, a few others.

[00:19:57] Chip: And then when I tried in 2007 and 2008. To bring Live Oak Bank to market and filed an application with the FDIC, I needed some help, and I ran into and actually hired Gene Ludwig who, as you know, ran Promontory Financial. Gene went to Yale Law School with the Clintons.

[00:20:19] Chip: And from 92 to 98, he was head of the OCC and all national banks, and that obviously promontory was quite successful as well.

[00:20:26] Chip: So Gene and I went to see he had an office across the street from the FDIC. We went to see Sheila Bayer at the time, who was chairperson of the FDIC. And she rather liked, in her words, the doggy bank, since we were making loans to veterinarians.

[00:20:41] Chip: So I got to know Gene pretty well, and he was a seed investor in Encino, which we spun off from Live Oak Bank and obviously followed that success.

[00:20:51] Chip: And he came down to Wilmington one day and said, let’s start an SBIC fund. So, if you roll that tape forward, we now have two funds, right? Being five in total from 70 banks. And, you know, this is an interesting situation. It’s not like all venture funds. So when Jean and I went to call on the CEOs of these 70 banks,you know, we were overwhelmingly successful.

[00:21:14] Chip: They basically said to us if you can give us a good idea or two over the next five years to keep our customers, so these FinTechs don’t take our customers. And you give us our money back and maybe a little bit more, we will consider that successful. and then, as you noted, when we started the fund in 2018, and certainly it’s changed in the last 18 months, interest rates were zero.

[00:21:43] Chip: There was more money in chasing a home for fintech investments than you could possibly imagine. You know, these companies were raising capital at, my gracious sakes, alive 20 times forward-contracted annual-recurring revenue.

[00:22:00] Chip: You know, sometimes even just a PowerPoint presentation and, you know, that’s changed a little bit now, as you well know, at least these valuations have come down.

[00:22:10] Chip: That too is an opportunity for Canopy because we have a lot of dry powder, so we probably got a couple hundred million dollars left in Fund 1. Fund 2 is just getting started another 800 million dollars. But the situation there is just as simple as, and plain as the nose on your face, right? So if you are a white hot fintech company, you want to sell to banks, and we can introduce you to 70 banks that have given us money to invest in your company.

[00:22:36] Chip: If you want to speak with a CIO of this bank or that bank. We can probably get you that meeting. So yes, to Sequoia, yes, to all the big guys on the West coast, but I don’t know that any of them can quite bring the value companies that we can by virtue of our LPs.

[00:22:56] Chip: Yeah.

[00:22:56] Vince: It reminds me when we first met, right, we met in the late nineties and John

[00:23:01] Vince: Reed was investing at Citigroup.

[00:23:03] Vince: We had Citibentures even back then, and he had this principle, the three eyes, he said, we invest for insight. We invest for integration and last we invest for investment and it worked. It really did work. And you know, there’s your fund, but there’s also the circle fund.

[00:23:18] Vince: And I know you, you got together on payrails, which I thought was interesting.

[00:23:22] Vince: And sort of last story, success of payrails. Why, what did you do? And it seems like one that really has demonstrated the power of cooperation with really smaller institutions like credit unions.

[00:23:33] Chip: Well, you know, this answer is really simple, right? We focus on people that have done it before. So the guys that wrote that code, this was the third time they basically tried to recreate check free.

[00:23:44] Chip: Same thing with Frank Sanchez. I mean, you know,

[00:23:47] Chip: Frank wrote the original code for Sanchez computer that, you know, you at Citibank and eCity used in the late nineties.

[00:23:54] Chip: So it’s, you know, you can have the smartest, whatever, AI, young developer, Facebook dude on the West coast. But if you’re dealing with banks and you’re dealing with core operating systems and transaction process, it’s just not cool, right?

[00:24:09] Chip: So you got to have people that have that level of experience to build businesses for commercial banks that are highly regulated compliance, this, all that other mess, right?

[00:24:20] Vince: It’s awesome.: I pay rails was a great example of where you brought together some smaller institutions, I think, and they all benefited from it.

[00:24:27] Vince: It’s a wonderful sort of story about cooperation and. You know, we deal with about 350 credit unions and

[00:24:33] Vince: look they’re struggling, right? They’re struggling because they just can’t keep up with tech. And it’s only through that cooperation through funds like canopy and circle that I think they get the insight, they get the opportunity to invest and they get the chance to actually access a platform.

[00:24:47] Vince: They probably would not have accessed. You’re certainly not spending with city bank or JPMorgan Chase is spending on these kinds of projects.

[00:24:55] Chip: Well,and you know, it’s the way they’re set up as a bit of a challenge too, because no way to raise additional capital, right? Because the depositors fundamentally have a claim on the capital accounts, so you gotta fund your growth with the earnings of the business and they’re primarily retail oriented institutions and don’t make much in the way of commercial loans. so it needs to be a collaborative thing. And for what I, and you know this business way better than I do, but it’s like for what I have seen, that’s a small world too.

[00:25:22] Chip: Everybody knows everybody, particularly the larger credit unions, and they try to pull together and obviously there’s a.The, between the banks and the credit engine, there always has been, right?

[00:25:32] Vince: Last word, Chip. So I had Matt Harris on from Bain Ventures and Matt did a great presentation called the Fog of War, where one of his predictions said we might be dealing with, he said, if you think about you, you touched on your earnings call, right? Great depression. We saw 9, 000 banks disappear. You know, we saw probably another 3000 banks disappear with the savings and loan crisis. And then a great recession, we saw about 572 banks disappear.

[00:25:54] Vince: And here we are, we have this next cycle and we always saw with three banks disappear. So Matt’s conjecture is this happens in waves and it’s only the beginning of the wave. We might be dealing with a U. S. banking market that looks like Canada.

[00:26:08] Vince: What do you think?

[00:26:09] Chip: Yeah, I don’t see it. You know, normally banks go down because of credit quality. I mean, the regulators would say liquidity. You saw that with, you know, Jimmy Stewart in it’s A Wonderful Life and what happened in March.

[00:26:20] Chip: But I don’t see it everywhere I go, everybody, all the credit guys let me just be clear on this.

[00:26:24] Chip: Right. They’re scared The credit guys are beginning to run these banks. They’re pulling back. They’re worried to death about the 1087-page document that’s sitting in front of the FDIC today on the top banks in the country, over 100 billion dollars to raise more capital.

[00:26:39] Chip: So the stock price is down.

[00:26:40] Chip: I got to have more liquidity. My net interest margin is down because rates are up and I’m actually losing some, you know, cheap deposits to, you know, higher rates.

[00:26:49] Chip: But I think the business, the capital is, is as solid as I have ever seen it, both on big banks and smaller banks.

[00:26:57] Chip: So, you know, we’ll see I know Matt, he’s one of the smartest guys I’ve ever met in my life.

[00:27:02] Chip: I hope he’s wrong on this one.

[00:27:04] Vince: Yeah I do as well. Listen, Chip, I can talk to you all day, but you’ve been really super generous with your time. So thank you so much. I enjoy you as a colleague. I enjoy you as a mentor and certainly love watching what you’ve been able to do.

[00:27:16] Vince: So it’s really been terrific.

[00:27:18] Vince: Thanks to all of our listeners and remember to please subscribe to the podcast.

[00:27:21] Vince: You can hear more stories like this and I’ll meet you back at our next 22 minutes in Lending.

[00:27:26] Vince: Take care, Chip. Thank

[00:27:27] Vince: you.

[00:27:27] Chip: Thanks for having me, Vince. All the best.