Is consumer credit the “Holy Grail” of lower volatility and higher returns?
Fri Jul 26, 2013
Returns have been predictable...and fantastic.
By Mitchell Nathanson
Until recently, institutional investors did not have a formal
mechanism to lend directly to consumers. While many hedge funds
invested in structured products backed by consumer debt (credit
cards, auto loans, etc.) before the financial crisis, many such
vehicles suffered from adverse selection and a lack of
transparency. They also performed terribly during the downturn
in 2008. As such, the market for ABS securitizationhas been
relatively moribund since.
In contrast, direct consumer lending has long been the domain
of large credit card companies and banks in near-monopolistic
fashion dating back to the 1950s. In the aggregate, returns
have been predictable...and fantastic.
According to Federal Reserve data, the credit card industry has
been profitable every single year since 1985, the first year
the Fed began tracking it. Even during the worst stretch of
this recent consumer credit cycle (a 10.6% charge-off rate in
the second quarter of 2010), net returns were still positive
with the average credit card rate at over 14% that year. The
average return for the industry has been about 10% per annum
net of charge-offs, with minimal annualized volatility and no
down years. What institutional investor would not want that
kind of risk-adjusted return?
Now, for the first time, banks are not the only ones with
access to that return stream. Powered by new regulations such
as Basel III, Dodd-Frank, and multiple FASB rules, investors
now have the ability to lend to individual consumers directly,
and not through securitized or pooled loans. This opportunity
is not exclusive to the U.S.and is now available across Europe
and other developed markets, with ample opportunity to spread
to emerging markets.
Given the data available, it is clear that the returns of
thisasset class closely replicate that of the credit card
industry with superior risk/return characteristics compared to
sovereign and corporate credit. These include (1) Higher, short
duration interest rates ranging from 5 to 30%, with virtually
all loans originating at 3 or 5 year terms, (2) Less principal
risk due toa fixed, mortgage-like amortization schedule with
principal repayment beginning in the 2nd month of each loan,
(3) Little to no interest rate risk. Rates for these loans are
fixed and yield compression and talk of Fed tapering has barely
affected the asset class. The average credit card interest rate
is about 13%. This still leaves a spread over the prevailing
risk-free rates in excess of 1,000 basis points!
The market for investible consumer credit in the U.S. is about
$2 billion per year, which is de minimus compared the $2.8
trillion non-mortgageU.S. consumer credit market. Globally the
market size approaches $7 trillion, so the opportunity for
growth remains vast.
So what's the catch?
While the risk-adjusted upside for consumer credit remains
high, this strategy like any other does come with some risk.
There is macro risk: In an economic downturn, consumer defaults
go up across the greater credit spectrum. It is a simple fact
of life that not every consumer pays back their unsecured
debts. The worst returning years for the credit card industry
since the Fed began tracking it were 2008 and 2009 (still
positive at roughly 5% net of charge-offs in each year).
However, default rates are low compared to high-yield corporate
bonds, and usually don't exceed single digits annually
regardless of market conditions.
In addition to macro and default issues, no credit strategy is
without liquidity risk. While institutional investors have
clamored for better liquidity terms for their hedge fund
investments since 2008, there remains no robust secondary
market for this highly fragmented asset class. While
traditional redemption windows of other types of hedge fund
strategies might not be available in consumer credit just yet,
the strategy produces consistent, incremental yield and the
return of some principal each and every month.
Finally, there is supply risk. As more institutional investors
become aware of this asset class and return profile, enough
loans need to be provided for the increasing demand.
The evidence so far has validated investors'early entrance into
this market. Regulations and evolving market structure will
continue to define the space. But with the vast majority of
consumer credit still stuck on the balance sheets of
traditional financial institutions who continue to be squeezed,
there is ample opportunity for investors to fill the void.
Mitchell Nathanson is managing partner and chief investment
SEN Capital Partners, a New York-based hedge fund
specializing in consumer credit strategies.