The marketplace lending business began with a British firm, Zopa, in Born from an idea that combined the financing aspects of the bond market with the innovation of the largest marketplace in the world, eBay, Zopa created an online marketplace for consumer loans. Essentially, the firm utilized technologic advances to bring together borrowers and investors.
The Evolution of the Asset-Backed Securities Market
In doing so, two needs were met: borrowers found a way to finance their debt in a quick manner without the red tape of bank approvals and forms, while investors were able to generate attractive returns while diversifying risk amongst a variety of borrowers. The success Zopa experienced in building a book of loans led to the launch of counterparts in the U. Thus, the peer-to-peer lending industry in the United States was born. As the Financial Crisis spread throughout the economy, individuals turned to peer-to-peer lending companies for borrowing needs as banks put a hard ceiling on the size of their loan portfolios.
However, this growth was a double-edged sword. Due to the Financial Crisis, borrower default levels increased, which raised investor concerns and lead to higher interest rates for borrowers to compensate investors for the additional risk.
As the peer-to-peer industry grew, it also evolved from simple loans between borrower and investor. Institutional investors hedge funds, insurance companies, etc. 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. Previously, marketplace lenders were bringing together individual borrowers and investors and serving as the facilitator for a fee. Post-Crisis, new entrants in the market SoFi, Earnest, Avant were functioning more as traditional lenders and utilizing funds raised through forward purchasing agreements with institutional investors.
Brick and mortar lending serves consumers by providing physical locations in which to conduct the business of applying for and making payments on loans. This service appeals to customers that value face-to-face interaction when conducting business and are looking for guidance through complex financial transactions. In an effort to reduce leverage, operational risk, and cost, mortgage lenders can sell mortgage servicing rights to specialized firms. Mortgage servicing firms are paid a portion of mortgage payments to handle the logistics of servicing mortgage loans and can help reduce delinquency levels by working directly with borrowers in times of stress.
A component of mortgage servicing rights is servicing advances, which are reimbursable cash payments made by the servicer if a borrower fails to make a scheduled payment, or to support the value of the collateral property. These payments are not meant to serve as credit enhancement, but to provide liquidity to the underlying securitization. Servicer advances are traditionally repaid from receipts associated with mortgage loans and represent a separation of a component of the mortgage servicing rights, securitized as a stand-alone credit.
In November , the Berkeley City Council took an innovative approach to assist residents interested in joining the green energy movement. Berkeley established the Sustainable Energy Financing District to fund the installation of solar electric systems and repay the financing through property tax bills over a preset time period of 20 years.
As the innovator in this new field, the program delivered four distinct advantages to homeowners trying to reduce their reliance on fossil fuels:. Though PACE programs, both residential and commercial, have grown substantially over the last decade, the securitization of these loans is still in the early stages. Unlike most other ABS deals, the collateral associated with a PACE transactions is not a loan or lease, but a voluntary tax lien agreed upon by the residential or commercial property holder in order to finance energy-efficient improvements.
This was a private deal arranged by investment management firms and, while not publically available, illustrated the feasibility and appetite for such deals. Growth in the alternative energy market has resulted in significant migration to solar panel utilization. Prior to the introduction of securitization, the solar sector had been dependent upon investment tax credits and other subsidies to finance projects.
Much like the other sectors discussed in this paper, securitization of solar panel financing has made this sector more accessible to investors. Regulatory limitations prevent master limited partnerships and real estate investment trusts from participating in the market, making securitization the most effective and efficient method of exposure to this sector.
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Even as the market grows, the basis of the securitization has changed. Initially, securitizations were dominated by purchasing power agreement leases, but have shifted to solar loans. A purchasing power agreement is a contract where an individual or business permits solar panels to be installed on their property and agrees to purchase the power at a preset rate over a contracted period of time. The process of securitization in this market is still in its infancy, and there are obstacles ahead that may hinder the pace of growth.
Going forward, the most important challenges to overcome are the lack of a steady market and the necessity of expansion beyond residential solar securitization. But, as the world turns more to renewable energy and investors focus on green investing, the potential for solar securitization continues to grow.
As investors look for additional diversification and investment opportunities, the ABS market continues to evolve beyond the previously mentioned categories. Securitization deals ranging from diamonds, to agricultural crops, to venture capital have emerged over the past few years, and investors can expect even more innovative offerings in the future.
Fixed Income Perspectives
The Diamond Hill fixed income team is able to exploit some of the pricing inefficiencies in the ABS market through our bottom-up analysis, along with our deep understanding of deal structures and the companies bringing them to market. 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. 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 securitization deals 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 capacity estimates for their strategies.
We follow this approach and run contemporaneous regressions of default rates on interest coverage ratios for the nonfinancial corporate sector and for its individual industries. We find significant negative coefficients in these regressions for most sectors, indicating that lower ICRs are associated to higher default rates. The R-squared of the significant regressions are between 0.
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For those sectors with significant regression coefficients, we compute the level of ICR that corresponds to a particular default rate. Figure 2 shows significant differences across sectors for these ICR levels using default rates of 1. For instance, for the nonfinancial corporate sector All , an ICR around 3. The corresponding ICR levels for Communications are around 3. These differences imply that the same ICR level is associated to different default rates across sectors, and that the sensitivity of default rates to changes in ICR levels is different across sectors. This result highlights that a simple reading of a low ICR level for a firm may provide a misleading signal of distress.
To overcome this limitation, we analyze ICR threshold levels in debt covenants. Some lenders specify in their debt contract covenants an ICR threshold below which the borrower is considered to be in technical default. These contractual thresholds can be thought of as distress levels of ICRs.
Some descriptive statistics of loan covenant thresholds for ICRs by industry are displayed in Table 2. There is large cross-industry variation in ICR thresholds for loans in different industries. We use DealScan information in combination with detailed firm-level data from Compustat to generate a predictive regression of the relevant ICR threshold at the firm level.
Our firm-level predictors include industry, firm size, book leverage, cash holdings, and profitability. Table 3 displays the regression results and shows that large firms with low leverage and high cash holdings and profits are more likely to face higher ICR thresholds in their loan contracts. We use our firm-level predicted ICR thresholds to classify all Compustat firm-year-quarters into "vulnerable" or "not vulnerable". We focus on the DealScan-based ICR thresholds as they allow us to use firm-level information to predict relevant ICR thresholds, as opposed to the default-based indicators, which are calculated at the industry level.
We then aggregate every quarter all debt outstanding held by firms whose ICR is below their distress threshold and divide it by the total amount of debt outstanding that quarter in our sample of Compustat firms. The resulting share is our estimate of the aggregate share of vulnerable debt, which we name as the Corporate Debt Vulnerability Index.
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The evolution of this index over time is shown in Figure 3. This index displays a very strong countercyclical pattern since the s, with particularly high levels in the late s and in the Great Recession.
We evaluate if our corporate debt vulnerability index has predictive power for forecasting future economic activity. To assess the performance of this index, Table 4 reports the ability of the vulnerability index to forecast over 4- and 8-quarter horizon the growth rate of three different measures of real economic activity: payroll employment, private domestic fixed investment, and real GDP.
The data are quarterly, from QQ1. Positive negative values of the indices indicate tighter looser financial conditions. Shaded areas denote NBER recessions.