- The asset-backed securities market has expanded since 2008, with new types of securitization including marketplace lending
- The marketplace lending industry offers a yield advantage for investors who can exploit inefficiencies in this new and growing market
- Looking beyond the standard lineup of asset-backed securities allows us to add value for our clients
Asset-backed securities (ABS) were introduced to the marketplace in the mid-1980s, when the Sperry Lease Finance Corporation created a new type of securitization, one backed by computer equipment leases. Prior to the introduction of the Sperry ABS deal, mortgages served as the main source of securitization. Securitization begins with an agreement between a lender and a borrower as to the amount borrowed, interest rate paid, collateral used to secure the loan, and loan maturity. The borrower’s obligation is then sold or pledged to a trust along with a variety of other similar loans, creating the securitized product. Since the time of the initial ABS deal, the market has continued to grow and diversify through the implementation of new types of securitization, ranging from automobile loans and leases to cell phone payments, in response to a changing market environment after the Financial Crisis of 2008.
One of the unique aspects of the Diamond Hill fixed income team is our focus on securitized products including, but not limited to, residential and commercial mortgage-backed securities and the aforementioned ABS. According to the Securities Industry and Financial Markets Association (SIFMA), ABS is a $1.4 trillion market as of September 30, 2017 which has grown substantially since its emergence in the mid-1980s (see chart below). The size of the market peaked in 2007 leading up to the Financial Crisis and subsequently began a decline post-Crisis as issuance was greatly reduced and outstanding deals continue to pay down. Only more recently has the market begun to rebound as it expands beyond the traditional categories.
Growth of the Asset-Backed Securities Market
One of the newer categories of securitization is marketplace lending, which originated with a British firm, Zopa, in 2005. Zopa created an online marketplace for consumer loans, combining the financing aspects of the bond market with the innovation of the largest marketplace in the world, eBay. Essentially, the firm utilized advances in technology to bring together borrowers and lenders (investors). In doing so, two needs were met: the borrowers found a way to finance their debt in a quick manner without the red tape of bank approvals and forms, while lenders were able to generate attractive returns while diversifying risk among a variety of borrowers. The success that Zopa experienced in building a book of loans led to the launch of counterparts in the United States like Lending Club and Prosper in 2006. Thus, the peer-to-peer (P2P) lending industry in the United States was born.
As with most new industries, P2P lending experienced some early growing pains. Limited restrictions on borrower eligibility led to poor loan selection and high initial borrower default rates. Lenders were concerned about the uncertain nature of their investments from a term standpoint (typically a minimum of three years), which created a lack of liquidity. During the Financial Crisis, the Securities and Exchange Commission (SEC) announced that P2P lending companies were issuing securities and thus fell under the regulatory purview of the SEC. Firms like Prosper, Lending Club, and new market entrant Loanio had to temporarily suspend offering new loans while working through the process of registration. The firms gained approval from the SEC to offer investors notes backed by payments received on the loans. The liquidity issue was resolved when firms formed partnerships with FOLIO Investing in order to build a secondary market for their loans.
As the Financial Crisis spread to more aspects of the economy and banks put a hard ceiling on the size of their loan portfolios, individuals turned to P2P lending companies for borrowing needs. This growth was a double-edged sword. As a result of the ongoing impacts of the Financial Crisis, borrower default levels increased, raising investor concern and leading to higher interest rates charged to borrowers to compensate investors for the additional risk.
An Industry Evolves
As the P2P industry grew, it also evolved from simple loans between borrowers and lenders. Institutional investors (hedge funds, insurance companies, etc.) began to fund the loans for the various entities that had emerged from the ashes of the Financial Crisis to originate consumer and small business loans. These firms were filling a void created by the departure of large financial firms that were focused on shoring up balance sheets. As the business model evolved, so did the nature of the companies participating in this industry. Whereas before, these companies were serving as the facilitator between individual borrowers and lenders (for a fee), new entrants in the field such as SoFi, Earnest, and Avant were functioning more as traditional lenders and utilizing funds raised through forward-purchasing agreements with institutional investors. The current version of marketplace lending combines the innovative nature of P2P lending, such as using the internet and mobile devices to reach consumers and streamline their experience, with the more traditional approach of consumer financing.
As with any successful venture, money and investors began to flow into the marketplace lending business. The industry moved beyond the initial unsecured consumer loans into small business loans, private student loans, and non-agency jumbo mortgage-backed securities. While the consumer loan market has driven the majority of the growth, it is important to note the significant growth of private student loans issued by companies like SoFi, Earnest, and College Avenue. The below chart illustrates the growth across the various segments of the industry.
Growth of Marketplace Lending by Segment
Opportunities for Investors
With such dramatic growth from an asset and issuer standpoint over a short period of time, opportunities present themselves to investors willing to take the time to understand the structure of these securities as well as the potential risk and reward associated with them.
The marketplace lending industry offers a significant yield advantage for a variety of reasons. First, some issuers opt not to pay a Nationally Recognized Statistical Rating Organization (NRSRO) such as S&P, Moody’s, or Fitch for an official rating, which can drive yields higher to compensate for the lack of official rating that some investors require. For managers willing to conduct internal research and apply their own internal rating methodology, the excess yield offered from these non-rated securities can be quite attractive. Additionally, a large percentage of marketplace lending deals are coming to the market issued under Rule 144a, which provides a mechanism for the sale of privately placed securities that do not have, and are not required to have, an SEC registration. These bonds traditionally come with a higher level of yield compensation since they are not permissible for some investors.
Even for securities that do receive a rating from an NRSRO, the relatively short history of the marketplace lending industry can be detrimental to their rating. For example, a security that has the characteristics and structure of a BBB-rated bond may actually receive a rating of BB based on the lack of firm and/or industry history. Investors in these bonds will require additional yield and the bonds will be available to a smaller set of investors due to guideline restrictions. Finally, the size of the overall issue, which typically ranges from $200 million to $400 million, will prevent index funds and larger managers from participating in these new opportunities. Either the security is too small to be included in the index per its guidelines, or asset managers are of such a size that any allocation (even the entire issue) would not be a meaningful allocation to the portfolio.
The Diamond Hill fixed income team is able to exploit some of the inefficiencies associated with this new and growing market by applying our bottom-up research analysis and a deep understanding of the structure of the deals and the companies putting those deals together. Meeting with management of firms like Upstart, Avant, and others in person provides insight into the issuing firm’s philosophy, background, financial stability, and approach to the market, all of which can be differentiators among the various deals in the marketplace. We combine the qualitative aspects of understanding a company with the quantitative methodology of breaking down deals to their basic components to truly understand how they are structured and where risks may reside. The diversification of the marketplace lending industry, with numerous issuers and issues, helps to mitigate risk by spreading the allocation across a variety of structures and underwriting firms.
Capacity discipline also plays a very important role in the ongoing management of our fixed income strategies. Our smaller size allows us to take advantage of deal issues that larger firms would not consider, as the size of the deal would be a negligible addition to a very large strategy. At Diamond Hill, portfolio managers are solely responsible for determining the capacity estimates for their strategies. The key consideration in estimating a strategy’s capacity is to determine what asset size may hinder our ability to add value over a passive alternative. Portfolio managers have the authority to close their strategies before they reach an asset size where they believe that they can no longer add sufficient value.
Originally published on February 14, 2018.
The views expressed are those of Diamond Hill as of February 2018 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.