Consumer loan ABS deals may be showing higher delinquency rates amid higher interest rates, but recently originated deals are performing very well and catching the eye of investors drawn by high returns, according to Paul Limanni at regular issuer Pagaya.
GlobalCapital spoke with Limanni, who runs all funding and capital markets efforts for the fintech, about finding opportunities despite higher rates, the importance of being programmatic with issuance, and how the firm is using its artificial intelligence capabilities to differentiate itself.
He was largely optimistic on the asset class.
Pagaya is an AI-driven fintech that gives access of its modeling to its partners including banks and other financial institutions to originate loans. The firm issues ABS transactions with loans originated through their system in the subprime auto loan, consumer loan and RMBS sectors.
Since entering the ABS market in 2018 with a consumer loan securitization, Pagaya has issued issued 39 private securitization deals, across consumer loan ABS, subprime auto loan ABS and single family rental RMBS.
Consumer and marketplace lending ABS had two record years in 2021 and 2022, with $18bn and $18.2bn of issuance respectively, according to Finsight. Rising interest rates have since made funding costs exponentially higher for consumer lenders. Yet this interest rate environment also represented an opportunity for certain consumer loan ABS issuers, according to Limanni.
“The flip side [of higher rates] is that it provides an opportunity to remove a lot of the weaker hands in the space and rein in maybe some of the excess risk taking you saw in 2021 and the first part of 2022,” he said. “What this has done […] for folks who can continue their capital programs is to let them have the cream of the crop in terms of credit selection.”
Delinquencies and losses in the consumer loan ABS market have been trending upwards consistently since 2022, as American consumers, who no longer had access to federal stimulus programs, have started to feel the financial burden of persistent inflation.
Annualized net losses for KBRA’s Tier 2 marketplace consumer loan index, which comprises deals generally consisting of loans from borrowers with weighted average FICO scores between 660 and 710, was at 14.72% in May. KBRA’s Tier 1 annualized losses, including prime collateral, was at 6.12%.
The Tier 2 index includes collateral from issuers like Pagaya, Prosper, Upgrade, Upstart, LendingPoint and Theorem, according to KBRA.
Many issuers expanded originations to deeper credits, meaning borrowers with lower FICO scores, when the cost of capital was cheap in 2021 and early 2022, and “a lot of that's unwound itself in this new environment”, according to Limanni.
“The delinquency data supports that,” he says.
However, Limanni still believes that the market is in “a much better place today than a year ago”, and that many issuers have made big changes to get there.
“I think what a lot of investors are saying is that originations from the end of last year to now are exhibiting a much lower delinquency rate than what they saw in 2021,” Limanni said. “And it's getting folks to really look at our space and getting them excited because they say: I'm catching the asset where it's performing well, and the spreads and the yields are high.
“So a lot of people have begun to pivot and bring in more money to the space because of what they're seeing.”
These qualities are even drawing new investors into the sector.
“I can attest from our end that we have both our normal historical folks who've been in for five years participating, and then we're seeing a lot of new [investors] coming in,” Limanni said.
AI benefits
While volatility and high funding costs persist, Pagaya looks to differentiate itself from other issuers with its AI capabilities and its consistent presence in the ABS market as a programmatic issuer. AI helps Pagaya to quickly identify borrowers that can manage payments better in an unprecedented environment like this in which consumers have various financial burdens, according to Limanni.
“When you're in a dramatically changing economic environment, the benefit of using artificial intelligence modeling is that it allows you to identify the characteristics of the customer that matter more so in the local environment, not necessarily what worked for the last three to five years,” he said.
Being a programmatic issuer is also a great advantage for large liquidity with complicated assets, Limanni says.
“The reason why it's important to be programmatic, and in the space through good markets and bad, is because it gives you the reputation of being a benchmark issuer,” Limanni said. “Once you're viewed that way, your ability to bring deals in any market environment dramatically improves.”
‘Accept where the world is’
Part of being a programmatic issuer is also having a consistent structure among deals, a policy that Pagaya has followed. The only significant change in each deal Pagaya brings to market today is that they have loans from more underlying platforms, since the business has been growing over the years, which also results in larger deals.
From 2018 until the second half of 2020, Pagaya’s consumer loan ABS deals were each around $100m to $200m in volume. The company’s deal sizes started to increase in the second half of 2020, with the two biggest deals — PAID 2022-1 and PAID 2022-3 — each raising $1.2bn and $1bn, respectively.
“Structurally, we’ve been pretty consistent,” said Limanni. “We've had to account for higher capital costs and how the different mezzanine and equity folks’ demand has shifted.”
An inverted yield curve has meant issuers are paying higher yields for shorter-dated paper, but this is not going to deter Pagaya’s issuance plans.
“There's only so much you can do to extend duration farther up the curve on the asset, and arguably, the right thing [to] do is to accept that this is where the world is, and adjust your pricing and modeling to account for it,” said Limanni. “At the end of the day, we're going to keep issuing.
“Yes, the short end of the curve is higher cost, and it probably will be for another 12 months.”