Shift in consumer behaviour rewrites the book on ABS risk
The pandemic has put the brakes on a decade of economic expansion that was firmly driven by the strength of the US consumer and a rebuilt household balance sheet in the wake of the 2008 crisis. The sudden upending of consumer finances and soaring unemployment are just a foretaste of the new risks that the consumer ABS market is dealing with, and investors are in uncharted waters as the crisis moves into the summer. Jennifer Kang reports.
Urban flight was an early result of the pandemic, says Stephen Smitley, head of structured products at Aware Asset Management. As the crisis unfolded, it became clear that the outbreak in the US was concentrated in its largest cities, and the response was a sharp and sudden move away from large urban areas and into surrounding suburbs. The expectation that Covid-19 could return, combined with a successful experiment in working remotely, make crowded cities less appealing.
According to a survey by analytics firm The Harris Poll, 40% of adults living in US cities are considering leaving as a result of the virus, and in New York, nearly 420,000 people have already left for the suburbs.
“One of the biggest reasons why younger folks like to live in those areas [cities] is the proximity to work and being able to go out to socialise with others,” Smitley says. “People have willingly paid for that, but many are going to rethink that decision.”
It isn’t just where people will choose to live after this. It is how they will choose to live. Intense pressure on consumer and household balance sheets could provoke a permanent change in spending habits, similar to what was observed in the wake of the 2008 crisis. Discretionary spending on everything from dining out to gym memberships to renting cars has been slashed. Even when strict social distancing orders are lifted, consumers will still be much more wary of frequenting communal spaces like these, observers predict.
Whole business securitizations, which have boomed in the past three years, will likely be impacted particularly hard. Issuers such as Planet Fitness and Massage Envy will deal with cashflow issues, while fast food chains like Sonic — a frequent issuer of ABS — could see more stable performance. In the long term though, the esoteric ABS market is likely to see a shift in the kinds of assets that end up moving through the pipeline, and some of the issuers that have tapped the robust demand for esoteric ABS could find it difficult to return to the capital markets.
“Consumers are probably not going to go get a massage or hit the gym, which will have its effect on part of the securitization world at least in the short term,” says Francisco Paez, head of structured products research at MetLife Investment Management.
Among restaurant chains, fast food franchises are better placed to weather the crisis than the casual dining segment, even if both offer drive-through, pick-up and deliveries, investors say.
“We are more reliant on online ordering as opposed to going out to restaurants now, so all the delivery companies are doing super well,” says Howard Schickler, partner at law firm Katten Muchin Rosenman. “We’re seeing upgrades in those platforms and people are trying to figure out if there’s a way to monetize those programmes even more. That’s an important development going forward in the ABS space.”
Forbearance masks real data
In the era of Covid, rising forbearance has become the top concern for market participants. A growing fear is that forbearance policies in consumer securitization segments, ranging from prime autos to residential mortgages, is hiding the true magnitude of losses, sources say.
Forbearance has become an integral part of many issuers’ Covid-19 relief plans to buy some time for their clients to recover. However, the market is no longer expecting a quick V-shaped recovery. Even as the economy opens up in stages, many of the millions of job losses are likely permanent, says Hando Aguilar, vice president and senior portfolio manager for American Century Investments.
To account for this new risk, investors have added forbearance rates as a factor in their credit risk analysis, alongside basic elements like prepayments and recoveries.
The key question is how forbearance translates into real, observed delinquencies, says Dave Goodson, head of securitized at Voya Investment Management.
“There is a significant disconnect between credit performance and consumer data across all sectors,” said Chris Pink, managing director and co-head of asset backed finance at Wells Fargo. “If you look at delinquencies, it’s in really great shape. For some sectors, the numbers are lower than they were a year ago. That doesn’t dovetail with the 15% unemployment and the possibility of it rising.”
Two factors are propping up credit performance as the crisis enters the summer. One is the $1,200 stimulus many people received in the spring. Second, many issuers are providing extensions and forbearance plans to provide some relief to their borrowers.
The true numbers could be much more dire than what current data suggests, especially in auto ABS, according to Joseph Cioffi, a partner at law firm Davis & Gilbert.
“The answer may lie in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Section 4021 of the Cares Act provides that, if a consumer is granted forbearance or other forms of payment relief due to Covid-19, servicers are required to ‘report the credit obligation or account as current’,” Cioffi explained in a post published in May. “Therefore, forbearance programmes are effectively obscuring delinquencies and we will likely not see the impact until a full payment period after the forbearance expires.”
Many of the forbearance policies are expected to wind down in June and July, but investors say there is a high possibility that lenders will grant further extensions, given the unemployment numbers. Heightened levels of forbearance could become a new reality in the near to medium term if the recovery is uneven or if borrowers find difficulty re-entering the workforce.
The level of forbearance and extensions plans differ considerably by sector. Lenders in the subprime auto ABS world generally have been more conservative, granting 30 days of forbearance.
For the prime sector it’s quite different, says Pink. In prime auto, there isn’t a playbook for modification, so forbearance policies have been much more generous. The extensions are usually 90 days, and the prevalence of extension activity in prime auto loans is high, at 10%-12%, compared with 4%-6% in subprime.
“A part of the reason is that prime operators are large banks and very much in the public eye. Because there's so much scrutiny on them, they want to do everything they can, and also in many cases not repossess vehicles. For them it’s better to forbear,” says Pink. “On the other hand, 90 days of forbearance is a lot for a subprime borrower who’s probably living paycheck to paycheck. A lot of subprime issuers are repossessing vehicles.”
Sectors in decline
The earliest and hardest hit securitization asset class was aviation ABS. There will be a return to normal at some point when a vaccine arrives, says Goodson, but the road to that point will be difficult. Once the vaccine becomes widely available, there may even be some pent-up demand for international travel — but that is a scenario that probably won’t play out until 2021, sources says.
“I think the travel industry is forever changed,” says Schickler. “I don’t see people travelling the way they did before. Until there’s a vaccine, people will be doing more domestic travel and driving more, especially given the price of oil. Gas is so cheap and hotels are relatively inexpensive.”
Unsecured consumer ABS is the sector with the most unknowns. Although online purchases are elevated, consumers are no longer spending money on large purchases that require smaller personal loans.
Moreover, marketplace lenders have significantly tightened their credit criteria, while others have halted new originations.
“It’s becoming a cash-focused society,” says Schickler. “There’s more interest in anything that can be done online as far as consumer spending. However, you also see a decline in unsecured consumer loans because people are not making large purchases. They’re not travelling, not going out, not doing home improvements, so consumer spending is down across the board. These people are just using cash for necessities at this point.”
Many online lenders were born at the tail of the last financial crisis, but many will struggle to make it through this crisis, given the constraints on the funding sources.
Market participants say the online lending sector is most likely to see a wave of consolidations throughout the Covid-19 crisis. Those that benefit the most from the consolidations will be banks, equipped with ample deposits and motivated by their need to adapt to a digital-first market.
“It’s only been two months, but I’ve heard chatter among different associations like LendIt, Structured Finance Association or the Loans Syndication and Trading Association that banks are certainly considering consolidation,” says a structured finance lawyer. “There’s already a lot of unsecured lenders who are partnering up with banks to provide them with artificial intelligence algorithms.”
At the other end of the crisis spectrum are several asset classes that investors are finding value in.
Any sectors eligible for the Federal Reserve’s revived Term Asset Backed Securities Loan Facility (TALF) are doing well, while corporate-linked markets like whole business securitizations and aircraft are now far less desirable.
Cell tower and data centre securitizations stand out among esoterics, says MetLife’s Paez, because they are protected from the effects of the crisis for the most part.
Some market participants are expecting the second half of 2020 to see a new boom in esoteric ABS activity as investors grow comfortable with credit risk in the post-Covid era. There may also be some first time issuers from the pharmaceutical and healthcare sectors, says Ira Schacter, senior partner at law firm Cadwalader.
“We’re expecting tremendous activity in the second half of the year in esoterics as interest rates continue to be low and there is an ongoing need for financing,” Schacter says. “I’d be very bullish on esoteric finance because there will be some very interesting first-time issuances, given what’s going on in the healthcare sector.”