Citi’s CHAI shelf attracted WSJ headlines this week as the coupon associated with the riskiest bond priced ~5% higher than a similar bond offering last year.
Institutional investors who seek financing from warehouse lending facilities, credit lines, and securitization programs, are asking: how much has financing cost increased over time for marketplace lending? How does this impact P2P funding?
Citibank has brought four CHAI securitization deals with Prosper into the capital market. The CHAI shelf provides a nice controlled analysis to explore this question. We look at the weighted average spread (above UST rate) across the full capital stack for a holistic view of financing costs:
(Note that the CHAI deals have similar collateral pool characteristics related to grade distribution, FICO, coupon rate, and aging at the time of issuance.)
Financing costs have increased. While we see a gradual increase from the first CHAI deal to the third (~100 bps), we find that the most recent deal CHAI 2016-PMI spread has almost doubled as compared to the prior deal CHAI 2015-PM3.
Strong Relative Value for Institutional Investors
Today, the securitization market is offering yields to institutional investors that in some cases are more attractive than funding the whole loans themselves.
A simple analysis – ignoring caveats and qualifications – is the following comparison of an investor that performs relative value analysis of buying whole loans vs. the mezzanine tranche in the recent CHAI transaction.
|Metric||Whole Loans||Mezzanine bond|
|Return||5 to 8% (after exp. losses), varies by grade||12.50% after expected losses|
|Risk||Losses immediately reduce returns||Loss protection up to 12%|
|Excess Spread||Zero||5.71% per annum at pool level (Kroll est.)|
|Ratings||None||Yes (Kroll Preliminary BB-)|
|Leverage||Costly||Cheap, overnight repo with haircut|
|Administration||Costly||Easy, CUSIP format|
|Cashflows||Idiosyncratic||Predictable monthly payments|
|Reps & Warrants||Limited to loan servicing agreement||Also includes bond covenants|
We find that investors owning the mezzanine bond can earn a higher unlevered return, access liquidity, bear lower administrative costs, enjoy additional investor protections, and protection from expected credit losses as compared to owning the whole loans.Investors that have the flexibility in mandate to purchase whole loans or CUSIPs will prefer to purchase the latter.This is surprising. Whole loans carry risk premia related to lack of liquidity and other considerations such as uncertainties associated with cashflow projections. Indeed, aggregators seek to package pools of raw loans and transform them into securities and capture value through security transformation.
Increased Financing Costs for Aggregators
For investors that act purely as aggregators, as credit facilities roll-over, dealers will pass on higher financing costs to institutional investors. Aggregators generally look forward to securitization as a source of permanent non-recourse funding and expect comparable if not cheaper financing costs compared to costs during the warehouse period. (Sometimes aggregators will securitize despite higher funding costs on account of regulatory capital considerations, or an urgency to recycle capital to fund new origination.) Moreover, securitization as a funding source is also in competition with fixed-term financing solutions as aggregators can shop around for the cheapest total financing cost.
Consequently, we expect that the cost of credit facilities to increase to reflect the widening in spreads.Higher financing costs imply lower margins for institutional investors who will demand a commensurate step-up in rates to earn the same net return. This is exactly what happened in CHAI 2016-PMI, and why we see platforms responding by raising rates accordingly.
Reduction in Leverage
Sophisticated institutional investors utilize leverage to achieve their hurdle rate of returns for their end-investors and LPs. As the cost of financing increases, the net interest payments after liability costs (e.g., excess spread) to providers of financing are reduced.
Excess spread is an important form of credit enhancement and is ~5.71% in CHAI 2016-PM1 transaction. A reduction in excess spread may lead to lower advance rates.
In short, leverage has less mileage, and platforms will need to attract additional capital to offset this effect.
Impact to other P2P Installment Lenders
Platforms that do not fund via the ABS markets directly, or indirectly via their institutional investors, may feel they are isolated from the effects of wider credit spreads or may believe that superior underwriting is sufficient to attract capital. This view is incorrect.
Consider a platform that has a 2 to 3% reduction in cumulative credit losses as compared to another platform for a similar risk cohort. All things being equal, the investor is still better off buying ABS where they enjoy 12% in credit enhancement, as in the recent CHAI deal.
Smaller platforms that have not performed a securitization must increase the net returns of their loans (after financing costs and expected charge-offs) to compete for investor attention. P2P platforms seek capital from institutional investors performing relative value analysis in a dynamic market.
Spring Thaw in Macro Outlook
From a macro perspective, for weeks, the securitization market has shown a dearth of liquidity and an abundance of volatility. Recently we see:
- The S&P has recovered about 10% from Feb 11th
- Barclay’s High Yield Bond ETF came off its local low of 31.40 to 34.15 per share as well
- The spread sector has recently rebounded with several deals coming into the CMBS market
- Collateralized-debt obligations are showing signs of spread tightening
- Given the issuance of CHAI 2016-PMI, we consider the sign of unfrozen securitization a welcoming development. Deals are getting done, albeit at higher financing costs.
We have an improved macro picture today compared to the time of ABS West in late February. This is a positive for institutional investors who are looking for the best value in credit spread products, which are still leaning toward their wider end of the historical range.
What does this mean for the industry and PeerIQ?
In our October newsletter, we discussed the importance of seeking diverse and resilient sources of low-cost capital. The fragility of the funding chain linking platforms to the institutional markets has added urgency to our work with platforms and investors.
Taking a step back, we observe that there is tens of trillions of dollars in the US fixed income market. The P2P market in contrast is merely tens of billions of dollars. There is an abundance of capital to fund the continued growth of the market.Institutional investors are grappling with a “new asset class” amidst a barrage of noisy headlines. Clinical data & analytics that promote transparency, comparability, and broaden the base of ABS investors are essential to unlocking these large pools of capital.Platforms that have sustained capital access during turbulent times will slingshot past their rivals and deliver a better rate to borrowers.We look forward to seeing you at the LendIt conference, where we will share how we are working with the world’s leading platforms and institutional investors to promote a smooth functioning market.
- PeerIQ CEO, Ram Ahluwalia, will be a panelist at Commonbond’s “Marketplace Lending Panel” this Tuesday, March 29th, discussing the current macroeconomic environment and other key current developments across the space
- PeerIQ will participate in a Marketplace Lending Operators MeetUp panel discussion on April 7th entitled, “What Marketplace Lenders Need to Know Right Now.” Sign up for the event here!
- PeerIQ will be at LendIt in San Francisco April 11–12th
2. Hiring Update: Introducing Andrew Meier and Wilfred Daye!
We are excited to introduce two new members to our team this month.
- Andrew Meier: Andrew Meier is the latest addition to our data operations team. Prior to joining PeerIQ, Andrew worked in the Capital Markets Strategy group at PwC Strategy where he advised banks, private equity firms, and financial technology companies on strategic business issues. Andrew received a dual-degree B.S. in Physics and Mechanical Engineering from Rhodes College and Washington University in St. Louis, respectively
- Wilfred Daye: As Managing Director of Quantitative Strategies, Wilfred leads the quantitative strategy effort at PeerIQ. Prior to PeerIQ, Wilfred was a Structured Financing Trader for UBS, responsible for portfolio construction and risk management of securitized product collaterals. Before UBS, he was a senior counterparty risk quant for Deutsche Bank. He was a senior portfolio market risk manager for D.B. Zwirn, LLC, specializing in both cash and synthetic structured credit derivatives. Prior to his buy-side experience, he led Client Valuation Group for Lehman Brothers and was part of Risk Finance team at Barclays Capital. Wilfred began his career at Lehman Brothers, where we worked as an analyst for CMBS trading desk. He earned B.S. in Biochemistry from University of California, and M.S. in Financial Engineering from Claremont Graduate School. He was a doctoral candidate in Pathology at USC- School of Medicine. He holds FINRA Series 7, 63, and 24 licenses, and was awarded the CIAA designation
3. Industry Update:
- A Ripple of Fear (The Economist, 3/26/16) The challenges facing P2P lending are overstated says PeerIQ CEO
- Bond Offering Tied to Prosper Marketplace Loans Gets Chilly Reception (WSJ, 3/25/16) PeerIQ analysis shows continued elevated financing costs for P2P ABS
- Supreme Court Seeks Administration Views on States’ Interest-Rate Caps (WSJ, 3/21/16) U.S. Supreme court invites Solicitor General to file a brief expressing the administration’s views on Madden v Midland
- China Online Financing Firms Face More Regulatory Tightening (WSJ, 3/23/16) Regulatory scrutiny tightens in a desire to improve risk controls
- Jack Dorsey’s Bet on Online Lending Could Have a Huge Payoff (Inc., 3/25/16) Square ventures into the online lending world
- Avant Expands into Auto Lending with New Refinance Product (AmericanBanker, 3/21/16) Avant launches new auto loan refinance product
- How This Niche Lender Found a Way to Branch Out (NationalMortgageNews.com, 3/17/16) DRB to offer paperless mortgages via mobile
- Building a $13 billion dollar company – how we took data and sold it eight different ways for success (LinkedIn, 3/22/16) Markit’s success story—how the erstwhile startup took data, sold it, and added complimentary data sets and sold it again