Underwriting Insurance Companies: Finding Opportunity in Consumer Loans

Written by PJ Collins

When it comes to investing in consumer debt, the headlines can be misleading. We see the opportunity.

As banks continue to reduce financing activities, consumer lending is taking up more space in investors’ private credit allocations. known as Asset-based financing, this form of lending is the engine that drives the real economy, and we believe it has the potential to enhance portfolio returns, reduce volatility, and diversify existing exposure to corporate credit – both public and private.

But with interest rates expected to stay higher for longer, is this a good time to increase exposure to consumer debt? It’s a fair question – especially in the United States, where a recent Federal Reserve survey showed that some borrowers are falling behind on car and credit card payments.

We think the answer is yes, and here’s why: Not all loans are the same – even when they are It is made for borrowers with similar credit scores and against similar collateral. For investors, the main consideration is not the type of loan or the near-term economic outlook, but the quality of underwriting—the private lender’s assessment of the borrower’s creditworthiness and the quality of the loan.

In this sense, private credit investors underwrite insurance companies.

Asset-based finance: a booming market

Also known as specialty financing, asset-based financing has grown over the past two decades into a $6.3 trillion market that provides much of the financing for residential and commercial real estate, automobiles, credit cards, small business loans, business equipment, and a variety of specialty products. Sectors – including revenue streams associated with intellectual property royalties. Most loans are made against collateral – usually financial assets or fixed assets, such as cars or business equipment.

Of course, banks in the US and Europe once did much of this lending themselves, but stricter regulations have forced them to cut back on loans. Private lenders have filled this gap. Now, many banks sell a significant portion of the loans they originate to private credit investors, often through forward flow arrangements in which the buyer agrees to purchase a certain amount of loans within a specified time frame.

Because these assets tend to be less liquid and more complex, they typically offer a yield premium over high-yield bonds, leveraged loans, and other forms of public credit (an offer).

Liquidity premiums for specialized financing (percentage)

North America is the most mature market due to the volume, depth and availability of data. But Europe’s small size, different legal systems, and varying degrees of data quality create inefficiencies that could lead to opportunities for private credit investors able to navigate these younger markets.

With older loans, a year or two can make a big difference

But the wide variety of private lenders means that underwriting standards on originating loans can vary widely. In our view, the soundness of the loan security is one of the most reliable performance indicators. It doesn’t take long for lax underwriting to cause problems.

When the Covid-19 pandemic ended, many non-bank lenders were keen to boost growth by maximizing the volume of loans they originated, so underwriting standards fell. Meanwhile, massive one-time stimulus checks have fueled consumer spending. Many consumers spent on expensive goods, including new or used cars, which were subject to severe price inflation. It was not uncommon to see buyers reduce their prices by 20% or more. However, because the procurement financing funds were a one-time payment, they were not a reliable indicator of performance.

The distress or delinquency in the U.S. auto, credit card, and other loan markets that is making headlines today is largely driven by loans originated in 2022 when lax underwriting was common.

On the other hand, 2023 loans performed better, thanks to stricter standards and interest rates more in line with the market. In our view, now seems like a good time (for those who can look past the 2022 loan headlines) to take out newly originated loans, which are generally higher quality loans. What’s more, fewer investors are actively buying full loans following the weakness following the coronavirus crisis. We believe that those with the ability to be selective can isolate high-quality assets and creators and increase their return potential.

Credit Sources: Skin in the game is important

The ability to obtain loans is still important, and there are many lenders and platforms through which investors can do this. In order to promote diversification and mitigate potential shocks, investors can also require that loan originators retain a certain percentage of all loans – known colloquially as “keeping skin in the game.” This creates incentives to maintain strict underwriting standards.

A typical portfolio may include hundreds or thousands of loans with different types of collateral and cash flows, which may provide diversification. The model portfolios also show a low correlation to public stocks and bonds, as well as direct corporate lending, the sector that dominates private credit allocations for many investors.

Lenders have much less control over the direction of the economy than they do over guaranteeing loans. If growth slows and unemployment increases, losses could rise. But analyzing historical data and asset performance at different stages of the economic cycle may help managers identify attributes that make a loan likely to hold up well in different credit environments.

The opinions expressed here do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions of all of AB’s portfolio management teams. Views are subject to change over time.

Original post

Editor’s note: The summary points for this article were selected by Seeking Alpha editors.