Is consumer credit the “Holy Grail” of lower volatility and higher returns?

Fri Jul 26, 2013

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Returns have been predictable...and fantastic.


Mitchell Nathanson of SEN Capital Partners
   
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 officer of SEN Capital Partners, a New York-based hedge fund specializing in consumer credit strategies.