6 min read 16 Nov 22
There is no denying that the outlook for the world’s major economies has become more challenging in recent months as fears around climbing interest rates and the effects of inflation take hold. Macro risks, specifically stagflation, are also combining with geopolitical, monetary and fiscal policy uncertainty, which is having a knock-on (and distortive) impact on asset prices and liquidity across many markets in the current climate.
In the case of consumer finance (also known as ‘specialty finance’), the extent of the price action in recent months has seen some residential mortgage and consumer loan assets across Europe trading at levels that imply a very significant amount of annual credit losses relative to long-term averages and, in most cases, higher than the levels of default and loss severity recorded during the global financial crisis (GFC). But is this justified?
Not only are these GFC levels of stress assumed to kick in straight away but markets are assuming that defaults will persist in the years to come; effectively pricing in a GFC event every year. Yet, on balance, this view could prove to be overly cautious.
Let’s remind ourselves of a few realities. Economic growth is expected to slow and consumer confidence has plummeted to new lows across many advanced economies. Though household savings are relatively high compared to historical norms, unemployment rates are very low, and there is nuance to how people are responding and managing their finances amid the cost-of-living crisis. If household income growth (mainly through wage growth from labour income) fails to keep pace with inflation, then the fact that much of the population is in employment and earning income, is a huge positive for the debt serviceability of consumer finance assets.
In a cost-of-living crisis, consumers are inherently in the eye of the storm. But in fact, they have been notable recipients of huge fiscal stimulus and support packages over the past few years amid the pandemic. Add to this the billions of euros pledged in funding measures announced by governments across Europe in recent months to help households cope with rapidly rising energy bills. According to Bruegel, an economic think-tank, “since the start of the energy crisis in September 2021, €674 billion has been allocated and earmarked across European countries to shield consumers from the rising energy costs.”
While headlines continue to drive sentiment at the current juncture, the extent of the dislocation across credit and asset-backed securities (ABS) markets is arguably distorting what investors may perceive about the risk-return performance of these assets, as well as the ability of the specialty finance asset class to withstand macroeconomic headwinds.
Over the past decade or so, we have seen very low defaults and losses on residential mortgage and consumer loan assets that we expect to substantially pick up in the future. This is what we are assuming when underwriting investments – while also factoring conservative assumptions into purchase price decisions when bidding on assets, allowing us to back-solve the price of a loan pool to earn a desired spread on the loans, post losses.
It is crucially important to think about asset resilience through a range of different macro and market scenarios. For instance, we look at what happens when defaults on these loans increase suddenly, i.e. borrowers go into arrears on their debt payments and are unable to pay back their loans, and build-in assumptions for a deeper decline in value of the collateral backing consumer loans, such as residential property. We also model the resilience of returns assuming higher or lower prepayment rates and higher financing costs.
By calibrating default and loss severity assumptions and adjusting higher to see what happens to expected returns (IRR) – we find that even at defaults equivalent to GFC levels of stress, investors have been attractively compensated. In many cases, our analysis shows that these assets still have the potential to yield strong positive returns even when pricing in defaults and losses of the magnitude seen during the GFC.
Investing in performing residential mortgages and consumer loan portfolios has the potential to offer stable short-dated, income-driven returns with low duration.
Essentially, investors do not need the current risk premium to dissipate to make excess returns. Returns on residential mortgages and other consumer loans are driven by contractual interest payments on the loans as borrowers pay down their loans over time, rather than returns predicated on market gain. Similar to other structured credit assets classes such as synthetic SRT and senior ABS, mezzanine investments benefit from the coupon income. By investing in junior tranches, it’s also possible to benefit from the excess spread.
The structural features inherent in these investments could mitigate risk for investors from even very high levels of loan defaults, and help to sustain income generation despite headwinds. These include:
1. Rapidly de-risking investments – Front-ended amortisation structures, which tend to act as a buffer to ensure these investments have the potential to remain highly cashflow-generative as borrowers pay down their loans. Assets have short weighted average lives (WALs) and are therefore rapidly de-risking. The average duration of a typical investment is around 2.5 years, so this means that investors are not taking a 10-year, or even a 5-year, view on the economy.
2. Resilience under rigorous analysis – The vast majority of assets are also secured against (have full recourse to) the borrower and mortgage investments tend to be at lower loan-to-value (LTV) ratios than newly-issued mortgages – the weighted average LTV of our investments is ~60%.
3. Lower sensitivity to rising rates – In many European countries, long-term, fixed rate mortgages are common, with borrowers opting for loans which have reset dates that can be more than 20 years away. Although this does not apply to variable rate loans, borrowers with a fixed-rate mortgage means debts don’t automatically cost more to service as rates rise (this happens only at the reset date). While consumer assets are fixed rate (for borrowers), the structure can be hedged to floating rate (for investors) to provide a self-adjusting mechanism for rising returns as interest rates increase.
In the current environment, we feel that the opportunities we are sourcing across the residential mortgage and consumer loan universe are quite exceptional in some areas. The nature of investing in the asset class with patient capital and a largely institutional investor base, together with the flexibility to invest in both private and public situations, is proving particularly valuable during periods of illiquidity and volatility in the broader credit and ABS markets.
For investors, not only does the asset class have the potential to generate attractive short-dated, income-driven returns, but allocating capital to consumer finance assets like residential mortgages today can be used to reduce duration and make portfolios less susceptible to changes in interest rates – which could be particularly valuable to many investors in the current climate.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.