Is it the loan performance or loan originator that matters?

24.08.2018

mintosblog

With an unparalleled number of loans originated by many different loan originators around the world, the Mintos marketplace provides a great way to build a very well-diversified investment portfolio of loans. While diversification is the most important component for reaching long-range financial goals whilst also minimising risk, the question remains – how to pick which loans to invest in? Should one look at the loan performance, or rather, at the financial strength of the loan originator? Or perhaps both? Is loan performance important at all if the loans come with a buyback guarantee from the loan originator?

We get asked these questions and see investors eagerly discussing them in forums. Martins Valters, the COO/CFO and Co-Founder of Mintos, decided to take the time and jump into the discussion to provide our view on this subject.

Investors on the Mintos marketplace can invest in a wide variety of loans. We strive to provide a great user experience and make investing in loans easy and transparent. Equally, we put a lot of work into the legal setup and technicalities that investors usually don’t see and remain under the hood.

In general, by investing in a loan, investors are buying claim rights against a borrower based on the assignment agreement where the loan originator transfers (assigns) to the investor the claim against the borrower arising from the loan agreement. This means from then on the borrower owes money to investors. We call it the Direct Structure. In some instances, mostly due to regulatory limitations in certain countries, we use the Indirect Structure where investors are buying claim rights against the loan originator and not the borrower. Under the Indirect Structure technically the loan originator owes money to investors, however, the repayments still depend on the final borrowers’ payments and the underlying loans issued to the borrowers are pledged in the name of Mintos. You can read more about both investment structures here.

Irrespective of the investment structure, as each borrower makes payments according to their loan agreements, the received principal part of the payment reduces the carrying value of investors’ investment in the loan, while the interest and late payment fee portion of the payment is treated as investors’ income. In other words, investors make money from their investments as borrowers are repaying loans.  

The importance of loan performance

As a result, the borrowers’ repayment discipline is the most important aspect in driving the returns for investors. When we connect any loan originator to the marketplace, first and foremost, we look at the loan performance. We examine if, based on the historic loan performance, we can be reasonably confident that loans originated by the respective loan originator will provide acceptable risk-adjusted returns to investors on our marketplace. If the loan performance is not satisfactory, then we don’t connect the loan originator to the marketplace and the loans are not offered to investors for investment. This is something that is non-negotiable and is hardwired into our due diligence process.

For example, if a loan is EUR 2 000 and it is offered to investors at a 10% interest rate, then the expected loan payoff (i.e. total loan repayments) should be at least EUR 2 000 principal, plus the 10% annualised interest for the respective period. If it is less, such a loan can’t be placed on our marketplace. In reality, the loan payoff should be higher as loan originators have to also cover their operational costs – marketing, servicing borrowers, running recoveries, etc. – and also allow for a profit margin (you can read more about this in our recent blog post about the cost structure of short-term loans here).

How do we assess loan performance at Mintos?

At Mintos, we conduct vintage analysis to evaluate the credit quality of a loan portfolio. This means that we group loans on the basis of an origination period or “vintage” (usually calendar month) and track their performance – how many loans are repaid, how many go into delays and how many default. This allows for a better understanding of the loan performance over time as it is not biased by the changes in the total portfolio size.

As part of the vintage analysis, we look at payoffs – the total received repayments of principal, interest and any other fees over the principal issued. In particular, we look at the payoff time and what is the total payoff as a percent of the principal issued. The payoff time shows how many months it takes to receive repayments equal to the disbursed loan principal. This measure should closely correlate to the term of the loan. A slow payoff and a low total payoff can indicate problems with the underwriting and/or with the collection process.

Below is an example of a payoff analysis for 8-10 month personal loans. As depicted in the graph, the vintage payoff is reaching 100% within 5-7 months and the final payoff levels at 120% after 9-11 months for all the vintages thus providing around a 20% annualised return. Based on the historic track record we would conclude that the loan performance is satisfactory and that such loans should provide adequate risk-adjusted returns to investors and generate enough of a total payoff for the loan originator to cover their expenses and profit margin.

Many of the loan originators on the Mintos marketplace operate in multiple countries, in addition, some provide more than one loan product. We evaluate each new country and loan product separately. It means that the loan originator can originate and service the best performing loans in one country, but if the loan performance in the new country is lagging behind or there is not sufficient track record we will not allow loans from the new country on our marketplace. The same goes for new loan products. There might also be a different approach to loans originated by the same loan originator in the same country. For example, we might identify that there is a significant difference in performance between loans issued to new clients and loans issued to existing clients, i.e. repeating borrowers. That can be especially true for short-term loans where the performance of loans to repeating borrowers can be satisfactory, while that of loans to new clients is not. In that case, we would restrict the loan originator and allow it to only place loans from repeating borrowers on the marketplace.

Unfortunately, sometimes borrowers will not be able to meet their payment deadlines. This could be due to the loss of their job, mismanagement of personal finances, or a plethora of many other reasons. Borrower default is part of the lending business. Defaults can vary a lot among different loan types, different countries, and even among different borrower segments of the same loan type in the same country. However, there is no easy answer to the question “what is the right level of default”. The loan performance has to be viewed within the context of many other factors, including the interest that is charged to the borrowers. It could easily be the case that loans with higher default rates can yield higher returns at the end of the day compared to loans with lower default rates because in the former case the borrowers pay higher interest rates and that compensates for defaults across the portfolio.

That leads to the question: should investors look at the performance of loans on an individual loan basis or on a portfolio basis? In general, when looking at loan performance investors should consider their investments in loans as a portfolio, rather than separate individual investments. The simple reason for this is diversification. If an investor has invested EUR 1 000 in one loan and the estimated probability of default is 5%, then if that particular borrower defaults, the investor risks losing the entire amount. However, if instead, the investor invests EUR 1 000 in 100 loans, with EUR 10 in each with the same 5% probability of default, then there is a risk that on average 5 loans will default. The remaining 95 borrowers will continue to make regular payments and the received interest over time should more than compensate for the defaults. Even though the expected default is the same in both cases, the volatility of returns will be much higher when investing in just one loan. In fact, diversification is so important that we have created a separate series of blog posts about the ways investors can diversify their investment portfolio on our marketplace, which you can read here.

What about loans with a buyback guarantee?

So, first and foremost investors should look at the loan performance. But what about loans with a buyback guarantee where the loan originator guarantees they will repurchase the particular loan from the investor if the borrower’s payments are delayed by 60 days or more? A common misconception is that for loans with the buyback guarantee investors are investing in loan originators, not loans and that the loan performance is not important. However, that is not true.

To explain why loan performance still matters the most let me dig deeper into how the buyback guarantee works. The buyback guarantee is provided by the loan originator. If the borrower is late for 60 days or more, the loan is automatically bought back by the loan originator at the nominal value of the outstanding principal, plus accrued interest to date. Here it is important to understand where the cash flows come from to cover the buyback guarantee. The funds to buy back the delayed loans come from the interest rate spread generated by the loan originator.

The interest rate spread is the difference between what is charged to the borrowers and what is passed on to investors. For example, let’s assume the loan originator issues 100 loans at EUR 1 000 each and assigns them to investors. The loan originator charges the borrower 30% annually and the expected default rate for these loans is 10%. On the Mintos marketplace, the loan originator has two options on how to sell these loans to investors – with or without the buyback guarantee. If they sell the loans without the buyback guarantee (i.e. the default risk is born by investors) and passes on to the investors a 20% interest rate, investors at the end of the year would have made an 8% net return – investors would experience EUR 10 000 capital loss but earn EUR 18 000 in interest on performing loans (20% * EUR 90,000) for a net of EUR 8,000 return over EUR 100,000 invested. In this case, all the cash flows come directly from the borrower payments.

Alternatively, the loans could be sold to investors with the buyback guarantee, but instead of a 20% interest rate, the loans are sold at an 8% interest rate. In this case, the cash flows to investors would consist of two parts. The first part is the payments received from borrowers: EUR 90 000 principal and 8% of EUR 90 000 or EUR 7 200 in interest. The second part of the cash flows to investors are the payments received from the loan originator for the buybacks – principal EUR 10 000 (10% of EUR 100 000) plus accrued interest EUR 800 (8% * EUR 10 000) for the defaulted loans. The net result is the same as in the case of the loan without the buyback guarantee – investors earn an 8% net return and the loan originator makes EUR 9,000 to cover their costs and profit margin.

Although the money for the buyback guarantees does indeed come from the loan originator, it is important to note that this is money the loan originator earns through the extra spread. In case of loans sold without the buyback guarantee, the loan originator earns 10% interest (30% total minus 20% passed to investors), while in the case of loans sold with the buyback guarantee the loan originator earns 22% interest (30% total – 8% passed to investors). With the additional 12%, the loan originator earns an extra EUR 10 800 (12% * EUR 90 000) – that allows the loan originator to cover the buyback guarantee and pay to investors the EUR 10 000 plus accrued interest of EUR 800 for loans that are late for 60 days or more.

When considering if the loan originator can place loans on the marketplace with the buyback guarantee it is very important for us to see that the buyback guarantee is provided from the extra spread. If we don’t see on the loan portfolio level that the buyback can be covered from the extra spread we don’t allow the loan originator to provide the buyback guarantee.

As a result, even for loans with the buyback guarantee, it’s still the loan performance that matters the most. If the loans are performing according to expectations the loan originator generates enough extra spread to cover the buyback guarantee. On the other hand, if the loan performance would deteriorate and the actual default rate turns out to be higher than expected the loan originator would run into difficulties to honour the buyback guarantee.

The role of the loan originator

If it’s the loan performance that matters the most when investing in loans on Mintos then what is the role of the loan originator and why should investors pay attention to their performance?

First and foremost, the loan originator plays a key role in servicing the loans and collecting borrower payments. The quality, stability and experience of the loan originator as a servicer directly affects the loan performance. When there is a stable loan originator as a servicer, investors can be sure that the borrower payments will be collected and distributed in an orderly manner and the only thing that matters is loan performance. However, in case the loan originator would go out of business and stop servicing the loans there would be interruptions in collecting payments from borrowers and passing them to investors as it would take time for Mintos to step in and put in place a backup servicer and the loan performance could deteriorate accordingly. Therefore, at Mintos, we pay particular attention to the loan originator as a servicer and analyse the management and staff experience, financial position of the loan originator, policies and procedures, controls, and historical servicing performance to make sure that we can reasonably conclude that the loan originator will be around to service the loans.

At Mintos, we believe that the loss of a loan originator as a servicer is arguably the main risk investors face when investing in loans. In the event that a loan originator goes out of business, we have put in place arrangements to ensure that investors continue to receive payments on the loans in which they have invested in through the Mintos marketplace. As a representative of the investor, would take over the management of the claim from the loan originator and transfer to any third party at Mintos’ discretion. The best setup to decrease the risk of losing the servicer of loans is to have a hot backup servicer, which is ready to jump in the very next moment after the loan originator’s default to take over the servicing of the loans. Of course, having a hot backup servicer would also add additional cost to the setup and that would at the end of the day reduce the returns for investors.

Secondly, the loan originator plays a fundamental role in originating and underwriting loans. If the underwriting standards are low-quality then the loans originated by the particular loan originator will underperform and that will directly impact investor returns. Such factors as the loan originator’s and management experience, risk management and control, and the collateral risk assessment process are key when reviewing the loan originator’s origination and underwriting.

Finally, in the case of loans with the buyback guarantee, the loan originator is also a provider of the buyback guarantee. Here in particular we look at the financial standing of the loan originator to assess if loans can be provided with the buyback guarantee, which is especially important at the beginning as it takes time for the extra interest rate spread to build up. However, as discussed above, the buyback guarantee is covered from the extra interest rate spread the loan originator keeps. Only in the cases where the loan performance would deteriorate and the default rates exceed the expected default rates the financial strength of the loan originator would come into play.

It is important to note that loan performance has a very direct impact on the overall sustainability of the loan originator. If the loan performance is good this will have a direct positive impact on the loan originator and result in better financial results and financial standing. This, in turn, will make the loan originator a more stable loan servicer. On the flip side, a severe decline in the loan performance might significantly impact financial standing of the loan originator even bring down the loan originator as such.

Bringing it all together

When investing in loans first and foremost it is the loan performance that matters. Loans that are performing according to expectations will provide the expected returns to investors. On the other hand, underperforming loans will have a negative effect on investor returns, even if the loan originator provides a buyback guarantee. Meanwhile, the loan originator plays a key role as a loan servicer, but also as an originator and underwriter, and provider of the buyback guarantee in case the default rates are higher than expected. Investors can invest in well-performing loans but if the counterparty risk of the loan originator is high investors might require higher expected returns to compensate for additional risk. On the flip side if the counterparty risk of the loan originator is low investors might be content with lower expected returns.

In any case, the importance of diversification cannot be underestimated, be it across different borrowers, loan types, loan originators, countries, etc. The majority of investment professionals agree that diversification is the most important component for reaching long-range financial goals while minimising risk. Therefore, at Mintos we have our own saying: don’t put all your money into one loan, diversify!

Looking ahead

At Mintos, we are committed to providing an easy, transparent and diversified investment experience. We acknowledge that investors, to make well-considered decisions in which loans to invest in, need more information about both the loans and the loan originators. Therefore, we have been working behind the scenes and in the upcoming months investors can expect to see:   

– More information about the individual loans (e.g. such as recently added annual percentage rate (APR) charged to the borrower);

– Loan performance on a vintage basis in a user-friendly format;

– Streamlined and timely disclosure of loan originator annual and quarterly reports;

– Mintos Ratings for loan originators representing their counterparty risk;

– Backup servicer setup for the larger loan originators in bigger countries.

Thanks for taking the time to read this post. As always, your feedback is very much appreciated. In case you have any questions, feel free to leave them in the comments below or reach out to [email protected]

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