Part 2: Structuring for the Downside in Asset-Backed Lending

To avoid losses when defaults occur, the investor must develop the appropriate “structure” for the investment. Put simply, the investment’s structure determines: “who loses what when…”

Consumer Loan Example: Asset-Backed Lending

To illustrate these points, I’ll talk through a portfolio of consumer loans originated by an Online Lender (“Originator”) structured as an asset-backed lending facility.

In an asset-backed lending investment, the Originator makes loans, puts those loans into an SPV, and the Investor lends money to the SPV. In other words, the loan to the SPV is “backed” by the cash flows from the consumer loan — hence, the term asset-backed.

For this discussion, let’s say the investments have the following characteristics:

Asset-backed Lending Facility:

Senior Secured Loan from Investor to Originator

  • $800,000 loan
  • 10% annual interest rate, paid monthly
  • 80% advance rate [also, known as Loan-to-Value ratio]
  • Principal paid fully in 2 years

Loans provided by Originator to Consumers, which “collateralize” the Investor’s Loan

  • 1,000 consumer loans
  • $1,000 a loan
  • 20% annual interest rate, paid monthly
  • Principal paid fully in 2 years

[Note: the advance rate is the loan to value from the lender’s perspective.]

Day 1 Balance Sheets

To build some intuition, let’s talk through how the Investor’s and Originator’s balance sheets work together.

On day 1, the Investor’s balance sheet will include $800,000 in Investments for the amount lent to the Originator. For simplicity, the investments are secured by the Originator’s $1,000,000 of consumer loans. The Originator’s balance sheet will include $1,000,000 in Investments, a reduction of $200,00 in cash for the equity contribution to the SPV, and $800,000 in borrowings from the Investor.

[Depending on materiality you might also see some disclosure in the borrowings footnote to elaborate on the terms of the borrowing and situations that would cause them to be required to pledge additional collateral. This allows the Originator to absorb the first $200,000 of losses on the facility before the Lenders’s $800,000 loan is impacted. For prudent risk management, the Originator would likely hold more investments than required, but let’s assume for simplicity they do not.]

Takeaway: The Originator’s liability (borrowing) is an asset (loan) to the Investor. Separately, the Originator’s investments in consumer loans are pledged as collateral to the investor, but sit on the Originator’s balance sheet. The loan to collateral ratio called the advance rate must be maintained at all times.

The Investor’s Reserves

Since the Investor intends to hold-to-maturity, the Investor will only establish an allowance for loan loss reserve when it is probable that more $200,000 of the consumer loans within the facility will default.

Determining the probability of default is often referred to as the PD grade of the investment and the loss given default is referred to as the LGD grade. PD and LGD grades are simply weights applied to the outstanding principal balances to determine the expected losses within the portfolio. They are called “grades” because the weights are determined using a scaled or graded system that considers both historical experience and management judgement, typically outlined in a policy to maintain a level of consistency.

The calculation below reflects a simple loss given default/ probability default (LGD/PD) model:

Expected Losses = Amount outstanding ($800,000) * Probability of Default (PD) * Loss Given Default (LGD)

The loss given default is typically based on historical experience. The assessment includes understanding the status of the loan in its seasoning (time outstanding), FICO, Debt to Income, payment history, industry/ occupation of borrower, and sensitivities to macroeconomic variables. Qualitative considerations are also considered because the past may not always be the best predictor of the future, for instances, such as a global pandemic. In any case, the assumptions used should be disclosed to investors on the investor call or in the MD&A section (i.e. 20% unemployment; GDP down 25% next quarter etc).

The Investor’s Borrowing Base

Another consideration when establishing a reserve is what’s called the “borrowing base.” The borrowing base is the amount of Investments that sit on the balance sheet of the Originator plus any excess cash within the SPV, which together cover or collateralize the Investor’s loan to the Originator. The higher the borrowing base, which means the lower the LTV ratio, the more defaults that can occur within the facility before the Investor loses a dollar of income or principal.

Let’s talk through a few examples. For each, on Day 1 the borrowing base is calculated as the advance rate as 80% * $1,000,000 in eligible loans plus cash, $0 in this case.

When a loan within the borrowing base defaults, it’s no longer considered part of the borrowing base within an ABL facility. To maintain a level of coverage for the Investor, covenants often exist that require a certain borrowing base to be maintained by the Originator, meaning the borrowing base must be greater than or equal to the amount of the senior secured lien plus the accrued interest owed to the Investor.

Scenario #1: 0 Consumer Loans Default after a year

Now, let’s assume at the end of year one, 0 loans defaulted and the $200,000 of cash earned through interest on the loans was maintained within the facility.

Here’s what remains on within the Originator’s SPV:

$1M of receivables

$200k of cash

$800k loan

$80k of interest payable to the Investor

The Investor’s borrowing base can be broken down as follows:

$1M*80% + $200k = $1M Borrowing Base Requirement

$800k loan + $80k of interest payable = $880k Total owed to Investor

Net Interest margin= $120k

The Net Interest Margin or Residual is effectively the cash within the Originator’s SPV that the Originator can pay themselves while maintaining the borrowing base above the requirement.

Scenario #2: 10% of Consumer Loans Default

Let’s assume 100 consumers default during year 1 and their loans are “written-off.” Let’s also assume these borrowers made 0 interest payments during the period.

Here’s what remains on within the Originator’s SPV:

$900M of receivables

$180k of cash

$800k loan

$80k of interest payable to the Investor

The Investor’s borrowing base can be broken down as follows:

$900k*80% + 180k = $900k Borrowing Base

$800k loan + $80k of interest payable = $880k Total owed to Investor

Net Interest Margin = $20k

The $80k excess is the amount of cash that must be maintained within the SPV to meet the borrowing base requirement.Even with 10% consumer defaults, the Investor’s interest income ($80K) and principal ($800K) remains intact.

Scenario #3: 35% of Consumer Loans Default

Let’s now assume 350 consumers default during year 1 and their loans are “written-off.” Let’s also assume these borrowers made 0 interest payments during the period.

In this scenario, the following remains within the Originator’s SPV:

$650k of receivables

$130k of cash

$800k of loan

$80k of interest payable to the Investor

The Investor’s borrowing base can be broken down as follows:

$650k *80% + $130k = $650K Borrowing Base

$800k loan + $80k of interest payable = $880k Total owed to Investor

Borrowing base — Total owed to Investor = Residual

Residual = ($230k)

In other words, the Investor’s loan is technically under collateralized by $230k, insofar as there is a borrowing base breach. As a result, only $130k of cash and $650k serve as collateral against the $800k lien, implying $20k (or $100k if you also include the accrued but unpaid interest) of the loan is effectively unsecured.

On a practical basis, there is $780k of collateral on a $800k loan, so unless significant excess net interest margin is generated from the loans there will be a loss against the principal owed.

More specifically, if it’s unlikely that the principal and interest will be recovered, interest should stop accruing. This means the loan is placed on nonaccrual status and the cash received will reduce the outstanding principal. This effect is what’s displayed in the graphic above. Notice, no income is received. Also, since we’re assuming no reserve has been established for expected loan losses, the cash is applied to amortize the outstanding principal on the loan from $800k to $670k. Effectively, the investor is taking an impairment on the principal of their position and would likely write-off the accrued income that they no longer expect to collect.

In such cases, the Originator is in default. To cure their default, they could provide more collateral (typically, cash), pay off a portion of their loan early or increase the interest rate on new originations. Defaults may cure as collections come in overtime as well.

In these cases, understanding the balance sheet of the Originator is critical. It not only helps determine if the advance rate is intact, but it also helps determine the likelihood that losses will be sustained if a borrowing base covenant is breached.

The point here is that defaults within the facility (meaning the consumer loans) DO NOT necessarily mean the Investor will lose income or principal due to advance rates or other credit protections. When defaults occur, an advance rate covenant between the Investor and Originator may be breached. Even in this case, the Investor’s principal and interest may remain intact. However, when it becomes probable a loss will be incurred affecting the balance sheet amount, a reserve may need to be established. For instance, one may argue in scenario #2 that reserves may need to be increased because there’s a higher likelihood of the loans approaching a situation that looks like scenario #3.

Conclusions:

  • Know the accounting for your investments.
  • Reserves are established by management to estimate the expected credit losses.
  • Make sure you understand all defaults that are occurring within the entire facility.
  • Defaults DO NOT necessarily mean loss of income or principal, but they do signal a higher probability of both.
  • Do not over model. The past may not be the best predictor of the future, especially in a global pandemic.
  • Understand the balance sheet of the originator. It’s important when things go poorly.
  • Most importantly, reserves should reflect reality. And income should not be recorded when it’s uncertain. Otherwise it will reverse on you at the worst possible time.