Despite a looming recession and the threat of lingering high interest rates, investors anticipate asset-backed securities (ABS) backed by consumer loans remaining resilient and attractive relative to alternatives. Nevertheless, some sectors will likely fare worse than others, especially as student loan payments resume this month.
The residential mortgage-backed securities (RMBS) market, the largest of the consumer-loan ABS sectors, faces headwinds as home prices remain stubbornly high and mortgage rates leap past 7.0%. While this is a familiar challenge to the RMBS market, investors see none of the risks that fueled the 2008 housing crisis at play this time, such as an oversupply of floating-rate mortgages extended to borrowers in precarious financial situations.
However, one has to look back 20 years to find a mortgage market as constrained as today's, said Greg Handler, head of mortgage and consumer credit at Western Asset Management. With the average homeowner paying less than 4% on existing mortgages, and the current mortgage rate around 7.5%, there's little incentive to refinance or buy another home. That has dramatically reduced the prepayment risk of agency RMBS, which accounted for $1.7 trillion in new issuance in 2022. RMBS is generally a much healthier asset class now than it was 15 years ago, because borrowers are paying low, fixed mortgage rates and holding much more equity in their homes.
Instead of cutting the prices and hurting forward sales they've offered buydowns. Borrowers on new home purchases in September were paying something like 4%.
In addition, the surge in housing construction during the pandemic never dampened housing prices, Handler said. When excessive construction does occur builders typically offer buydowns, in which borrowers pay more upfront in return for lower interest rates, to reduce inventory.
"Instead of cutting the prices and hurting forward sales they've offered buydowns," Handler said, adding "borrowers on new home purchases in September were paying something like 4%."
RMBS also benefits from mortgages resting at the top of borrowers' payment-priority ladder, said Brian Ford, head of structured finance research at Kroll Bond Rating Agency (KBRA). He noted that auto and solar-panel loans are also prioritized by borrowers, with credit cards close behind, and toward the bottom are unsecured consumer loans and student loans.
"Those are the two places where you're likely to see weakness first, and we're already seeing that happening in the unsecured consumer loan space," where delinquencies and losses have risen at a faster pace, Ford said. "That will likely continue as we move into next year."
SLABS put to the test
Most student loans are owned by the government and thus carry minimal credit risk, plus the Department of Education is providing a year grace period before reporting delinquencies to credit-scoring agencies, but other markets could suffer. Morgan Stanley's October 11 Consumer Pulse Survey found that average and median monthly student-loan payments are expected to be $326 and $200, respectively. Only 24% of respondents indicated they'll be able to make the payments without adjusting spending in other areas, and 40% said they would be unable to make all or part of payments.
Consumers with mortgages and auto loans typically first stop paying the debt they get the least utility out of, such as the $20,000 unsecured loan that's already been spent.
The Biden Administration's SAVE Plan and other government programs will reduce payments for mostly lower-income borrowers, at least for a while, but payment resumption will likely impact ABS more broadly.
"Many consumers have already been struggling to keep up with other debt types before the resumption, as shown by the rising delinquencies we have seen across ABS spaces," Morgan Stanley says, adding that more than 30% of consumers with unsecured personal loans also had federal student loans, as did around 25% with mortgages and auto loans, and 19% with credit cards.
Melvin Zhou, managing director in KBRA's consumer ABS team, said the rating agency has observed deterioration in unsecured consumer-loan ABS, and it has downgraded or put on watch several of those transactions.
"Consumers with mortgages and auto loans typically first stop paying the debt they get the least utility out of, such as the $20,000 unsecured loan that's already been spent," said Evan Shay, securitized credit analyst in the fixed-income division of T. Rowe Price.
The student-loan impact may end up being more of a slow bleed than major hemorrhage, given the borrower protections [that should help consumers continue to make payments]? However, subprime borrowers are already stressed. Christopher Kauffman, senior portfolio manager for fixed-income at Allspring Global, said marketplace lending ABS deals whose borrowers have FICO scores in the mid 600s to low 700s are dramatically underperforming those with scores in the mid-700s.
SOFI Consumer Loan Program deals from 2021 and 2022, he noted, are collateralized by loans from borrowers with FICO scores in the mid 700s and currently have annualized default rates between 5.5% and 6.5%. Meanwhile, similarly seasoned deals from LendingPoint and Pagaya, in which borrower FICO scores are in the mid to high 600s, are experiencing annualized default rates between 18% and 27%.
"Deals like marketplace loans didn't exist back in 2008 and we haven't seen how they will perform in a true recession, so there's some anxiety there," Kauffman said. He believes that the probability for a mild recession has increased.
Subprime auto ABS also faces challenges. Kauffman noted the relative value his firm saw late last year in subordinate classes of subprime auto deals originated in late 2020 and early 2021 that had lower loan-to-values (LTVs) and had de-levered, resulting in significant credit enhancement and some upgrades. However, used car prices peaked at the end of 2022 and LTVs have increased, typically exceeding 100%, which Kauffman described as "not necessarily a deal killer but certainly a negative factor."
The challenges facing sponsors
Economic headwinds can also adversely impact ABS sponsors and servicers, just when issuers need their services the most.
"If servicers get overstretched and can't deal with the situation appropriately, it can make performance during a bad fundamental credit backdrop even worse," Shay said.
Rising interest rates and inflation are increasing risks across fixed income assets. Still, Shay said, consumer-ABS spreads remain at historically high levels, compensating investors for those increasing risks. For example, he said, the spread offered for AAA-rated prime auto ABS rests around 100 basis points over Treasuries compared to the low to mid 100's early in the pandemic and the five basis points after government stimulus was flowing.
ABS Investors are broadly still cautious about the consumer but ... we're being adequately compensated for the risks we're taking.
"ABS Investors are broadly still cautious about the consumer but also trusting in the structural protections of securitizations, and we're being adequately compensated for the risks we're taking," Shay said.
Kauffman placed subprime credit cards in the same risky category as subprime autos, especially as weighted average or average FICO scores fall into the 600s. Prime credit card delinquencies are increasing but remain below long-term averages, he added, and deals also benefit from above average monthly payment rates and high excess spreads to absorb losses.
"Some of the off-the-run ABS sectors [are] where we see more value—areas [that] will be relatively resilient to a potential recession," Kauffman said. They include relatively small markets such as insurance-premium transactions that securitize loans backed by individuals' insurance policies, and fiber ABS backed by consumer payments, where durations extend out as long as five years and investors receive a liquidity and complexity premium.
Certain longer duration segments, primarily in more esoteric ABS, look particularly attractive as Allspring Global looks for potential swaps between longer-term investment-grade bonds and securitization credits, Kauffman said.
"We're seeing better relative value in ABS than we do in investment-grade corporates, for instance," Kauffman said.
