Asset Performance under Periods of Stress - Market colour from Yuhan Yang

During the current COVID-19 driven period of uncertainty, the impact on financial assets is being driven by changing economic and public safety developments. Financial markets are continually reacting to a combination of rapidly changing circumstances, including:

• how local leaders react;
• how populations adhere to suggested/enforced measures;
• how heath systems identify and treat patients;

In periods of stress, asset holders benefit immensely from having a clear view of the impact of market movements on the value of their portfolio. More than ever, maintaining an up-to-date, accurate valuation of their book can impact on a firm’s profitability. By identifying vulnerabilities within a portfolio before a market has shifted, and by highlighting opportunities to exit mis-priced assets, accurate valuations can ensure a firm has the information they need to weather market developments. In addition to valuations, we also believe that scenario analysis and stress testing can provide valuable insight in this climate.

When assessing the potential performance of loans/securities in a stress environment we consider both potential i) credit losses and ii) mark-to-market impact.

Taking consumer loans as an example, our primary metric for credit loss is charge-off rates. In a stressed climate charge-off rates incorporate both high expected roll-to-default rates for delinquent loans, as well as high loss severity rates upon default. To assess potential stress charge-off rate multiples, or number of times losses could increase in a given year, we look at the magnitude of previous loss rates of consumer credit related asset types across a range of jurisdictions.

Additionally, mark-to-market impact under various scenarios can also be assessed by applying historical observations of spread widening experienced by consumer loans in both primary market and secondary ABS markets.

Source: Board of Governors of the Federal Reserve System (US), March 2020.

Elevated charge-off rates were also observed in the market-place lending space during the Global Financial Crisis, which resulted in a sharp decrease in net return. The chart below shows how an equal weighted portfolio of marketplace originated US consumer loans saw net returns falling to around 1% as defaults washed through the book.

Source: Brismo and LoanClear analysis, March 2020

Taking into account a variety of other consumer related debts, across a range of jurisdictions and lender types, a multiple ranging from 1.5x at the low end (EMEA consumer loan ABS defaults) to 4x at the high end (US credit card ABS charge-off rates) can represent most of the historical stress observed during recent times of crisis.

Mark-to-Market Impact due to Spread Widening

In addition to multiples of credit losses, some asset types tend to be discounted at a higher rate under market uncertainty, which can result in additional reductions in value. In terms of US consumer loans, primary origination of both non-bank and bank lending experienced limited widening during the Global Financial Crisis. Currently, we see similar trends under the COVID-19 driven stress, where the originators are taking measures to strengthen their underwriting criteria whilst also applying some increases in lending rates.

Source: Board of Governors of the Federal Reserve System (US), LendingClub and Prosper, March 2020

The secondary ABS market witnessed much more volatile spread movements during the Global Financial Crisis. However, the sharp increase in spreads for mezzanine credit card ABS is partially due to their leveraged nature. An estimated weighted average spread widening of approximately 900 basis points across the entire capital structure is a better reflection of an unlevered loan portfolio exposure. As of mid-March 2020, some widening in the secondary US credit cards ABS market has started to appear.

Source: J.P. Morgan Securities LLC, March 2020

The impact of spread widening on valuation also depends on the duration of the asset, which is usually mitigated in the consumer loan space given the reasonably short duration of 1 to 2 years, and tends to be magnified in case of longer duration exposures.

- Since 2003, LoanClear has advised on over $700 billion of credit exposure for more than 50 clients around the globe -

In the current crisis, LoanClear can provide transparency and guidance for participants in European, US, and Asian loan and credit markets.

LoanClear’s experienced team of specialists combine in-depth knowledge of loan products, data, and scenario modeling with real time market information. LoanClear has access to global primary and secondary markets spanning many loan types and credit products, including non-bank originated loans.

Advisory services include Fair Market Valuation, expected loss and impairment analysis, cash flow scenarios, risk analysis, benchmarking and portfolio solutions.

Get in touch with your usual contact, or contact us via info@loanclear.com, to explore how we can help to provide you with scenario or valuation analysis.