October 2024 - It Takes Two to Profit

In this month’s edition of The LoanStreet Beat, we examine how credit unions can mitigate slowing originations volumes and grow their balance sheets through strategic partnerships. In addition, we recap an active economic news cycle and share our observations on loan trading. Enjoy, share and please comment below!

LoanStreet Market Commentary

The September data releases were largely positive for the Fed.? Inflation has cooled and the labor market, while showing signs of cracking, has been resilient.? The month started with the August nonfarm payrolls which rose by 142k, compared to the forecast of 165k (https://www.bls.gov/news.release/empsit.b.htm).? Further, the payroll numbers for the previous two months were revised downwards by 86k in total. This brings the 3-month average to 96k, the first time the number has been below 100k since mid-2020.? At the same time, the unemployment rate dropped from 4.3% to 4.2%, suggesting that although job growth has slowed, it’s still strong.? Further support came from the jobless claims which continue to come in below expectations.? The goal of the Fed rate hikes was to cool the economy, and with respect to labor that seems to be what is happening.?

That being said, it might be too early to call what the Fed has achieved so far a “soft-landing”.? For one, while the headline PCE inflation is down to 2.2%, the core number (which excludes food and energy) is still at 2.7%.? With geopolitical risks at elevated levels, energy and food prices are at risk of rebounding.? Further, with the recent stimulus in China, there are risks of inflation in China, which would lead to higher input costs for producers and therefore higher inflation for all.? In addition, the recent port strike could impact supply chains and put upwards pressure on inflation should it drag on (https://www.cnbc.com/2024/09/19/largest-port-on-east-coast-begins-preparations-for-a-strike.html). Lastly, related to the labor market, the latest consumer sentiment data (https://www.conference-board.org/topics/consumer-confidence) showed consumers are concerned about their ability to find jobs and pessimistic about their financial situation going forward.? This could impact spending and therefore be a drag on economic growth.?

The market has found solace in the fact that the Fed is willing to aggressively cut rates if needed, as seen from the 50 bps rate cut during the September meeting.? The Treasury market has largely priced in the cut, as the reaction in Treasury yields was muted.? The stock market on the other hand, continues to push towards record highs as the perception is that the Fed will step in should labor continue to deteriorate.? At this stage, the biggest risk to a soft landing is inflation accelerating for some of the reasons mentioned above (strikes, geopolitical risks, Chinese stimulus), while the labor market continues to deteriorate.? This would put the Fed in a tough position as to its next steps.????????

Loan Trading Trends and Implications

On the LoanStreet marketplace, we continue to see a surge in activity.? This is driven by (i) favorable pricing for the sellers, as their loan rates remain elevated relative to the steep drop in Treasury rates, and (ii) slower loan originations which have turned many credit unions into buyers.? There are no signs of the buy-side demand subsiding, as loan origination volumes are likely to continue to fall as consumer spending drops.? To ensure we have enough supply to meet the demand, we will start to open up the credit-box for the participations offered.? That being said, because credit concerns are still top of mind for many buyers, wider credit boxes will make informative loss data even more important.? When it comes to product mix, there is a limited supply of auto, so buyers should expect tighter spreads and looser credit boxes. However we have recently seen a surge in residential pools, which is resulting in elevated yield levels – a great value for buyers.? As an added benefit for residential pool buyers, the pools generally require relatively low CECL reserves.??

As the market slowly shifts towards favoring sellers, buyers will be forced to open up their buy-side criteria into new asset classes and/or looser buy-boxes.? The good news for buyers is that, by being open to new asset classes and/or riskier loans, they can pick up higher loss-adjusted returns.

In this active participation market, there are plenty of opportunities for both sellers and buyers.? Sellers should focus on being able to provide clean and interpretable performance data for any asset they are planning on selling.? With the strong focus on credit, having robust performance data helps get the deal across the finish line.? Another area of opportunity is deal structure. As rates drift lower, and prepayment risk is top of mind for many buyers, one seller strategy is to share in the risk through a higher servicing fee and a lower premium.? By taking on some of the prepayment risk, the seller is able to attract more buyers and ultimately get better execution on the deal.? For the buyers, as mentioned previously, the buy-box will need to expand to allow for either new asset classes or riskier loans.? This doesn’t mean that buyers need to accept lower loss-adjusted yields; they simply need to be comfortable buying outside their normal credit box.??????

Deep Dive: It takes two to profit

As has been reported by multiple publications (and as can be seen from the Q2 call reports) that loan growth across the credit union industry has slowed.?

The above graphs, from Callahan & Associates Peer Plus tool, show recent loan growth is below pre-pandemic levels.? This is particularly true for credit unions with under $1B in asset size.? This presents an opportunity for credit unions to consider partnerships with non-bank originators who are able to target customers that credit unions might not be able to reach.

While the concept of partnering with a non-bank originator is nothing new for credit unions – this has been happening for years – there have been recent developments in the structuring of such partnerships. The many available options require different processes for setting up such partnerships.?

The first step in any non-bank originator process is that the credit union must decide which asset type they are going to pursue and ensure that they have a proper understanding of such asset class.? Since partnership opportunities exist among virtually all asset classes under the sun, this is a great chance for credit unions to diversify away from their usual product mix.? Some examples include powersports, elective medical, agriculture, manufactured housing, electric vehicles, fix and flip residential and many many more.? A credit union can easily pivot to a variation on a product that they are already familiar with. For example, electric vehicles are like autos, or fix and flip is like residential. While there are underwriting nuances when evaluating electric vehicles as compared to regular ICE cars, the diversification can be valuable.??

Once you decide on the asset class, another consideration is the structure of the partnership.? Here you are given two options, originate-to-hold or originate-to-distribute. In both cases, partnerships allow you to manage the volume and learn the new asset class at your own pace.?????

Originate-to-hold:

The originate-to-hold model is the simplest version of the partnership.? The third party and the credit union agree on a credit box and the loan originator simply originates loans within that box.? The loans are held on the balance sheet of the credit union and volume is dictated by the size of the balance sheet of the credit union and their appetite for a given asset class.?

Originate-to-distribute:?

The second strategy is a bit more complicated as it’s influenced by factors outside of the partnering credit union, mainly by the secondary market appetite for a given asset.? In this structure, the credit union partners with an originator with the intention of selling the loans to downstream buyers.? This allows the credit union to leverage their balance sheet as they typically only need to retain 10% of each loan and are able to participate out the remaining 90%.? ? This strategy gives the originating credit union more leverage when negotiating with a third party as it typically means the credit union is able to take on more volumes when compared to a originate-to-hold strategy.?

The strategy that a credit union might go with will depend on their goals.? If the goal is to grow the balance sheet, holding onto the loans makes sense.? If the goal is to generate non-interest income, participating out the loans would be the better course.? Of course, the two strategies are not mutually exclusive.

Given the leverage, the originate-to-distribute strategy can be extremely profitable for the originating credit union. This is because, while the credit union is only holding 10% of the loans on their balance sheet, they are earning a servicing fee and potential upfront premium on the full 90% that was sold.? As a simple example, suppose your balance sheet limit for a given product is $10MM.? With the buy-and-hold strategy, you are limited to funding just the $10MM in loans.? Depending on the originating needs of the non-bank originator, that $10MM might not be enough, limiting your ability to negotiate pricing.? With the originate-to-sell strategy, you are able to originate $100MM of loans while participating out 90%, allowing you to stay within the $10MM limit while giving you more pricing power due to the volume you are taking on.? Not only do you have pricing power, but depending on the pricing you are able to obtain on the secondary market, you are also earning servicing and a premium on the $90MM sold.? You continue to earn the interest income on the 10% retained allowing you to match the returns of the buy-and-hold strategy while earning a profit on the loans sold.?

While partnering with a third party originator can come with its own set of risks, these risks can be mitigated.? For example,? third parties can be early-stage companies with limited historical performance data, which might make it difficult to evaluate the proper loss reserves.? Even if the company has been around for a few years, it’s unlikely they have been through multiple credit cycles, making the performance data they do have not as reliable.? Here are a couple of whitepapers we have written on the subject of how to look at and evaluate losses- https://loan-street.com/resources/what-to-expect-expecting-losses/ and https://loan-street.com/resources/static-cling-use-static-pool-analysis-to-avoid-getting-shocked/.? Loss expectations are a key component of how the loans should be priced.? For that reason it is important to gather as much data as possible to ensure you are properly assessing the losses.? Once you have your loss estimates, you can move on to targeting a given net return which makes sense for you and adjust the pricing as needed to meet that return.???

Further, and specific to the originate-to-distribute model, there is a risk the market moves in such a way in which you are unable to sell your loans at a profit.? For this reason it is important to consider flexible pricing and volume requirements with your third-party originator to allow for changes should the market expected yield for a given product change.? In addition, it is important to have regular follow up calls with your partners to ensure everyone is on the same page when it comes to return expectations.

The process of setting up a partnership with a non-bank originator also comes with some operational hurdles, the biggest one being the field of membership requirement. If your field of membership does not allow for a partnership that you find compelling, another option might be to become a downstream buyer from a credit union that is able to arrange the partnership.? Another challenge is pricing – in particular making sure the product meets your internal return hurdles.? To address this concern, it is important to be transparent as to what your return expectations are.? The third-party originator typically has flexibility on the rates they charge their customers and can work with you on setting up appropriate pricing.? This process involves negotiation and some awareness of where loans are trading on the secondary market.? The secondary market can give you insight into what others are willing to pay for these loans and is an important data point even if you don’t plan to sell the loans.??

At a time when organic loan originations are slowing, exploring third-party origination partnerships makes sense.? Not only do they offer growth for your credit union, they also allow for diversification into new asset classes.???????

Monthly Economic Data Summary

• Based on the 9/27/2024 report, the PCE gauge of inflation increased 0.1% MOM and up 2.2% YOY. Below the estimated 0.1% and 2.3%, respectively.?
• From the same report, core PCE, which excludes food and energy, rose 0.1% MOM and 2.7% YOY. The YOY was as expected while the MOM came in below the forecasted 0.2%
• On 9/11/2024 we received the latest CPI gauge of inflation, the headline was an increase of 0.2% MOM while the YOY was up 2.5%. Both inline with estimates.
• The latest jobless claims report for the week ending September 21st, showed a decrease of 4k claims to a total of 218k, compared to the expectation of 223k. The continuing claims climbed to 1.83MM.?
• The latest used-vehicle Manheim Market Report (https://site.manheim.com/en/services/consulting/used-vehicle-value-index.html) for mid-September showed a decrease of 0.2% MOM. ? Down 5.0% YOY, on an adjusted basis.?
• The Case-Shiller home price index (www.spglobal.com/spdji/en/documents/indexnews/announcements/20240924-1474554/1474554_cshomeprice-release-0924.pdf) showed national home prices increasing MOM by 0.1% while increasing YOY by 5.0%. These are lagging data and reflect the CS indices for 07/24.
• Based on the CME market watch tool (https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html), the expectation is the Fed will cut by 25 bps in November.?

This article was authored by Matt Rudzinski, Director of Sales and Trading.

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Disclaimer

LoanStreet is not a Registered Exchange, Financial Planner, Investment Adviser, or Tax Adviser. The information provided herein is for general informational purposes only, and does not, and is not intended to, constitute legal, financial, investment, or tax advice.