Constructive Conditions for Consumer Loans

“Buy when there is blood in the streets.” This famous quote from Baron Rothschild has been consistently proved right time and time again. Yet, loss aversion bias makes investors reluctant to follow this advice. Buying when there is blood in the streets may expose one to short term underperformance unless the timing is perfect. But one thing is certain: if the investment horizon is not short term, history has taught us that you are often better off following the baron’s advice.

2022 will be remembered, among other things, as the year when the world abruptly woke up from the torpor of years of extremely low interest rates (negative, in many cases). What surprised most people was the combination of the magnitude and speed of the change.

Consumers and corporates alike have been wrongfooted. Refinancing and debt servicing have become more difficult. Investors took note and reduced the amount of capital available for consumer and SME loans. However, this withdrawal from the market is precisely the reason why this represents a great time to increase exposure to consumer loans. As a matter of fact, “buying when there is blood in the streets” has a logical and well documented background: a reduced amount of capital available has the effect of making originators much more selective in their risk underwriting and allows them to charge more for what is now considered increasingly scarce sources of capital. The chart below shows how the Weighted Average Coupon (WAC) on consumer loans has changed over the last year or so, as tracked by Fasanara. As you can see, the average yield reacted almost instantaneously to an increase in interest rates between Q2 2022 and Q2 2023, with a 2% repricing.

What is even more interesting is that, in parallel, origination has become more selective with the average FICO score of the borrowers approved for loans increasing over time (graph below). The improvement shows a bit of lag compared to the increase in interest rates and it is meaningful in size (4.9% improvement in average FICO over the time period analysed).

Another relevant data point that we constantly track supports the concept of less risky underwriting. The average income of new borrowers at the time of application shows a gain of more than $20,000 in the period under observation. Higher income is important because it improves the ability of a consumer to service the loan, reducing the debt to income ratio.

In a nutshell, we have clear evidence of better quality borrowers with a lower probability of default that, on average, are paying significantly higher interest rates.

In this context, another factor is worth mentioning. Prepayments, interest and amortisation of principal balance all contribute to a fast recycling of capital into less risky and higher yielding loans. Assuming an instant repricing, by month 11, funds in a seasoned portfolio of US consumer loans will have already been recycled into higher quality loans to the tone of 40%, with the number growing to 80% by month 23. Such portfolio shows a clear ability to reprice fast.

The conclusion is simple. While the art of perfect market timing is a chimera, even in an age of AI, there is clear evidence that risk adjusted returns in consumer loans are on a trajectory of strong recovery that will benefit the asset class for the foreseeable future.

Please note, for the purpose of this analysis, we reviewed a large pool of standard consumer loans with similar characteristics originated across multiple US based platforms. Fasanara’s Consumer Loans Fund will also benefit from the exposure to shorter dated European consumer loans that facilitate an even faster portfolio level repricing.

By Daniele Guerini, Head of Origination at Fasanara

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