Second Mortgage: Chris Larsen’s E-Loan

Chris Larsen is trying awfully hard to tune out the stock market.

It’s not easy. The Nasdaq may have swooned, but its every movement remains a national obsession. Larsen’s high-technology peers buzz about valuations. Colleagues fret about their options. Then there’s the triumphal decor of his Dublin, California, offices: the Business Week cover story on the receiving room wall chronicling his company’s IPO and in the conference room an Esquire offering from October proclaiming, “The one stock every American must own.”

The stock is E-Loan. Larsen is the company’s co-founder and chief executive officer. And the one stock every American must own is hurting. From a July 1999 peak of $63, shares have plunged to less than $5, off 94 percent. Larsen and cofounder Janina Pawlowski have seen the value of their holdings decline from $114 million at the IPO to $11 million late last month.

“Clearly, there’s been a lot of hype,” says Larsen. “You can’t go to any event or any party without hearing about the market. It’s hard, but you have to push away the noise and focus on what it takes to build a great company.”

First, though, you have to survive. E-Loan’s is a now-alltoo-familiar tale in dot-com land: A startup with impressive venture capital backing and a business plan that seems ideal for the Internet takes an IPO-fueled flight into the stratosphere before crashing back to earth. Supported by such leading venture firms as Benchmark Capital, Softbank and Technology Partners, E-Loan put forward a simple and appealing business proposition. It would originate loans for consumers without the hassle and overhead of traditional bankers and branches. Its hugely ambitious first target was to disintermediate the more than $1 trillion of mortgage credit issued annually. The Internet would enable E-Loan to simplify and speed up originations and to operate on a national scale in competition with tens of thousands of presumably dozing neighborhood brokers.

Those assumptions got swamped by two waves, structural and economic. First, it turned out that the business model worked better on paper—literally—than in practice. Then E-Loan got caught in this spring’s rout of Internet commerce stocks. Traditional mortgage brokerage, though highly localized and fragmented, proved tough to crack. As a result, E-Loan’s activities became overwhelmingly concentrated in refinancings, which tailed off sharply last year as the Federal Reserve Board pushed interest rates higher.

The company responded, like many nimble Internet operations, by modifying its strategy and diversifying. In August 1999 it acquired online auto lender from Bank of America Corp. A few months later E-Loan shook up its top management by installing Joseph Kennedy, a former automobile industry executive who came aboard in February 1999, as president and chief operating officer. Nonetheless, increasingly cautious Wall Street analysts began to poke holes in the business plan, and investors bailed out as E-Loan kept missing revenues and earnings targets.

By this spring E-Loan was in deep trouble. In April—in the midst of the dot-com stock plunge—it reported that firstquarter revenues had risen to $7.1 million, from $4.8 million in the year-earlier period. Alas, its net loss had ballooned to $24.8 million, from $11.4 million. With only $20 million in the bank, E-Loan faced the likelihood that it would run out of cash by autumn.

An obvious remedy, a secondary stock offering, was out of the question, according to a source close to the company. Why? Says this source: “We couldn’t give the shares away.” But like other cash-strapped upstarts with nowhere else to turn, E-Loan got a second mortgage on life by going back to the venture capital community. It raised $40 million, which backers said would be enough to last through next fall. The private equity transaction valued the shares at an 8 percent discount to the $4.06 that they were then trading at.

In the process, E-Loan also gained a strategic partner with great clout: Charles Schwab & Co. The leading online brokerage contributed $10 million to the round, joining original venture firms Benchmark and Technology Partners and newly participating e-finance startup specialist Financial Technology Ventures. As part of the deal, E-Loan became the preferred lender on a new mortgage center available to Schwab’s 3.7 million online customers. Separately, E-Loan entered into an agreement with eBay (Benchmark partner Robert Kagle is a director of both companies) to finance the online auction site’s used-car sales.

Web business strategists and investors place great stock in such partnerships; a company like Schwab confers an implicit and powerful endorsement. Schwab head of business strategy Daniel Lehman, who negotiated and oversees the alliance, says E-Loan is “not just doing something on the Web that has been done in the real world. It’s not just about technology or making money per se. It’s about the fact that getting a mortgage is a really difficult experience for people, and that shouldn’t have to be true. It sounded like they wanted to do on the liability side of the balance sheet what we have done with assets.”

Now E-loan’s grand plan is to become a single manager for all consumer loan products—"the whole right side of the balance sheet,” as company officials put it. The vision is ambitious and noble: to simplify and democratize the lending business. But it remains far from fulfilled, and E-Loan continues to face huge obstacles. The digital clock is counting down as the company burns through the latest capital infusion, waiting for the Internet—which is still a fledgling medium—and its denizens to mature. The legions of high school and college kids who grew up with it will soon be in the marker for home and auto loans and other forms of credit. That speaks to potential. The stock market increasingly heeds only what companies have done for it lately. lt can be brutally efficient in punishing those who don’t produce prompt results, driving them into the arms of acquirers or even out of business.

“E-Loan was supposed to be this big category-killer,” says CIBC Oppenheimer & Co. e-finance analyst Vincent Daniel. “But it was way, way overhyped. This market isn’t like books or online brokerage. It’s going to be extremely difficult to disinter mediate.”

CHRIS LARSEN LOOKS LIKE CENTRAL CASTING’S idea of an Internet CEO. With his polo sweater unbuttoned to mid-chest and his sandy blond hair and mild sunburn, the 39-year-old Stanford University Business School graduate looks more like a surfer than a captain of finance.

E-Loan had its genesis in a bricks-and-mortar mortgage business that he and Pawlowski, now chairman of the company, started after they met in Palo Alto, California, in 1992, before the commercialization of the Internet. They built their venture, Palo Alto Funding Group, around software that Larsen had developed at Stanford. Their system enabled loan officers to analyze mortgage products from different lenders and come up with the lowest-cost option for a given borrower’s situation. But human factors got in the way. The company’s commission-hungry loan officers tended to disregard the automated recommendations. “The loan agents would just maximize their commissions, and they could care less what the consumer’s interests were,” recalls Pawlowski, 40, a former Xerox Corp. analyst whose father founded and ran the Rochester, New York-based Polish Federal Credit Union, which helped Polish immigrants buy homes.

Within a few years Larsen and Pawlowski, like many Web entrepreneurs, began to see the Internet as a disintermediating force—a way around those irksome middlemen. By 1996 they had fired their 20 loan officers, closed their branches in Palo Alto and Newport Beach, California, and starred E-Loan. The new company would offer directly to consumers both its own loans and those of numerous other lenders, theoretically delivering the best possible terms for borrowers. In December 1997 the pair announced their initial venture capital investment of $5.5 million from Benchmark and Technology Partners. Additional investments flowed in from Yahoo!, Softbank and others.

Indeed, it is hard to think of a market more ripe for disintermediation. U.S. mortgage originations totaled $1 .6 trillion last year. Year in and year out, industry experts anticipate a steady flow, factoring out housing booms and busts, of about $1 trillion. But the huge national appetite is divided up into relatively bite-size portions. Scores of institutions distribute their loans through tens of thousand of brokers, most of them either independent or working in small, local agencies. An Internet provider, not limited to any physical location and not dependent on salespeople, could theoretically offer more competitive terms over a broader and potentially unlimited geographical expanse.

Yet as an e-commerce proposition, mortgage borrowing is not as straightforward as, say, book buying or stock trading. Those transactions take minutes or seconds to complete. Closing a mortgage can drag on for weeks, involving myriad forms, signatures, lawyers and bureaucrats. And whereas avid online consumers may do business with or E*Trade Group several times in a given week or month, they likely will seek a home loan only once every decade or so.That makes it difficult to engender customer loyalty, and there are few if any strong, national brand names that reinforce such loyalty.

“The whole mortgage business as we know it is localized,” says CIBC Oppenheimer’s Daniel. “It’s very grassroots. The mortgage brokers are the people across the street from the real estate agents. They go bowling together. They go drinking together. E-Loan may be able to break that hold some day, but it’s not happening in the next year or two.”

The complexity and infrequency of mortgage transactions make the personal touch all the more appealing to the many inexperienced or ill-informed applicants. “Most people are, and will continue to be, very comfortable with the traditional methods of originating mortgages,” says Jonathan Fayman, an e-finance analyst at WR Hambrecht + Co.

In contrast to the origination of home purchase loans, refinancings don’t involve local real estate agents, and applicants don’t have the anxieties associated with homebuying (“Where will we live if the loan doesn’t come through in time?”). The fundamental terms on refinancings are set, and a borrower’s decision basically comes down to who offers the best interest rate. That simplicity explains why refinancings have made up the bulk of E-Loan’s business—as much as 90 percent of its transactions at the time of its IPO.

But refinancings are highly cyclical. The yield on ten-year U.S. Treasury obligations was under 5 percent in January 1999, then spiked to more than 6.6 percent in a little more than a year after a series of Fed interest rate hikes. It now stands at about 5.8 percent. In turn, refinancings decreased from 50 percent of all mortgages originated in 1998 to 36 percent last year, according to the Mortgage Bankers Association of America. As of mid-August, one of the group’s weekly surveys showed, the refinancing portion was only 17.7 percent.

The obvious way to boost revenues was to finance home purchases, which are less affected by rate movements. But E-Loan was boxed in as long as it could not break the localized lenders’ purchase-mortgage stranglehold. Meanwhile, it also faced such new competitors as LendingTree and E-Loan’s costs to attract new customers escalated. The problem: Many borrowers applied online only to obtain information; then they used it to negotiate better terms from traditional lenders. Processing all those non-revenue-producing applications costs money. According to research that Hambrecht’s Fayman published in March, E-Loan incurred costs of $2,947 for each loan it funded, roughly double the national average of $1,490 per originated loan and 40 percent higher than the $2,100 in revenues that E-Loan earns on most mortgages. And that excludes advertising and marketing expenses, which totaled $30.3 million last year. It doesn’t take a repoman to do that math.

The front end—the origination process—is not the only place where E-Loan economics got complicated. The company funds its loans with capital from LIBOR-based warehouse lines of credit and sells them, along with their servicing rights, into the secondary market. The purchasers are the wholesale divisions of banks and government-sponsored enterprises Fannie Mae and Freddie Mac. About half of E-Loan’s mortgages are sold individually. These tend to be very large, complex jumbo or adjustable-rate mortgages. Because of the very specific and often unique terms of these loans, they usually go to one of a very small group of secondary-market players whose balance-sheet structures enable them to hold these loans on their books at a profit. As soon as a borrower locks in an interest rate, E-Loan simultaneously finds the bank best suited to buy the loan and sells it.

More commoditized paper—say, a $150,000, 30-year, fixed-rate loan on a $200,000 home—will stay on E-Loan’s books until enough similar loans have been amassed to be sold in a private auction. A host of potential buyers is notified in a process that resembles a Treasury debt auction, but on a smaller scale. To mitigate the short-term risk of holding these loans in its portfolio, E-Loan’s five-person secondary-markets team enters into over-the-counter derivatives transactions on each loan as it is booked. The hedges are unwound after the loans are auctioned off.

The secondary market must remain very liquid for E-Loan to keep up its volume of new loans. As interest rates rise, the debt that E-Loan packages and sells fetches lower prices. Further clouding the secondary-market picture is uncertainty about the future of Fannie Mae and Freddie Mac, the biggest purchasers of mortgage debt. Major banking companies like Citigroup and Wells Fargo &Co., allied with such congressional GSE critics as Louisiana Republican Rep. Richard Baker, assert that Fannie and Freddie enjoy an unfair edge over the private sector through their government guarantees and that financial problems inside the GSEs could lead to a widespread economic crisis. If these opponents successfully rein the agencies in, E-Loan fears, it might get harder to quickly unload its credits on favorable terms.

E-Loan’s vulnerability to the one-two punch of rising rates and runaway costs was evident in its first earnings report as a public company, for the third quarter of 1999. The net loss ballooned to $20.2 million, from $16. million the previous quarter and $3.5 million in the year-earlier period. Though the deficit narrowed in the second quarter this year—E-Loan showed its first quarter-to-quarter improvement in net loss—Genni Combes of Chase H&Q and Richard Repetto of Lehman Brothers are the only two of 14 analysts covering the company who rate the stock a buy.

PROBlEMS ASIDE, E-LOAN OFFICIALS and employees, led by the effusive Larsen, affect an upbeat attitude. Managers only reluctantly concede chat the company can use some fixing. They have a new plan, they say, and are trying to implement it. Partly, the plan is based on expansion. A third of the space at headquarters, not far from the ping-pong and pool tables, is empty—and not because of layoffs. The space is earmarked for the scores of new recruits E-Loan expects to hire in coming months.

The job of executing the plan day-to-day falls to Joseph Kennedy, 40. Before joining the company in February 1999 as senior vice president of marketing and business development, he held the No. 2 job at Saturn Corp., where he spent 11 years and was widely viewed as heir apparent to CEO George Hurlburt.

“Saturn was all about taking a great big broken consumer process called buying a car, figuring out a new, better consumer process and building a brand around it,” says Kennedy. “And so when I got to know E-Loan, pretty quickly I saw a tremendous underlying parallel. The reason why buying a car is a nightmare is that at the core, this person you have to trust to take you through the process, the sales guy at a dealership, is commission-incentivized to take you for the biggest ride possible. It’s no different in the loan business with brokers.”

Kennedy quickly became an influential force. On October 28, the very day on which E-Loan released quarterly financial results, Kennedy displaced Pawlowski as president and COO, and she agreed to become chairman of the board. Stories quickly circulated in Silicon Valley and on Wall Street that Pawlowski had been forced aside by E-Loan’s venture backers, three of whom sit on the company’s board. Bur insiders deny any notion of a power struggle.Says Pawlowski: “After having worked with Joe for six to eight months, we decided that he would be perfect for president and COO. That was the position chat I was in, but prior to that I was also the CEO. So whatever role I can fit into and contribute, I’m always happy to do that.” Benchmark Capital’s Kagle adds: “I give founders a lot of credit when they have the self-confidence and the maturity to be able to say, ‘Hey, there are people better qualified than I to serve certain roles in the company, and let’s not let ego get in the way of making those decisions.’ I applaud the way Chris and Janina handled that."With the top management stabilized and money in the bank, E-Loan must now deliver on its quest to control costs and convert free-riding information seekers into paying customers, particularly in the purchase-mortgage market. (Roughly 60 percent of its loans are for home purchases now, though that reflects the general downturn in refinancings as a result of higher interest rates.)

Bowing to the influence of real estate agents, E-Loan has been playing them two ways. On one front, it allows them to track the status of clients’ pending E-Loan applications in real time on their PCs. E-Loan also has struck a strategic alliance deal with ReMax Realty, the largest seller of real estate in the world. ReMax agents get training and promotional materials touting E-Loan as a better source of mortgages than local loan brokers. And ReMax’s Web site has a link to E-Loan.

The Schwab alliance works similarly, in that the leading online brokerage has chosen E-Loan over established mortgage banks as its clients’ primary loan source. Addressing its customer-acquisition cost challenges, E-Loan spends next to nothing to add customers this way. Schwab first promoted the deal through an account statement stuffer in July, so statistics on how many loans have been funded are not yet available. But, Kennedy says, “Schwab has already become our No. 2 source of applications, and it continues to grow at a very healthy rate.”

E-Loan may also be hoping that some of Schwab’s celebrated business strategies rub off. Larsen, Pawlowski and Kennedy repeatedly invoke Schwab co-CEO David Pottruck’s clicks-and-mortar philosophy. They continue to rely on technology to improve the customer experience and encourage transactions. A new offering, E-Loan Express, allows customers with excellent credit histories to secure a loan by producing only a bank statement showing funds available to cover down payment and closing costs, rather than the piles of tax, earnings, brokerage and bank statements normally required for approval. At the same time, they are exploring ways to augment existing customer service, perhaps with phone calls and e-mail alerting clients to good deals on refinancings, to name a few possibilities.

“We don’t have a problem getting people onto our site. The real challenge now is how to take those people who walk in our door and close them,” says Ira Ehrenpreis, a general partner at Technology Partners in Palo Alto and an E-Loan director. “Increasing the amount of live human interaction is probably going to be a major part of that.”

E-Loan’s partnership with eBay also promises to bring in new customers at minimal cost. E-Loan is the preferred financier and tide and escrow custodian on eBay’s person-to person automobile auction site, a fledgling effort available for now only in California. Says Kennedy: “eBay already is a topten source for us for dealer-to-consumer auto loans. There are tremendous growth prospects here.” Still, he cautions, “this is not a business that’s going to grow and spike overnight.”

The Softbank connection could eventually pay dividends internationally. E-Loan is one of several U.S. companies (others include, Interliant and MessageMedia) that the Japan-based Internet financier has funded and hooked up with other Softbank-backed partners in overseas joint ventures. Since late 1999 E-Loan Web sites have gone up in Japan, the U.K., Australia, Germany and France. For now, however, E-Loan has more than enough to worry about at home, and that’s where Larsen and company are focusing their energies.

Moving beyond mortgages and into other markets is costly, but diversification can be a virtue. E-Loan’s acquisition a year ago of, for example, provided a stream of steady, high-margin loan volume at a time when rising interest races hurt mortgage flow. “That strategy is really what saved their hide,” says Hambrecht’s Fayman. “The auto-finance part of the business has been generating significant volume, while mortgages have been pretty dismal.”

Lending, liquidity and diversification are not the E-Loan leaders’ only strategic concerns. Larsen and Pawlowski are political animals who keep in close touch with Washington, because what happens there matters to E-Loan. In lockstep with the Clinton administration and much of corporate America, they actively supported the Electronic Signatures in Global and National Commerce Act. When the law takes effect in October, digital signatures will have the same legal standing as handwritten ones and E-Loan should be able to complete entire transactions online, without today’s costly documentation delays. (Of course, so should its competitors.)

In the brewing battle over Fannie Mae and Freddie Mac, E-Loan breaks ranks with the top private sector lenders and supports continued growth and diversification by the GSEs. “We would support [their] getting into other product areas. That’s not only good for us, it’s good for consumers,” says Larsen, who testified at congressional hearings in July against proposed restrictions on Fannie and Freddie.

In E-Loan’s net loss of $23.1 million for the three months ended June 30 there was a glimmer of hope: It was down from $24.8 million in the first quarter. Second-quarter revenues rose to $8.5 million, from $7.1 million in the first quarter and $4.6 million a year ago. E-Loan’s management and venture capital backers continually stress that it doesn’t need to take over the entire lending marker; it just needs to get another few percentage points of the market to migrate online, which would make a huge difference in its bottom line.

Kennedy talks of scale as a key ingredient in controlling costs. The theory that the Internet is infinitely scalable—capable of supporting virtually unlimited growth on relatively affordable fixed costs—is of course a primary tenet of the New Economy but has been difficult to prove in practice. The assumption is that initial marketing and administrative expenses can pay off handsomely as a business “scales” across the Web and as its per-transaction costs decli9ne. But online enterprises can’t seem to stop the cost spiral as they seek footholds in more and more markets. A case in point is’s continual postponements of profitability while it pursues an endless array of new markets such as toys and automobiles. Further diversification by E-Loan could look a lot like that.

The acquisition of—a plus in terms of diversification—required the issuance of 2.88 million new shares, diluting shareholders’ piece of the already meager value E-Loan is throwing off. That deal came when E-Loan shares were trading in the mid-20s. Yet the company is considering further acquisitions to broaden its product portfolio, seemingly undaunted by the single-digit stock price.

“Yeah, you’ve probably got to get the currency up a little,” says Benchmark’s Kagle. “But I think the other thing you’ve got to realize is that you just have to do some of these things. Stock prices ebb and flow. You have to be sensitive to the amount of dilution you incur on the one hand, but you don’t want to forgo important strategic moves just because your stock’s beaten up a little bit.”

All this raises the question of whether E-Loan should have gone public when it did. It clearly was able to raise as much capital as it needed from private sources, and that would have allowed it to avoid all the scrutiny from analysts, investors and the press that has exposed its weaknesses and damaged its credibility in the capital markets. Predictably, the company officials disagree. Delaying the IPO, they argue, would have avoided the pain of the speculative bubble. But it also would have cost E-Loan momentum in competition against other online lending upstarts. And it would have made it hard to recruit talent and almost impossible to pursue acquisitions.

“This stock should never have traded for $75 and had a $2 billion market cap, when you look at the fundamentals,” says Fayman. As far as it has fallen, it could be vulnerable to takeover, and sources say that several suitors have made advances in recent months. Among them, sources say, were Schwab and some sizable banks, though none of the talks became serious.

Schwab’s Lehman says that his company, which owns 6.3 percent of E-Loan’s shares, is not interested, and E-Loan officials say that the company isn’t for sale. But the pressure is on. If a year from now the operation is not profitable, or at least very close to it, then it will be further constrained form raising additional capital. Assuming that remains an option.