Vault Series: Philip Bartow, RiverNorth Capital Management

 

The new asset class of marketplace lending (MPL) was the topic of discussion at CFA Society Chicago’s Vault Series presentation on January 11, 2018. Presenting was Philip Bartow, lead portfolio manager for MPL at RiverNorth Capital Management. What was once a peer-to-peer market for consumer and small business loans has blossomed into a new institutional asset class totaling $27 billion as of 2016.  RiverNorth is a Chicago-based investment manager founded in 2000 with $3.8 billion under management. The firm specializes in opportunistic strategies with a focus on niche markets that offer opportunities to exploit valuation inefficiencies. Marketplace lending is the firm’s newest strategy.

The Environment for Marketplace Lending

Bartow began with a review of market and economic conditions that support the case for investing in MPL, starting with the interest rate environment. Although the Federal Reserve’s Open Market Committee forecasts three increases in short term rates in 2018, projections from the Fed Funds futures market are less aggressive. The market is saying “lower for longer” still rules the day. In addition, past increases in the Fed Funds rate have caused the yield curve to flatten, making shorter duration instruments relatively more attractive compared to longer investments.

Consumer financial health has improved greatly since the crisis of 2008-09. After a lengthy down trend, the unemployment rate has reached a level consistent with full employment, consumer sentiment gauges are at high levels and are moving in an upward trend. Growth rates of GDP and average hourly wages are finally showing some acceleration. Loan losses on consumer lending (residential mortgages and credit card loans) have fallen from crisis highs to, or below, long term averages.  In addition, corporate credit metrics are strong. Default rates on high yield bonds and leveraged loans have been running below long term averages for several years, and corporate earnings (based on the S&P 500 Index) are strong and expected to rise higher. The household debt service ratio, at just under 10%, sits at a 30 year low, and household debt/GDP at 80%, is at a level not seen since long before the last crisis. In short, the picture of economic fundamentals for both consumers and corporations is a rosy one. A slight rise in consumer delinquencies in 2016 is attributable to borrowers with low FICO scores, under 660 at origination.

The persistence of low interest rates, and the “risk-on” sentiment in financial markets, has pushed valuations to extreme levels. Credit spreads on high yield bonds sit more than a full standard deviation below average levels, and the VIX index of equity market volatility remains very low.

The Case for Marketplace Lending

At its essence, MPL loans involve the use of online platforms to provide secured lending to consumers and small businesses funded by institutional investors. Between borrower and lender sits an innovative loan originator that relies on technology to gather the data to support extending the original loan, servicing it, and monitoring the credit quality. There are 125-150 originators of loans but Lending Club, dating back to 2007, is the largest and most experienced in the market. Established “brick and mortar” banks are only just beginning to get involved.

Bartow began his case for investing in MPL by pointing out the huge spread between the average credit card loan (almost 21%) and the long term average yield in the bond market (measured by the Barclays Aggregate Bond Index) of 4.52%. MPL offer a potential benefit to both borrowers and investors inside this wide difference. The long term average coupon rate on MPL loans is just over 13%, while investors have earned an average of 8.13%.

Several characteristics of MPL loans are instrumental in providing better risk-adjusted returns going forward than direct consumer lending in the past.

  • In particular, originators focus on the higher end of the credit spectrum, lending only to borrowers with FICO scores of 640 to 850 (with an average of 705). This puts them in the higher end of the “near prime” category or better. Borrowers considered subprime and even prime are excluded.
  • In addition, MPL loans are always amortizing installment loans, in contrast to the typical credit card or consumer loan that comes in the form of a revolving credit line. MPL loans thus exhibit a constant rate of repayment, a predictable cash flow, and a lower duration, all of which reduce credit risk. In contrast, revolving credit loans don’t decline. In fact, they often increase ahead of a default as the borrowers tend to draw on their lines more as their financial health slips (slide 16).

An efficient frontier plot of the Orchard U.S. Consumer MPL Index covering January 2014 through September 2017 shows a superior risk-adjusted return versus a variety of relevant Barclays fixed income indices including the 1-3 Year Treasury Index, ABS Credit Card index, Aggregate Index, and High Yield Index, as well as the S&P 500 Index.

Bartow provided further information on the market for investing in MPL loans in general as well as some standards that RiverNorth follows. Although often compared to credit cards loans, MPL loans come in various types and are made to differing borrowers. The most common are consumer loans which are usually used to pay off or consolidate credit card debt. Originators may use a lower loan rate to induce borrowers to allow the originator to pay the credit card directly with the loan proceeds. Doing so has proved to lead to a better record of payment. Student loans and franchisee loans are other common types.

The secondary market for MPL loans is not a liquid one. Trades occur literally “by appointment” when originators announce dates in advance when they will bring supply to market. RiverNorth’s registered mutual fund that invests in MPL loans is an “interval fund”, meaning that it accepts new investments daily, but distributes withdrawals only quarterly, with a limit on the amount. Although many loans go into securitized products, RiverNorth prefers to invest in whole loans directly to improve gross returns. They also buy the entire balance of loans which gives them more control in the case of deteriorating credits or defaults. Loan originators, however, usually retain servicing rights on loans they sell.

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