The current—and almost decade-long—period of extremely low interest rates led many investors, especially those relying on a cash flow approach to investing, to seek alternatives to safe fixed-income investments.
Unfortunately—many such strategies, such as investing in dividend-paying stocks and high-yielding bonds—expose investors to dramatically higher levels of risk, especially left tail risk. Compounding the problem is that this greater risk tends to show up at exactly the wrong time—when equities are doing poorly.
Fortunately, over the past several years, we have witnessed a fundamental shift in the fixed-income landscape, one that provides an attractive alternative to investors who can accept the risks associated with illiquidity.
Fintech/Social Media Transforming Landscape
Banks have long been central to the creation of credit, which is driven by their ability to take in low-cost deposits and loan out money at higher rates.
While nonbank loan channels have always existed parallel to traditional banking, these channels historically were small niches in the overall economy. However, a new breed of lender has emerged to become a significant presence in the market. Initially, they were known as “peer-to-peer lenders” or “marketplace lenders.”
Growth in this space hit an inflection point after the 2008-2009 financial crisis. It was propelled by a severe contraction in bank lending, acceleration in the availability of financial services online and an increasing mistrust of, and dislike for, traditional banks.
Today these platforms are broadly recognized as “alternative lenders.” These technology-based lending businesses are disrupting the lending markets and have taken significant market share from traditional banks.
Because alternative lenders are not burdened with the substantial infrastructure costs of traditional banks (they don’t have physical branches) or the same level of regulatory oversight (banks are typically regulated by the full spectrum of state bank examiners, the FDIC, the SEC, the Federal Reserve and consumer credit agencies), they are able to offer loans at significantly lower rates.
It’s important to note that, while interest rates have fallen dramatically since 2008, the average revolving credit card rate has actually risen. Alternative lenders have been able to leverage their superior operating efficiency to offer more attractive pricing to consumer and small business borrowers while also delivering a superior service experience.
Banks Making Fewer Small Loans
The increasing cost structure at traditional banks in the post-Dodd-Frank Act era makes it increasingly uneconomic to originate smaller-sized business loans. Even though domestic banks significantly expanded their portfolios of business loans over $1 million following the financial crisis, at the same time, they have pulled away from making smaller loans.
With few other viable alternatives, many small business owners have resorted to borrowing on credit cards, taking on debt that often has a punitively high, variable rate.
For instance, at one of the largest U.S. banks, small-business credit cards account for more than 90% of loans to businesses with less than $1 million in revenue. As a result, alternative lending platforms have been steadily taking market share by catering to this underserved segment and cost-effectively originating smaller loans.
The biggest impact of this shift has been on small banks and, thus, on small businesses, because small banks make most of the small business loans. For example, the number of banks with less than $100 million in assets declined by 85% from 1985 to 2013.
And the trend continues unabated. Not only do alternative lenders have a cost structure advantage, but, as mentioned previously, their technology enables them to provide arguably better service, including faster turnaround times.
It’s important to note there is a difference between consumer loans, which are often uncollateralized, and small business loans, which are typically secured either by business assets, the business owner personally or both.
Alternative lending is not just a phenomenon in the United States. Today hundreds of alternative lending platforms operate around the world.
Furthermore, just as U.S. prime consumer borrowers frequently pay very high rates on revolving credit loans, borrowers who live in other parts of the developed world often face interest of more than 20% for bank credit. This has fueled the global expansion of consumer alternative lending.
In the United States alone, alternative lenders were expected to originate $30 billion in loans in 2016 and $150 billion in loans by 2020. The opportunity is enormous, as those figures remain just a small fraction of the nearly $900 billion in revolving U.S. consumer credits now outstanding. In addition, the market for small business loans in the United States is about $300 billion.
Student loans present another area of opportunity for alternative lenders, with the U.S. market totaling about $1.4 trillion. Student loans historically have been “one-size-fits-all.” The result is that high-credit-quality borrowers pay the same rate as low-credit-quality borrowers.
Alternative lending platforms can target borrowing students with high credit ratings (thus lowering expected losses from defaults), providing meaningful cost savings.
Hurdles For Alternative Lenders
There were two significant early hurdles for the industry. The first was that borrowers want their money quickly, but the platforms first had to find willing lenders. The matching process was not conducive to good service.
The second issue was information asymmetry between the individual borrower and the individual lender. Specifically, lenders did not know the borrower’s credibility as well as the reverse. Such information asymmetry can result in adverse selection.
Fortunately, financial intermediaries began to replace individuals as the lenders, buying loans from well-known alternative loan originators such as Lending Club, Prosper, Square and SoFi. Today, institutions represent the predominant source of funding for alternative loans.
For example, Lending Club, the largest U.S. platform, shifted from 100% retail funding in 2008 to 84% institutional funding in 2015.
'Faster' Funding Process
Alternative lenders prefer institutional capital because it makes the loan funding process faster from the borrower’s perspective. Institutional buyers typically buy whole loans, whereas it can take weeks for retail investors to fund a loan in fractional increments. And from a strategic perspective, dedicated institutional capital is more stable, allowing the platforms to grow responsibly.
To meet the rising demand, asset management firms such as Stone Ridge, RiverNorth Marketplace Lending Corp. and Colchis Capital Management have created investment vehicles that allow individual investors to access the alternative lending markets.
They do so via what are called interval funds. While interval funds are regulated by the SEC, they are not mutual funds, because they cannot provide daily liquidity, a result of the funds’ requirement for committed capital to make term loans to consumers, small businesses and student borrowers.
Interval funds provide limited liquidity (at intervals, as their name implies). Purchases can be made on specific dates, typically either monthly or quarterly. Redemptions can, in general, be requested four times per year, usually in the first month of each quarter.
Investors can request a 100% redemption, but a fund is typically only obligated to redeem a certain percentage of its assets. Thus, if a small percentage of investors request redemptions, each of them might be able to fully redeem their investment. Otherwise, they will be restricted to the fund’s pro rata limits.
While alternative lending offers an attractive opportunity for investors, it can be one that is fraught with risk. To minimize the aforementioned tail risks, investments in this space should be limited to higher-credit-quality loans.
The Importance Of Credit Quality
Riza Emekter, Yanbin Tu, Benjamas Jirasakuldech and Min Lu contribute to the literature on alternative lending platforms with the study “Evaluating Credit Risk and Loan Performance in Online Peer-to-Peer (P2P) Lending,” which was published in the January 2015 issue of Applied Economics.
Their data set consisted of more than 61,000 loans, totaling more than $700 million, originated by the Lending Club in the period May 2007 to June 2012. Almost 70% of loans requested were related to credit card debt or debt consolidation. The next leading purpose for borrowing was to pay home mortgage debt or to remodel a home.
They found that borrowers with high FICO scores, high credit grade, low revolving line utilization, low debt-to-income ratio and who own a home are associated with low default risk. This finding was consistent with one reached by the authors of the study “Trust and Credit: The Role of Appearance in Peer-to-Peer Lending,” which appeared in the August 2012 issue of The Review of Financial Studies.
The takeaway is that it’s important to screen out borrowers with low FICO scores, high revolving line utilization and high debt-to-income ratios, and to attract the highest-FICO-score borrowers, to significantly reduce default risk. They found that the higher interest rate charged for the riskier borrower is not significant enough to justify the higher default probability.
The authors also found, in the case of the Lending Club, the majority of borrowers (82%) had FICO scores between 660 and 749 (a score below 650 is considered low, a score between 650 and 750 is medium, and above 750 is high) compared with 28% of the U.S. national average. About 80% of Lending Club borrowers fell into the medium FICO score range, and the platform eliminates the one-third of borrowers who make up the riskiest population.
The authors’ findings on credit risk are consistent with those of Zhiyong Li, Xiao Yao, Qing Wen and Wei Yang, authors of the March 2016 study “Prepayment and Default of Consumer Loans in Online Lending.”
They too found that default can be accurately predicted by a range of variables. The authors observed that there is increased prepayment risk on these loans, because the lenders don’t charge any early prepayment penalties.
However, if the lender requires that all loans be fully amortizing, and none are long-term (typically three- to five-year maturity), duration risk is relatively small. And of course, loans that prepay have eliminated the risk of a later default.
In addition to significantly higher yields with relatively short durations, these loans also provide some diversification benefits. The reason is that their correlation with the equity markets tends to be low, except during periods when unemployment rises dramatically (such as during the global financial crisis of 2008).
For example, equity markets experienced significant losses in January 2016. However, there was no concurrent downturn in the economy that would have caused consumer defaults to rise. Investors saw the same thing following the Brexit vote in June 2016.
In both cases, while equity markets were declining, the performance of these loans was unaffected. Thus, there are times, though not all times, when an investment in these loans will help dampen portfolio volatility.
In addition, there are benefits to buying a portfolio of consumer loans that is diversified by geography (by states and even countries) as well as by profession/industry. For example, the ability of a dentist in London to pay back a loan versus a retailer in New York is likely to have a low correlation.
Even within the United States, states each possess a microeconomy that doesn’t necessarily move in tandem with others (for instance, the recent oil price declines only impacted a few areas).
It is also important to understand that consumer credit is somewhat different than corporate credit. There are examples of recessions that affected corporate balance sheets while consumer credit performed relatively well (with 2001 being a recent example).
A Win-Win-Win Investment
The alternative lending industry is bringing benefits to borrowers (by reducing the high cost of bank credit, credit card debt and payday loans, as well as by providing better service), and to investors (by providing opportunities to earn higher yields).
Today with proper controls in place, investing in these alternative loans may offer an attractive complement to a fixed-income portfolio. While they do entail incremental credit risk, alternative loans also currently provide sufficiently high net yields (in the range of 6-8%) to allow for high risk-adjusted forward-looking return expectations (after expected default losses) relative to other alternative investment strategies.
At the same time, given that the average duration on a portfolio of alternative loans is only expected to be about two years, term risk and related inflation risk is significantly reduced relative to a typical intermediate-term bond portfolio.
Thus, there is a trade-off—lower term and inflation risk but more credit risk and a lack of liquidity. That trade-off is made more favorable by the presence of a significant premium.
There’s a third important benefit. By disintermediating the major banks, alternative lenders are shifting these risk assets from being held on a very small number of gigantic balance sheets, which creates systemic economic risks (as we saw come to a head in 2008), to being held directly on a gigantic number of individual balance sheets.
This process benefits everyone: the borrower, who gets a lower rate and better service; individuals, who have access to attractive investments; and our economy, which now has less systemic risk concentrated in a few major financial institutions.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.