Subprime credit is also a bigger part of the conversation than it has been since the crisis. Those borrowers deemed to be below prime, underserved by traditional lenders, are obtaining credit from a range of alternative sources. Secured loans on assets such as cars, as well as unsecured debt, are more readily available than they have been at any time since 2008.
In early May, GlobalCapital gathered a group of experts at its headquarters in New York to discuss the state of the auto, student loan, credit card and marketplace loan ABS markets.
Participants in the roundtable were:
William Black, managing director, Moody’s Investors Service
Tracy Chen, portfolio manager, Brandywine Global
Rick D’Emilia, managing director, Wilmington Trust
Joseph Lau, managing director, Lord Capital
Gyan Sinha, CIO, Godolphin Capital Management
Sasha Padbidri, moderator, GlobalCapital
Gyan Sinha, Godolphin Capital Management: That question is interesting in a number of different ways. It’s not just growth policies, there are other policies as well that may be relevant to what this administration wants to do that may equally have a bearing. With respect to that, one of the things that you learn about when you study consumer credit is the role of healthcare and medical disasters, with respect to bankruptcy filings. The statistics are that something like half of all bankruptcies are driven by medical related issues. One of the things we have seen in the past four or five
years is 20 million more people have insurance today than
before, and if some of the policies that are being contemplated on the insurance side go through and lead to a drop in the rolls of the insured then that’s something we would worry about.
On the growth side, we’re not ‘betting the farm’ so to speak that we’re going to get policies that will drive growth up to 3%-4%. Even with the relatively tepid growth that we’ve seen over the last three to four years, consumer credit has done reasonably well. Unemployment rates have come down and hourly wages have gone up but they’re still not running at the same rate as pre-crisis. So we sort of know how consumer credit and other types of credit behave in a tepid growth environment, but on the other side, if some of the safety nets get knocked out, that’s something that we would worry about. So that’s how we think about the spectrum of political risks right now.
William Black, Moody’s Investors Service: One of the most important credit drivers for consumer assets is the unemployment rate, and that is something that’s been improving year over year for an extended period of time. We’re now in one of the longest economic expansion cycles, and we’re seeing signs of some risk starting to manifest itself in some of the loss numbers, particularly around some of the consumer asset classes.
Moody’s is forecasting the economy to grow faster this year than last year and expects that the unemployment rate will more or less stay where it is today. Most economists define where we are today at pretty much near full employment, so those macro statistics in the context of consumer credit — from a macroeconomic perspective — bode well for performance right now. But we are seeing, particularly in the consumer asset classes that supply collateral for asset backed securities, some signs of credit deterioration, either in the underwriting and/or in the performance.
In terms of growth policies, one of the things that we’re hearing a lot from the marketplace is this tension between those who want to unleash more growth by reversing or adjusting rules that some perceive to be a regulatory burden and others who see them as an important protection to consumers or the financial system. Many proposed changes haven’t been enacted yet, but they’re being talked about as potential sources of further growth. So there may be yet some growth left in this economic cycle.
Joseph Lau, Lord Capital: Yes, that’s a great point, and that was actually what I was going to identify as a wild card — is a change in regulation really going to result in growth in consumer credit, or are we really talking about just changes to regulation for the sake of regulatory change? As we’ve experienced over the last seven or eight years, all of the regulations that have come into place, the costs that have been associated with those and how they’ve flowed through consumer credit. So now, by making wholesale changes to regulations — even if it’s just scaling them back — are we essentially then introducing additional costs into consumer credit and not necessarily being able to pass through benefits to consumers that they’re going to be able to realise?
Black, Moody’s: That’s the tricky thing. What the market is talking about a lot right now are the costs of regulations
that have been put in place. What’s being talked about
less are the costs of not having those regulations in place, which I think you’re alluding to, and that’s the tension
that will take place as the new administration presumably starts to act on some of the things that were part of their platform.
Sinha, Godolphin: It is ironic that a lot of the banking sectors actually don’t want Dodd-Frank to be just tossed out because they have spent the last four to six years retooling their businesses to deal with this, so you can’t have this yo-yo of no regulation, regulation, and no regulation again, which is equally disruptive for everybody concerned.
Lau, Lord: Yes, when we think of the impact of something like the CARD Act on non-prime credit cards and the intended benefits to that consumer, there are massive costs to implementing these changes. Even to make those changes again — whether they’re beneficial or not to those consumers — are going to require a tremendous amount of infrastructure, and that’s going to have to be passed through. So even if it’s looked at as something that reduces regulation, those costs have to be borne somewhere.
Tracy Chen, Brandywine Global: With regards to Trump’s growth policy, one of the things I want to highlight is his priorities. Trump’s priority is to make America great again, and he is determined to onshore the manufacturing jobs and shrink the trade deficit. So as a result, the biggest risk is a potential trade war with China and other countries. Trade wars can only make imported goods more expensive, which can further squeeze the bottom line of retailers and pockets of consumers. One case in point is we have seen the lumber prices rally 30% year to date, partially due to the new tariffs that US exercises on Canadian lumber, so what’s the ramification of this on future US housing prices?
Right now, housing affordability is already stretched in certain parts of the country. So whether home builders can successfully pass on this higher building cost to home buyers remains to be seen. Mortgages and housing-related expenses are a big part of consumer spending, so I would think this will make the housing prices potentially even higher in certain places.
In addition, there’s Trump’s tax policy — he wants to have tax reform and to cut taxes. In theory this should have a boost to consumer spending. However, the devil is in the detail, which we are still waiting for. Following a continuous decline in the unemployment rate and a gradually tightening labour market, we already start to see household disposable income growth trending higher than the historical norm. The household debt to income ratio has been at a historical low post the global financial crisis. The household balance sheet is in a relatively good shape right now. We observe a major shift in the composition of households’ balance sheets. On the liability side, households de-levered on their mortgage debt, while levering up on student loans and auto loans. But overall the consumer household balance sheet is in a better shape than before.
Lau, Lord: I am cautious at this point. We have had a good consumer environment over the last few years. There have been a number of tension points in the last 12-18 months, the auto market being one of them, and while we haven’t seen general consumer performance deteriorate, there have been questions about what will happen when we’re no longer in a robust environment. That’s probably most important with unsecured consumer loans. While that product has existed historically, the proliferation of it in the last couple of years has been extremely strong. So while that product has a place, there have been a lot of questions about just ensuring that they will continue to perform, and that in a down cycle the returns will be appropriate and that the consumer will be able to handle the additional debt load that they’ve taken on.
Black, Moody’s: For unsecured consumer loans, when I think about the spectrum of consumer loans out there, that’s the canary in the coal mine — the subprime sector, in particular. So Joe referenced the proliferation of unsecured consumer debt, presumably referring to marketplace lending and some of the unsecured consumer lending that’s been going on by those types of lenders. I want to create a distinction between unsecured consumer loans like revolving credit cards and simple, installment loans. This is another not-much-talked-about distinction with a difference when it comes to order ranking consumer credit risk.
An installment loan has no utility the moment you disburse the loan, which does carry with it an additional layer of risk. When the economy turns, that’s where I’ll be looking for the first areas of consumers under duress. So that will show up in all likelihood in default numbers. We haven’t seen that to date. We’ve seen a little marginal deterioration which again, given the macro-economic content that we’ve talked about, you can argue is somewhat surprising, and that could be a matter of figuring out or fine-tuning the underwriting algorithms. Or it could be an early sign of some pushing the envelope with that cohort of borrowers. It’s too soon to tell exactly what is causing some of that deterioration, but nonetheless that’s the focus. Whether it be unsecured consumer installment loans or you can also point to subprime auto as well. At least for auto that’s another area of focus — that’s where the credit risk is.
Sinha, Godolphin: Just to follow, what’s also important is to keep the concepts separate. Marketplace lending is an organisational form rather than a sector in itself, and while there are marketplace lenders doing near-prime type loans, there are others like Avant that are going deeper down the spectrum. So marketplace loans should not be equated with subprime necessarily. It’s just a different way of organising the business structure.
The second point is that clearly, as you point out, they’re canaries in the coal mine, but the canaries seem to be fairly specific to particular business models like retail store cards. You’ve seen the Capital One reports of increases, but the increases percentage-wise are large, but they’re coming off a relatively low base of delinquencies and charge-offs. So it’s unclear whether it’s a macroeconomic signal or they’re paying for the sins of the past few quarters in terms of pushing the underwriting a little.
The third point is that in many ways secured subprime, especially auto-related, is actually more dangerous in terms of the expansion of the credit cycle. The security in the asset lulls lenders into a false sense of comfort, because they feel like, well, if the person doesn’t pay, I have the asset. So I think it can actually lead to more pro-cyclical lending trends, whereas on the unsecured side you’re kind of not really banking on recoveries. You basically know that if the person goes, they’re gone. So the focus is more laser-like on ability to pay, whereas when you have something where you have a greater sense of security because you’ve got this switch that can turn the asset and make it useless, then at the margin, what does that do to your underwriting framework?
Chen, Brandywine: Yes, I agree. If you look at subprime auto origination as a share of the total number of auto loan origination, it’s actually increased from just 5% to 30%. And if you closely examine the composition of subprime autos, you can find that some new deep subprime lenders have been ramping up their share of the lending market. There are new deep subprime lenders targeting borrowers with FICO scores below 550. As a result, there are many idiosyncratic risks embedded in different issuers and deals from different issuers perform very differently. I do agree that it’s OK to have subprime auto lending to target borrowers who are not able to get access to credit, but you need to keep the share of that market to below a certain limit in order to avoid systemic risk like what happened in the US subprime crisis.
Rick D’Emilia, Wilmington Trust: I’ll just comment on consumer credit in the first quarter of the year and the deals that priced. As a service provider to the industry, I look at the deals and how they’re executed and how they’re getting done. The deals in this space have been oversubscribed. We’re on more than half of the deals in the marketplace lending space and the deals have gone fantastically well and many have been oversubscribed. So the investor appetite for the deals is there.
There are a lot of concerns on the origination side, but the way the deals have been structured, given the short-term nature of the assets, the appetite is there from investors for the product. All this year the deals we’ve been on have been very well received, so it’s been a good market for marketplace loan securitizations, and as more firms enter the securitization market as well as the whole loan market, they’ll diversify as to what their outlets for the loans are. But the first four months of the year have been very good for the market.
Black, Moody’s: Yes Rick, you bring up a good point, but I think it’s important that we remember that the securitization angle of this brings another layer of analysis to the table. Again, depending on how you define marketplace lending, of course, the visibility that you have for performance is in the very rapid pay-down of those loans and the related ABS. I think that also gives investors some comfort that they’re not going to be exposed for an extended period of time.
Not to mention the other qualitative tests of securitization that are brought to the table when you package securities — the very basic building blocks of securitization, the fundamental aspects of the credit that we’ve been talking about. That is the value add that securitization can bring to the table to fund the real economy.
Lau, Lord: That’s a good point. Compared to the pre-crisis period for these asset classes, and circling back to the unsecured consumer segment, you really had three to five lenders in the unsecured consumer prime and non-prime space — MBNA, Capital One, Household/HSBC. They had heavy concentrations in their balance sheets and did very few securitizations, most of which were private.
So there is certainly greater disintermediation of that risk now. You can debate the robustness of some of the organisations that are involved in originating these assets, but certainly they’ve figured out how to diversify that risk, whether it’s through whole loan sales or the ability to use securitization to be able to transfer that risk to other parties, and using structures that are generally deemed by the investor universe to be pretty robust.
Chen, Brandywine: I agree. Securitization is a very powerful mechanism in terms of protecting investors via credit supports and a de-levering deal structure. As an investor, when we calibrate the excess spreads of certain subprime auto bonds with subprime auto loans charging a rate as high as 25% whereas the bond only carries a 5% coupon, investors are protected by an excess spread of up to 20%. It’s phenomenal protection of any potential default for investors.
Sinha, Godolphin: There are two specifics I am aware of. One is the public records data, and the other was the medical data. Apparently a lot of the tax lien data is very noisy and just erroneous in many instances. And anyone who’s dealt with their doctors’ bills and the insurance companies are going to understand how much of a disaster the whole medical billing industry is, so I could easily imagine how innocuous late pays or errors are getting into that. To the extent that that is going away, I think it actually probably cleanses the bureau data more than anything else.
And finally, I don’t know of any lender that just blindly takes a FICO score as a single input into an underwriting decision. If things move around and somebody who would have been a 750 now becomes a 760 — and everybody shifts 10 steps here and there — who cares? You just have to live with that. So yes, we personally are not particularly concerned about these things and if anything, to the extent they reduce noise in the bureau data, that’s probably helpful.
Lau, Lord: You make a good point. If you ask someone if you can get more data or less data, they’re always going to say more data. But at the same time what is the value of that data? We know with so many consumer lenders, part of the challenge for them is how to eliminate the noise without moving to a full judgement analysis or judgemental lending? Many have tried to move to automated systems where they can pare down to those risk factors that are truly relevant to their type of lending.
A great example of this is all the proliferation of handset financing. For all the telecommunication companies, where they’ve found certain variables around the performance of their own customer base, these have proven to be far more important than most of the identifiers on a credit report. So when you look and say OK, certain information isn’t pulled out, essentially they’re having to go through that exercise already when they pull down a credit report and try to parse out how they create their score cards.
So it’s not so much what information is on there. When we’re speaking to lenders, they are able to look through their consumers and determine what variables and how do they reweight them, so that they’re almost creating their own custom FICO score, more than they are relying on that FICO number because that number can be completely wrong. Sometimes two 680 or 700 FICO scores can have tremendously different credit performance and it’s not going to be in relation to any one specific variable; it’s a group of variables together.
Lau, Lord: FFELP is going away, but it seems like every year you make that prediction and you’re never quite right about it. Having run student loan financing businesses in the past, on the FFELP side, certain issuers continue to buy in those pockets of FFELP loans. So when we think of FFELP ABS, the number obviously continues to decline year-over-year but that remains a very important asset. Certainly for a lot of asset managers, it is a very important asset class from a portfolio perspective. On the private side, it’s been slow and we work with a number of issuers that have been building what they see as a future for student lending — whether we want to call that a marketplace application — that’s an unfair misnomer in many ways, for the same reason we’ve talked about, which is that marketplace is really an origination engine more than it is a sector unto itself.
But it’s really looking at private entities or finance companies attempting to determine ways to make student debt available, whether it’s on a refinancing basis or just making education affordable, and understanding the limitations that ultimately exist when a student starts school and is not going to make meaningful payments until they’re out of school. Knowing that that student is not really an understandable credit risk until they reach that point is going to be a very large burden based on the cost of education. All those variables have made it very, very hard for everyone that’s trying to tackle that model.
Black, Moody’s: It’s definitely challenging. It’s a long-term consumer asset class, and there is roughly $1.4tr worth of student loan debt outstanding. The vast majority of that — around $950bn— is direct loans which are not today being securitized. Now that is also being talked about as a potential source of collateral down the road, but I haven’t seen any firm proposals along those lines yet. Then you have roughly, $100bn in private student loan debt and the balance being this diminishing pool of FFELP collateral.
This is always a fascinating sector to talk about because there is — outside of securitization — the government’s role or the philosophical and policy questions that are raised perennially, and they’re all being talked about and brought into the headlines once again as we have this change in administration. During the Obama administration, standards were established effectively targeting for-profit institutions regarding the ability of their graduates to repay their loans. Basically, if the schools didn’t meet the criteria, they could lose an important source of funding and their ability to operate. The new administration has talked about putting a pause on that criteria. So that’s one potential change.
From a securitization perspective, this has very little impact because only a very small percentage of borrowers who are still in-school at for-profit schools are represented in any pools. There are also some discussions around changes to the Grad PLUS and the Parent PLUS programmes. There are some discussions around limiting the amount that the government will lend through those programmes, again, very high level conversations at this point. It’s nothing firm, but that may allow for either less access for borrowers or, at least in those channels clearly where they’ll have to make different decisions, or maybe that’s an opportunity for the private lenders to come in and fill a gap that’s been created as a consequence of scaling back some of those programmes.
The other thing that was talked about and still is talked about, is income-based repayment (IBR). That continues to be promoted by the servicers, and continues to grow as a percentage of the loan balances. What we do see that is interesting, is when you combine IBR with deferment and forbearance — which are other programmes to help give relief to borrowers — the total deferment and forbearance and IBR ratio has remained relatively steady.
D’Emilia, Wilmington: If you look at the student loan ABS market, we talked about how many loans are being securitized in government programmes, and there really is a handful of people that are doing that. But if you look at all of the names of all the refinancing companies — we’re on deals with some of the largest originators in the market — what I’m seeing from them is that while they’ve started as these refinance companies they’re doing in-school products too. Obviously there is a large amount of the other products, but there’s only a small handful of issuers. You will be seeing two or three new issuers in this space in the months ahead.
Chen, Brandywine: Student loan ABS is the number one sector with the biggest policy uncertainty risk. So as an investor, we do require higher risk premiums to allow us to be attracted to this sector. There was considerable rating downgrade and political uncertainty with regards to FFELP for the past one or two years, so we stayed away from it, but since the end of last year FFELPs have created a unique opportunity for investors. But if you compare FFELP with the private student loan sector, the private sector probably is more attractive in terms of the risk/return profile with better loan performance and less political uncertainty. But again, this sector is one with a lot of uncertainty compared to
other ABS.
Black, Moody’s: They’ve carved out a very nice niche for themselves. We’re talking about the ones that have made it to the securitization market. I’m aware so far of SoFi, DRB and CommonBond, which are, by and large, originating to borrowers who have been out of school, who have a track record, a job and verified income that’s quite high. They’ve often graduated from a top tier school as well. As these companies grow their businesses, they’ve expanded their origination platforms, their target markets and their loan types so now many of them are offering other products
as well.
But bringing it back to just student loans, their business model is one where they’re identifying people who took out loans when they were in school — therefore a riskier loan and priced as such, presumably — and now 10 years later, they have a job, they’re a known entity, they have a track record, there are less risks and they’re able to price that in and then offer an attractively financed product to them. And that is working for that cohort of super-prime borrowers that they’ve been focused on.
Again, it’s early, in the sense that none of these companies we’re talking about have been around that long, and they are operating in a very benign credit environment. But certainly, performance is exceptionally good, losses have been extremely low in those pools. But it’s difficult to gauge just how good their underwriting algorithms are given the benign environment that we’re in. So that remains a question unanswered until, quite frankly, we go through a more challenging credit time. That’s the critical question.
Sinha, Godolphin: Honestly, I like the fact that it is around. Will alluded to the fact that people talk about regulation, and then they talk about cost, but they don’t talk about the benefits. And one of the biggest benefits really is prevention of things like the recent financial crisis. We’re all ducking underneath the table, thinking about whether the ATMs are going to function next week. So I think if anything, it acts as a stabiliser. And honestly, speaking as a consumer, our interactions with American corporations today are increasingly skewed and driven by the corporations, whether it be through arbitration clauses or whatever it may be. So you need some sort of a stabilising force that levels the playing field. We’re seeing this with respect to the airline industry right now. To the extent that the CFPB has shined some light on what were fairly murky practices, it is really not in anyone’s interest to have financial products that don’t work for the people that take them out.
Over the last five to six years, mortgage lending has been very robust. You can quibble about whether more should have been done with respect to Fannie and Freddie versus the private sector, but do we really want loans coming back where borrowers really don’t have the ability to pay and there are no checks and balances? If that really doesn’t happen, would we all miss it very much?
Lau, Lord: There’s certainly a role for them as a centralised consumer protection body because the comparison I would make to pre-crisis, when you had so many different bank regulatory bodies, and having worked at a bank at the time, one of the challenges was you had so many regulators, depending upon the client you were dealing with and different regulatory standards for every one of those institutions. So having some type of centralised view on what consumer regulation should be is certainly a big plus.
It seems like one of the challenges with the CFPB right now continues to be the politicised nature of its further existence. Every couple of weeks, someone in Congress is raising the idea that it shouldn’t continue to exist which, in some ways, feels like it drives it to continue to justify why it is existing.
Chen, Brandywine: Ideally, the role of the regulatory institutions should effectively synchronise with the ebbs and flows of a credit cycle. At this point in the credit cycle, we’re still in the late expansionary stage where the lenders are just about to loosen their lending standards because of everything going so well. So at this point the role of regulatory institutions like the CFPB is more important than at the earliest part of the cycle where the lenders are very cautious and tight with lending standards.
D’Emilia, Wilmington: We’re inundated with new warehouse facilities by banks willing to lend to issuers, so that’s where I see the large institutions willing to give significant warehouse finance in this space, and that’s increasing. That’s something that’s not quite seen in the securitization market right now, but that’s a precursor. Banks are giving more entities several hundred million dollar lines that are going to be securitized within six to 12 months. So I am seeing an increased activity there, and it bodes well for the issuance of ABS.
Lau, Lord: We’ve seen a tremendous amount of activity in even more non-standard products. We talk about standard consumer, but then there are other applications of consumer lending that are in the early stage — they might be in their first financing, getting a bank involved for the first time, so it might even be further than six to 12 months, but they’re beginning to build a business plan.
So standard consumer ABS certainly feels like it’s going to continue to be very strong so long as the consumers say so. But it also feels like there are a lot of additional applications that people are bringing to market with an expectation that that will move from the lending market to the securitization market because those businesses are developing the tools and the platforms they need to be securitization-ready.
Black, Moody’s: Yes, it goes back to what we were saying when we talked about it in the beginning, that the macroeconomic backdrop for originations and credit performance is pretty good right now. It’s had a better than expected first four months of the year in terms of the issuance volume for the ABS consumer sector. But we still have a long way to go for the year.
So in total, we’re calling for single-digit growth, year-over-year, in terms of issuance volume. But certainly, origination of raw material — if you want to call it that — for potential securitizations is, as I said, where you’re going to have the issuance volume. In student loans, that’s probably from the refi lenders mostly right now, and they’re growing off of a small base but they’re growing quite rapidly.
For autos, we said sales volumes are dropping, but they’re still very, very high from a historical perspective. We expect to see some marginal collateral performance deterioration in some of the more recent vintages, probably as a consequence of several successive years of marginal risk-taking.
And for credit cards — some look at them as a barometer for consumer credit in general — certainly, the securitized collateral is performing exceptionally well. I’ve been calling the bottom of the charge-off rate for many years running now, and been wrong. But in 2017, we’re going to hit an inflection point and losses are going to come off historic lows. But by all measures, credit cards are performing exceptionally well, and will continue to do so for quite some time, particularly the securitized collateral.
Chen, Brandywine: For year 2017, our base case is still a reflationary year with synchronised pick-up in global growth. Led by the US, China and the eurozone, global inflation started peaking slightly but the level is still moderate without urgent need for aggressive rate hiking. With the Federal Reserve’s benign and gradual monetary policy normalisation, it should still be a Goldilocks environment for risk assets. With the French election behind us, the political risk in the near term is declining. However, we are fully cognisant of the other three major risks. One of them is with regards to the normalisation of the Fed’s balance sheet. When and how they are going to taper their MBS and Treasury reinvestment, that’s a big unknown. Another risk is whether China’s growth will slow down drastically with its current financial market deleveraging and regulatory tightening. The third risk would be involved with political risk surrounding Trump’s administration, i.e., whether they can deliver their promise of fiscal stimulus, especially tax cuts. So, in a rising rate environment combined with a certain degree of uncertainty, I view ABS — based on a nature of short duration and mostly floating rate — would still be investors’ favourite. And also given the fact that we are in the late stage of this credit cycle, consumer ABS has always been a very decisive play for investors. We foresee healthy new ABS issuance volume this year given strong investor demand and the benign macroeconomic environment.
Sinha, Godolphin: The way we look at it is that there’s an overall macro cycle, in which we’re still in a reasonably benign phase. Bond rates are low but we don’t really expect them to tick up. Maybe there might be some regional issues that you have to be careful about. But embedded within this economic cycle you have different industries and sectors that are at different points in their own cycle. For example, subprime auto is very mature and you could start to see some more headlines emerge this year, which is independent of what the macro cycle is doing.
For credit cards, there are pockets, as you said, of stretching. The marketplace lending space is probably the most interesting because that’s where a rationalisation happened last year. It basically was the best thing since sliced bread, and then nobody wanted to touch it, but now people are beginning to see that the models are now consolidating and there’s a bit more stability, so people are starting to re-engage with the space.
A lot of the tools that have been traditionally available to specialty finance companies are beginning to be made available, as you pointed out, to people that are coming in, like ourselves — and are interested in the loans and want to use the ABS market as term financing.
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