Insights
Alternative Lending and the Resilient Consumer
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Resilience
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June 24, 2020
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Alternative Lending and the Resilient Consumer
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June 24, 2020
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Alternative Lending and the Resilient Consumer
Alternative Lending and the Resilient Consumer |
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Please see important disclaimers at the end of this article.
The coronavirus pandemic has taken a devastating human toll, while wreaking havoc across economies and markets. Alternative lending has not been immune to these conditions, but we believe this fintech-driven asset class has exhibited fundamental resilience during the acute initial phase of the downturn. Recent data supports continued optimism.
For unsecured consumer alternative loans originated after the onset of COVID-induced economic shutdowns, the marketplace model that alternative lenders use for matching consumer borrowers with loan investors has driven rapid recalibration in underwriting standards, reflecting changed economic realities. Tighter credit conditions and higher interest rates on new alternative loans compensate investors for both heightened risk and heightened risk aversion. For unsecured consumer alternative loans underwritten before the economic shutdowns, three factors are critical: how much the loan impairment rate increases relative to the sharp change in the U.S. unemployment rate, how long the loan impairment rate remains elevated, and what percentage of impaired loans ultimately results in charge-offs—defaulted loans removed from the books or marked down to low expected recovery values. As discussed below, early impairment data is encouraging.
How Do Changes in the Unemployment Rate Affect Changes in the Consumer Loan Charge-Off Rate?
Before reviewing consumer alternative loan performance during the initial phase of the downturn, we present an intellectual framework that models the expected change in the alternative lending charge-off rate as a lagged function of unemployment rate change. This framework is informed by historical credit card data that tracks consumer charge-off trends over extended periods of time, including multiple prior recessions. Of course, behavior of the American consumer through prior recessions is no guarantee of how consumers will behave going forward—particularly given that this pandemic lacks recent historical precedent. Furthermore, while credit card lending is also a form of unsecured consumer lending, we recognize that it provides an imperfect proxy for consumer alternative lending. Credit card loans might sit higher in borrowers’ payment priority hierarchies than do loans facilitated by alternative lenders. Conversely, alternative loans generally repay via automated pulls directly from borrowers’ bank accounts, and they typically amortize rather than revolve like credit card loans.
With these caveats in mind, we have analyzed how alternative lending might perform as we move through the pandemic. Key variables include how high the unemployment rate rises, how long it remains elevated as the crisis abates, and how unemployment rate changes translate into lagged changes in the loan charge-off rate. Display 1 shows that, historically, changes in consumer credit card delinquencies have broadly tracked changes in the unemployment rate—both up and down. For example, both spiked during the Global Financial Crisis (GFC) but normalized soon thereafter.
Source: Based on quarter-over-quarter absolute change in credit card delinquency rate from 3/31/1991 – 12/31/2019 per Federal Reserve data (https://fred.stlouisfed.org/series/DRCCLACBS) , as well as quarter-over-quarter absolute change in average quarterly unemployment rate from 3/31/1991 – 3/1/2020 per Federal Reserve data (https://fred.stlouisfed.org/series/UNRATE). Derived from analysis by Upstart Network, Inc.
Source: Based on quarter-over-quarter absolute change in credit card delinquency rate from 3/31/1991 – 12/31/2019 per Federal Reserve data (https://fred.stlouisfed.org/series/DRCCLACBS) , as well as quarter-over-quarter absolute change in average quarterly unemployment rate from 3/31/1991 – 3/1/2020 per Federal Reserve data (https://fred.stlouisfed.org/series/UNRATE). Derived from analysis by Upstart Network, Inc.
Similarly, while the explanatory power is limited, regression of historical credit card data demonstrates roughly a 1:1 relationship between unemployment rate change and credit card charge-off rate change on a three-month lag. The regression suggests that any expected increase in charge-off rate following a rise in the unemployment rate typically would only apply to the period immediately following the unemployment rate increase. Afterwards, we would expect the charge-off rate to stabilize. Likewise, we would expect the charge-off rate to fall following an unemployment rate decline, which is typical after a recession. With this framework, it is important to remember that changes in the charge-off rate are annualized, so the duration of unemployment rate increase is critical when thinking about the prospects for alternative loans underwritten pre-pandemic.
Charge-Off Rate Change Expectations Based on History May Not Reflect Positive Factors at Work Today
Historical credit card data stems from prior recessionary periods that lacked the truly unprecedented fiscal and monetary stimulus measures in place today. We expect these stimulus efforts will reduce the pass-through from unemployment rate changes to lagged changes in the loan charge-off rate. Furthermore, U.S. households significantly reduced their aggregate debt relative to GDP in the aftermath of the GFC. They also entered the current crisis with debt service ratios at low levels not seen in decades.1
Industry-level data from the lending analytics firm dv01 highlights the U.S. consumer’s resilience during this challenging time. Encouragingly, Display 2 shows that from the beginning of March to the end of May, change in the rate of unsecured consumer alternative loan impairment (including both delinquent and modified loans) was in line with change in the official U.S. unemployment rate. The impairment rate change also was well below change in Morgan Stanley Research’s estimate of the adjusted unemployment rate, after correcting for undercounting in the official rate.2 Furthermore, both the unemployment rate and the loan impairment rate trended down in May as the economy began to recover.
Of note, we expect a significant percentage of impaired loans to be repaid as the economy recovers and borrowers transition out of short-term loan forbearance programs. This suggests that the lagged increase in charge-off rate might prove well below what historical credit data would suggest following the massive increase seen in the unemployment rate. According to dv01, “These are very positive trends for investors and indicators of the strength, proactive responses, resiliency, and long-term sustainability of online lending as a steady and established product and asset class.3”
Source: dv01 - Loans in the dv01 dataset have weighted average FICO score of 715, weighted average coupon of 13.6%, and weighted average balance of approximately $11,400; https://www.bls.gov/news.release/empsit.t15.htm , and Morgan Stanley Research, US Economics | North America, “May Payroll: The Beginning of the Reopening Bounce,” June 5, 2020.
Source: dv01 - Loans in the dv01 dataset have weighted average FICO score of 715, weighted average coupon of 13.6%, and weighted average balance of approximately $11,400; https://www.bls.gov/news.release/empsit.t15.htm , and Morgan Stanley Research, US Economics | North America, “May Payroll: The Beginning of the Reopening Bounce,” June 5, 2020.
In addition to the positive impact of current government stimulus programs, historical data does not take into account the large percentage of recently jobless describing themselves as temporarily unemployed, which suggests continued attachment to prior employers. This is very different than the period following the GFC and may be akin to the “Volcker Recession” of the early 1980s.4 Like the COVID economic shutdown, the Volcker Recession effectively was exogenous. Importantly, that recession was followed by rapid hiring; suggesting that a V- or swoosh-shaped recovery might be more likely than the U-shaped recovery experienced post-GFC—assuming the health crisis continues to abate. Indeed, Wall Street research departments project a relatively rapid snap back in economic activity with a commensurate drop in unemployment (Display 3). However, both downturn and recovery dynamics will depend on progression of the virus and on countercyclical government stimulus, and we expect the slope of recovery will be more gradual than the slope of deterioration.
Source: Bloomberg as of June 12, 2020. Data via most recent economic forecast from the research departments of the above referenced financial institutions. Data includes projections through June 12, 2020, that had been updated following the May unemployment report released on June 5, 2020.
Source: Bloomberg as of June 12, 2020. Data via most recent economic forecast from the research departments of the above referenced financial institutions. Data includes projections through June 12, 2020, that had been updated following the May unemployment report released on June 5, 2020.
What Does This Mean for Investing in Alternative Loans Going Forward?
We believe that alternative lending performance will be influenced by the pace of employment recovery, with divergent outcomes across different groups of consumers. Consumers’ willingness and ability to service debts will be influenced by their financial histories, balance sheets, incomes, types of employment and states of residence—with COVID-19 amplifying the effects of all these variables. Alternative lending’s differentiated underwriting takes these factors, and many more, into consideration when determining whether a loan should be extended and at what risk-adjusted pricing.
We also expect performance to differ across loan vintages. Seasoned, partially amortized loans may prove less sensitive to acute changes in the economic backdrop than similar but less seasoned loans underwritten just before the downturn. This is because contractual monthly principal amortization may naturally reduce a borrower’s propensity to default as the loan progressively pays down. Furthermore, newly originated alternative loans underwritten after the onset of the downturn should reflect changed economic circumstances through tightened credit standards and higher borrower interest rates.
From an investor’s perspective, reinvesting cash flows from alternative loans already in a portfolio into new alternative loans could facilitate vintage diversification that could in turn reduce recession sensitivity. Over time vintage diversification could allow the portfolio to reflect changing economic conditions in terms of varying credit standards and borrower rates across portfolio vintages (Display 4). In our view, loan vintage diversification provides a powerful risk management tool for investors in alternative loans that may not be as available to investors in traditional corporate credit portfolios which repay principal only at maturity.
Diversification does not eliminate the risk of loss.
Source: AIP Alternative Lending Group. The chart assumes a simplified illustrative $100MM portfolio of loans with a 7% coupon rate. The chart also assumes no losses or prepayments, and $20 million of additional investments each month. It further assumes that the first investment was made on 12/31/19 and that all interest and principal payments from the loans were re-invested into new vintages on a monthly basis.
Diversification does not eliminate the risk of loss.
Source: AIP Alternative Lending Group. The chart assumes a simplified illustrative $100MM portfolio of loans with a 7% coupon rate. The chart also assumes no losses or prepayments, and $20 million of additional investments each month. It further assumes that the first investment was made on 12/31/19 and that all interest and principal payments from the loans were re-invested into new vintages on a monthly basis.
Conclusion
While the unemployment rate remains staggeringly high, the official rate decreased from 14.7% in April to 13.3% in May.5 This suggests that light may be flickering at the end of the tunnel. We cannot yet determine how long the unemployment rate will remain elevated, how much government stimulus will moderate the pass-through from unemployment rate changes to charge-off rate changes, how much consumer balance sheet repair following the GFC will insulate consumers as they deal with the lingering effects of the downturn, how likely employers will be to rehire as the economy reopens, or how the virus will progress from here. However, as GDP troughs and the unemployment rate declines, we grow increasingly optimistic about the forward-looking opportunity set for alternative lending. In the primary market for new alternative loans, those already unemployed are not typically eligible to borrow, meaning the benefits of tightened credit and higher borrower interest rates become more apparent as the magnitude of new jobless claims declines. We also have seen compelling alternative lending secondary market opportunities across both whole loans and asset backed securities.
Importantly, we are encouraged by unsecured consumer alternative lending’s fundamental resilience during the acute phase of this downturn, as reflected in early impairment data. In these uncertain times, as in more normal times, we believe that diversified exposure to alternative loans across regions, sectors, platforms and vintages remains the best way to access the asset class. Alternative lending may diversify both traditional fixed income and private credit allocations.
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Managing Director
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