Alternative loans to small business borrowers tend to be about $75,000 to $150,000, and they typically go to companies with revenue in the range of $1 million to $2 million. Common uses for the proceeds include business expansion, inventory, financing property, and plant and equipment purchases.
Source of Capital for Alternative Lenders
The industry overcame two significant early hurdles to get where it is today. The first was that borrowers wanted their money quickly, but the platforms first had to find willing lenders. The matching process was not conducive to good service. The second problem was the information asymmetry between the individual borrower and the individual lender. Specifically, the lender 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 lenders, buying loans from well-known alternative loan originators. Today, institutions are the predominant source of funding for alternative loans. For example, Lending Club, the largest U.S. platform, shifted from 100 percent retail funding in 2008 to 84 percent institutional funding in 2015.
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.
Institutional investors were able to provide funding by creating investment products, such as closed-end “interval” funds, that individual investors can utilize to access the market. These funds are not mutual funds because they do not provide daily liquidity. After all, you need committed capital to make term loans. Instead, they provide for redemptions (with limits) at regular intervals (such as quarterly).
This type of financial intermediary can help reduce asymmetric information risk by setting strong credit standards (such as requiring a high FICO score), performing extensive due diligence on the originators (to make sure their credit culture is strong), structuring repayments in ways that can improve performance (such as requiring that all loans be fully amortizing and that automatic ACH repayments are made on individual loans, thereby eliminating the choice of which loans to pay off, as with credit card debt) and requiring the originator to buy back all loans shown to be fraudulent. They can also require that business loans be repaid directly from sales receipts. Additionally, they can enhance credit quality by utilizing social media to confirm information on the credit application. By improving transparency, they also facilitate the flow of capital to borrowers in a more efficient and dependable manner.
The Importance of Credit Quality: The Evidence
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 appeared in the January 2015 issue of Applied Economics. Their dataset consisted of more than 61,000 loans, totaling more than $700 million, originated by the Lending Club in the period from May 2007 to June 2012. Almost 70 percent 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. The following is a summary of the authors’ findings:
Borrowers with a high FICO score, high credit grade, low revolving line utilization, low debt-to-income ratio and who own a home are associated with low default risk. This was consistent with a finding from Jefferson Duarte, Stephan Siegel and Lance Young in 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.
It is 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. The higher interest rate charged for the riskier borrower is not significant enough to justify the higher default probability.
Emekter, Tu, Jirasakuldech and Lu’s 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 noted that increased prepayment risk exists with consumer 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. Of course, loans that prepay have eliminated the risk of a later default.
Diversification Benefits
In addition to relatively high yields with relatively short durations, investing in alternative loans also provides 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 2008-2009). 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 falling, the performance of these loans was unaffected. Thus, there are times, though not all times, when an investment in these loans will help to dampen portfolio volatility.
Furthermore, buying a portfolio of consumer loans diversified by geography (by states and even countries) as well as by profession/industry comes with certain benefits. 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 micro-economy that doesn’t necessarily move in tandem with others (for instance, well-publicized oil price declines in 2016 only impacted a few areas). It is important also to understand that consumer credit is somewhat different from corporate credit. There are examples of recessions that affected corporate balance sheets while consumer credit performed relatively well (2001 is a recent example).
There are some other issues, however, that merit consideration.
Asset Location
Given that all the income from loans purchased from alternative lending platforms will be ordinary and, thus, taxed at the highest rates, investors should prefer to hold this asset in tax-advantaged accounts. Low-tax-bracket investors, however, could consider holding it in taxable accounts. In certain situations, though, it may be appropriate for high-tax-bracket investors to use this asset in taxable accounts as an alternative to municipal bonds. Such investors would accept incremental credit risk in exchange for a higher expected after-tax return and less duration (inflation) risk.
Because interval funds do not provide daily liquidity, they cannot be held inside a 401(k) plan unless the participant has created a self-directed brokerage account.
The Role of Fixed Income
While, on average, the correlation of alternative loans to equity (market beta) risk tends to be low, it is important to understand that the correlation will rise during economic downturns, when unemployment, and thus credit losses, increase. The main role fixed income should play in a portfolio is to dampen its overall risk to an acceptable level. As a result, unless an investor has a very low equity allocation, and also has both the ability and willingness to accept more risk, an allocation to this asset likely should be taken from a portfolio’s equity portion.
Summary
Until quite recently, most investors have not had direct access to the consumer, small business and student loan credit risk premium. The alternative lending industry offers that access, as well as benefits to both borrowers (by reducing the high cost of bank credit, credit card debt and payday loans while delivering better service) and to investors (by providing opportunities to earn higher yields).
> Today, with the proper controls in place, investing in these alternative loans can offer an attractive complement to a fixed income portfolio. While they do entail incremental credit risk, alternative loans also currently provide sufficiently high yields to permit high 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 18 months, 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. That trade-off is made more favorable by the presence of a significant premium for both credit risk and illiquidity.
Our recommendation that alternative lending assets are worthy of consideration may seem contrary to our longstanding position that investors should limit fixed income to only the safest vehicles (such as Treasuries, government agencies, FDIC-insured CDs and AAA/AA-rated municipals that are also general obligation or essential service revenue bonds). The reason for our original recommendation was that research has shown corporate credit risk has not been well rewarded, especially after considering fund expenses. In this case, however, while alternative lending assets are not of the same quality as the aforementioned safe bonds, the evidence shows that investors have been well rewarded. It is just that, until recently, the general public has had no access to these investments. They instead resided on the balance sheets of banks and other lenders. Fintech firms have disrupted that model and investment management firms have now provided access to investors.
Risk and Expected Returns
The term “expected return” or “forward-looking return expectation” is a statistical estimation for the compound return of an asset class over the long term. It is important to understand that expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts, and are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results may differ materially from those anticipated in an expected-return forecast. With those caveats in mind, our estimate for the expected return to prime alternative loans is similar to what we expect for the U.S. stock market, though with only about one-quarter of the volatility—an attractive combination.
Accessing Alternative Loans
Historically, consumer and small business credit risk underwritten by banks was not shared directly with outside investors. Fortunately, we can now directly access these attractive assets through interval funds, such as the Stone Ridge Alternative Lending Risk Premium Interval Fund (LENDX), the RiverNorth Marketplace Lending Fund (RMPLX) and the Colchis P2P Income Fund (a limited partnership). Our preferred vehicle, the one we recommend for our clients, is LENDX.
Chapter 6:
Reinsurance
While nobody “likes” to buy insurance, every year consumers spend trillions of dollars on insurance policies. We do not, however, buy insurance to protect ourselves against regular, predictable events. Rather, we budget for such expenses. On the other hand, when dealing with the possibility of rare, unpredictable downside events—such as premature death, disability or destruction of property from a fire, earthquake or hurricane—we do buy insurance to protect ourselves against an outcome too risky to bear on our own. The premiums we pay transfer risk, with buyers seeking to eliminate the effects of an extreme, negative event.
The price that the insurance company charges to bear the risk of extreme events, which can lead to large losses, decomposes into two parts: an expected payout and a risk premium to compensate the seller for the uncertain nature of any payout, which may be sudden and dramatic. In other words, when individuals buy insurance, they hope, and expect, to incur a loss (they anticipate that, on average, the insurance company will generate a profit).
Reinsurance
Reinsurers are an important part of the overall insurance industry. But, while most people are familiar with at least a few of the largest insurance companies, reinsurers generally are not household names because they do not deal directly with consumers.
Reinsurance is insurance that is purchased by an insurance company as a means of risk management, allowing them both to service their clients (selling more insurance than they have capital to otherwise support) and to diversify risks. The reinsurer is paid a reinsurance premium by the “ceding company,” which issues insurance policies to its own policyholders.
Many traditional reinsurers have legacies reaching back to the mid-1800s. Typically highly diversified, reinsurers offer protection on a broad spectrum of client risks. That broad diversification across uncorrelated risks is what allows reinsurers to be “structurally levered.” Regulators allow reinsurers to hold substantially less capital than their total exposure because it is highly unlikely that losses will occur simultaneously across uncorrelated and geographically dispersed risks. As an example, a reinsurance company whose risks are highly diversified might be required to hold $2 of capital for every $5 of reinsurance risk.
Collectively, the reinsurance industry had about $600 billion of capital in 2017. Since the 1990s, Insurance-Linked Securities (ILSs) have allowed investors to participate directly in reinsurance risks.
Investment Opportunity
The reinsurance industry’s existence presents an opportunity for investors to add an asset, through participation in the reinsurance business, with equity-like expected returns uncorrelated with the risks and returns of other assets in their portfolios (stocks, bonds and other alternative investments). Stock market crashes don’t cause earthquakes, hurricanes or other natural disasters. The reverse is also generally true—natural disasters tend not to cause bear markets in stocks or bonds. This lack of correlation, combined with equity-like returns, results in a more efficient portfolio, specifically one with a higher Sharpe ratio (meaning it has a higher return for each unit of risk).
Historically, insurers and reinsurers’ capital base consisted of traditional debt and equity. However, since Hurricane Andrew in 1992, and especially since the tumultuous hurricane season of 2005, the industry increasingly has turned to third-party capital. The interaction between the reinsurance markets and the capital markets is known as “convergence.” Through convergence, investors are able to participate directly in the catastrophe risk space, rather than being forced to simply buy the debt or equity of insurance and reinsurance companies. Today, about 12 percent of the capital committed to reinsurance comes from third-party investors, not reinsurers themselves.
Diversification Benefit
Consider that there is no logical reason to believe losses from earthquakes should be correlated with returns to stocks, bonds, commodities or currencies, or any factor in which you can invest (such as momentum or the carry trade). In addition, a well-run reinsurance fund should be diversified across types of events whose losses are also uncorrelated. For example, a well-diversified reinsurance fund might invest in policies covering losses from fire, tornados, earthquakes, hurricanes, political risks, harm to fine art and damage while goods are in transport (marine and on land). Again, each of these risks generally should be uncorrelated—there is no basis to think that losses from earthquakes correlate with losses from hurricanes.
What’s more, today we are seeing innovative new insurance products that protect against losses from hacking, business interruption, concert cancellations and even insufficient snow at ski resorts. Such offerings present further diversification opportunities.
The Importance of Global Diversification
Reinsurers also should diversify each of their risks globally because, for example, the risk of earthquakes in the United States is uncorrelated to the risk of earthquakes elsewhere around the world. The last earthquake that caused major losses in California had a magnitude of 6.9 on the Richter scale. It occurred in October 1989. The last major quake in Turkey was a 7.6 magnitude event th
at occurred in August 1999; the last major quake in China was a 7.9 magnitude event that occurred in May 2008; the last major quake in Japan was a 9.0 magnitude event that occurred in March 2011; and, in 2016, central Italy experienced a series of significant earthquakes beginning in August and continuing into October, with the largest being a 6.6 magnitude event. While it is certainly possible multiple major earthquakes can occur in the same year, it is not that likely. Additionally, because other types of risk that reinsurance usually covers are uncorrelated to earthquakes, the risk of a catastrophic portfolio loss is greatly reduced. In technical terms, the negative skewness of a diversified reinsurance program is much less than it is for any one type of insurance risk.
It is important to understand that the equity-like expected returns associated with accepting the risks of an investment in reinsurance are compensation for the chance of occasional large losses. As with equities, writing insurance against extreme, but rare, events comes with accepting negative skewness in the distribution of returns. Because investors dislike negative skewness, they demand a large premium for accepting such risks (resulting in a high expected, but not guaranteed, return). And as noted, a well-structured reinsurance fund can minimize the risk of negative skewness by diversifying across many different types of risk and across the globe.
Reducing the Risk of Black Swans Page 6