Before the financial crisis the vast majority of the population had never heard of a securitization. But thanks to the incessant media coverage back then and movies like The Big Short the term is now part of the culture, although few people have a good understanding of the inner workings of a securitization.
What I want to do in this article is provide the casual observer with a more complete understanding of securitization, paying particular attention to how it applies to marketplace lending.
In its most basic form a securitization is just a pool of assets that have been packaged together and sold as if they were one asset. The underlying assets are typically loans or receivables of some kind that generate a regular cash flow. The new asset is a bond that can be bought and sold by large institutional investors.
The reason securitization is popular is that it provides the seller with a way to liquidate assets that would otherwise sit on their balance sheet for a long period. It also allows for a more efficient allocation of capital because it opens up the asset class to a broader pool of institutional investors. The proceeds are often used to originate more loans and the process is repeated. In this way a relatively small amount of capital can be put to work multiple times.
The Problem with Securitization
As we all found out during the financial crisis there can be many problems with securitization, one of which is a lack of transparency. In the lead up to the financial crisis securitizations were sold with little understanding of the details of the underlying loans which were residential mortgages. Many of these mortgages were discovered to be very high risk even though they were marketed as low risk.
Speaking of risk, credit ratings agencies are the ones who are supposed to know exactly what is inside a securitization. They rate each issuance based on their analysis of the risk of the underlying loans. The trouble was back then that pretty much everyone misunderstood the risks and the rating agencies went along with the herd mentality that suggested real estate as an asset class would keep going up in value.
These problems are eminently avoidable with better transparency and analytical tools. I would like to think we have learned our lessons from the financial crisis. Time will tell but I do think most people realize that an overheated property market, or any type of asset for that matter, is something to be wary of now.
Securitization as Applied to Marketplace Lending
It is much easier to explain how securitization works by going through an example. We talked to Perry Rahbar, the CEO and founder of dv01, recently to talk us through the recent Lending Club securitization that was completed in December.
This securitization was named LCIT 2016-NP2. LCIT stands for Lending Club Issuance Trust – this is a new SPV (Special Purpose Vehicle), also called a shelf, that Lending Club created to standardize their securitization process. Lending Club’s first securitization LCIT 2016-NP1 was an unrated deal that was completed last summer. NP stands for Near Prime – these are Lending Club’s loans that were issued outside of their standard program.
The total amount of the loans in the LCIT-2016-NP2 securitization was around $131.3 million and the average interest rate on the loans was 27.25%. The average FICO score was around 640 with all loans having a FICO score under 660. Just under 90% of the loans were 36-months in duration. Because these loans are not part of Lending Club’s standard program you won’t see any loans like these on Lending Club’s website available for retail investors. These loans were part of a special program that Lending Club created for institutional investors.
There were 16,378 loans in this deal and they were all bought by Jefferies at origination and held for a couple of months before the securitization. Jefferies was the underwriter on this deal meaning they did all the legwork in putting the deal together.
This was a rated securitization, unlike LCIT-2016-NP1, with Kroll Bond Rating Agency providing the rating. Like most securitizations there were separate tranches (or bonds ) where each tranche represents a different slice of the deal’s risk. This way investors with different risk appetites can participate in the deal. LCIT 2016-NP2 was separated into three tranches as follows with Class A being the lowest risk and the residual being the highest risk:
Class A – $85.3 million, Rated BBB
Class B – $16.4 million, Rated BB+
Residual – $29.5 million, unrated
What About Credit Enhancement?
You see this term “credit enhancement” used in securitization and it simply means that credit quality is increased above that of the originator’s underlying asset pool. How? By splitting the securitization into tranches as just described above or by overcollateralization, which implies more collateral (loans) then liabilities (bonds).
One of the mechanisms of securitization is this concept of seniority between tranches – this is what gives the different tranches different risks. In the Lending Club example, Class A is the senior tranche while Class B and the residual are junior tranches with each acting as a protective layer to the more senior tranches.
What this means is that the senior tranches have first claim on any cash flow that the SPV receives. So, when loans default within the securitization the losses are absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. So, in the case of the Lending Club example above losses would have to total $45.9 million (out of $131.3 million) before the Class A would suffer any losses.
In this way the Class A can be rated quite highly, much higher than the underlying loans would suggest because they truly are less risky given this credit enhancement. With the Lending Club example, Class A has around a 35.5% credit enhancement.
The yield on each of the different tranches reflects the risk involved. The A class will have the lowest yield – in this case 3% with the B class coming in at 6%.
The Importance of Transparency and Data Analytics
As I said earlier one of the causes of the financial crisis was a lack of transparency in the securitization process. Companies like dv01 are attacking this problem head on. dv01’s solution is called a Loan Data Agent. Its goal is to offer institutional investors an efficient and transparent securitization process, both before and after investment.
To accomplish this, dv01 integrates directly with marketplace lenders to receive daily data feeds, which it normalizes, formats, and rolls up for monthly level reporting. All the data from these feeds lives in dv01’s online portal, giving institutional investors the ability to log in from anywhere to quickly analyze and understand risk exposure and performance. Investors can gather insight on collateral composition and performance in seconds, as well as download loan tapes with the click of a button.
Securitization was one of the bright spots in a difficult 2016 for marketplace lending with a record number of deals done. To maintain the confidence of investors the kinds of tools being built by dv01 and others are essential.
Despite all the negative publicity securitization received during the financial crisis it is an important part of the financial ecosystem. Without it many large investors would still be sitting on the sidelines. I expect we will continue to see more and bigger deals being done and that will be a good thing for the growth of the industry.
Peter Renton is the chairman and co-founder of LendIt Fintech, the world’s first and largest digital media and events company focused on fintech. Peter has been writing about fintech since 2010 and he is the author and creator of the Fintech One-on-One Podcast, the first and longest-running fintech interview series. Peter has been interviewed by the Wall Street Journal, Bloomberg, The New York Times, CNBC, CNN, Fortune, NPR, Fox Business News, the Financial Times, and dozens of other publications.