Social Finance created quite a stir when it bagged a rating from Standard & Poor's for its second securitization of peer-to-peer loans.
The online lender priced $251 million of notes backed by refinance student loans for graduate borrowers. Both S&P and DBRS rated the senior notes 'A.'
The assignment appeared to be an about-face for S&P, which had previously been critical of the asset class. But what’s most striking is how much weight the Big Three credit rating agencies still have among investors, and by extension, issuers.
SoFi already had the distinction of issued the first rated peer-to-peer securitization in December 2013, with $151 million in senior notes backed by $168 million in collateral. The $251 million July 2014 transaction is backed by $278 million in collateral. Both rounds included retail and institutional investors, with over 30 top tier institutional investors participating in July. Morgan Stanley served as the structuring agent and joined Goldman Sachs in distributing the senior notes.
But a ratings from S&P - or any of the three major credit rating agencies - broadens the pool of potential investors and opens up the entire money manager universe as buyers of the securities.
The assignment appeared to be an about-face for S&P, which had previously said it was not ready to rate the asset class because of the lack of performance history, lack of underwriting consistency and regulatory uncertainty.
The disclosure of the rating was certainly unusual; the presale report was not published until after the deal had priced. And S&P took the unusual step of issuing a statement explaining why it had taken the assignment. “SoFi's original business model relied on accredited alumni and other individual investors to fund its loan originations, SoFi is now primarily funding itself with customary institutional and bank financing,” the report stated.
Nino Fanlo, SoFi’s Chief Financial Officer said in an interview that the rating was also based on the caliber of SoFi's customers and its approach to underwriting, which “allows us to expand our school footprint and build a roadmap for other types of lending, such as personal loans and mortgages."
As of May 31, 2014, SoFi had $230 million of forward loan participation commitments from depository institutions and $241 million of borrowing capacity from its four warehouse lenders.
Fanlo said that the company has four institutions that provide funding for the company to aggregate its products, which include: Goldman Sachs, Morgan Stanley, East West Bank and Bancorp.
DBRS, which rated both of the SoFi’s deals, said it used the current default rates from other issuers in the student loan world and the Department of Education as the main indicators to determine loss expectations for the SoFi deals. “We very much continue to the view the SoFi transactions as student loan transactions,” said Chuck Weilamann, senior vice president at DBRS.
SoFi is unique among both peer-to-peer lenders and student loan originators in that it only refinances existing student loans. Borrowers are already in the workforce. By comparison, a more typical pool of student loans includes some borrowers that are still in school and have not even begun to make payments. “These are seasoned borrowers,” said Weilamann.
The second deal is structured somewhat differently than the issuer’s debut securitization in that it offered both a floating rate and a fixed rate tranche.
The initial securitization pool was mainly MBA students form the top 100 schools. The second deal expanded the underlying obligor mix about 30% were lawyers, 8.5% that are doctors.
Expanding beyond the original pool of schools opens up refinancing options to borrowers “who may not have attended a particular institution but have established themselves in the workplace and have met certain criteria including FICO and free cashflow tests,” Weilamann said.
The credit quality in the second deal has also improved in terms of FICO and free cash flow. The average FICO for this pool is 776 and free cash flow was over $5700 per month.
The fact that investment decisions are still driven by ratings from S&P, Moody's Investors Service and Fitch Ratings demonstrates that institutional investors have been slow to make changes to investment guidelines to accept any Nationally Recognized Statistical Rating Organizations (NRSRO) rated security.
DBRS, which was approved as an NRSRO under the revised rule in September 2007, rated bothe of the SoFi securitization deals.
“That's not to say their hasn't been any changes, we are aware of certain investors who have made changes to accept any NRSRO rated security, but there are still a large number of institutional investors who require a rating from the big three’,” said Joe Petro, chief operating officer in Morningstar’s structured credit ratings business.
Morningstar received its designation as a NRSRO in July 2013. The Securities and Exchange Commission's Office of Credit Ratings administers expanded rules relating to NRSROs under the reform act of 2006 to improve competition, transparency and accountability among credit rating agencies and competition in the credit rating agency industry.
Petro said that Morningstar continues to bring the issue of antiquated investments guidelines to the attention of investors, but “many have expressed that it is not an easy change to make.”
“This is clearly one of the bigger challenges facing any newer agency, and one that we are very focused on addressing with investors,” said Petro.
Although many regulated investors—such as banks, credit unions, and insurance companies —have to have their own independent credit valuation process and surveillance; “there is still large pool of capital run by mutual fund companies and third-party asset managers [that] seem to rely on the credit ratings agency’s and how a security may trade,” said Ron D’Vari, chief executive at NewOak Capital.
“As a result investment banks and issuers tend to select one of the big three,” D'Vari said.
He said that another reason why investor may be slow to move away from accepting other NRSRO ratings, outside of the “big three” is that many asset/risk management systems are not built for monitoring more that three credit ratings at one time. “Since vast majority of securities are rated only by one or all three major CRA's, it will take a while to move away from past paradigm and move toward the new regime,” said D’Vari.
The ironic point, according to Petro, is that while some investors are legally challenging the activities of the big three during the credit crisis, they still require their ratings.
For the moment SoFi remains the only issuer to obtain a rating from any rating agency for a peer-to-peer securitization.
Fanlo believes that it is SoFi’s strategy to aggregate loans that gives investors the best array of choice, unlike competitors in the peer-to-peer space that “have taken more of a consignment investment strategy. ”
Under a consignment strategy, it is the investors and the pool of assets that the investor has purchased that have to be rated, said Fanlo.
That makes it difficult for the ratings agencies, which Fanlo said “are used to rating issuers”.
“The only deviation from [rating issuers] is that [ratings agencies] have rated aggregation vehicles like CLOs and CDOs, where the underlying assets themselves were rated and there were specifications on how to get higher ratings via creating subordination,” he said.
Eaglewood Capital Management, the only other issuer to come to market with a peer-to-peer securitization, is a case in point. Last year the issuer announced that it had completed an unrated, $53 million peer-to-peer deal. An additional $47 million was issued from the transaction structure in May 2014. The $100 million combined transaction securitized unsecured consumer loans originated through the LendingClub Corporation and purchased by Eaglewood’s inaugural fund, Eaglewood Income Fund I, LP.
Eaglewood said it considered getting the transaction rated but ultimately felt that the cost of getting a rating was greater than the interest savings the deal would achieve with the ratings.
That said, the P2P space is maturing with an increasing number of investments coming in from large financial institutions that understand what is necessary to create a platform with broader syndication.
“We have seen folks like Blackrock and Santander make contributions and start to aggregate loans as well as a number of financial institutions that have provided senior lending facilities to these different programs in the space,” said Weilamann
For example, Prosper Marketplace, Inc., a leading peer-to-peer lending company, announced in September that it has raised $25 million in funding which included a new investment by BlackRock similar to the lines of Warehouse financing secured by SoFi.
According to a story reported by the Financial Times in June, Santander UK is to begin referring its customers to online peer-to-peer lender, FundingCircle UK.
FundingCircle expanded to the U.S. in October 2013 and expects to lend up to $100 million in 2014. Last year the firm raised $37 million from investors led by the venture capital firm Accel Partners. Ribbit Capital, Union Square Ventures and Index Ventures also participated in the financing.
The company said that it is eyeing a 2015 securitization for its loans. Sam Hodges, co-founder and US Managing Director of Funding Cirlce said the level of institutional appetite the company has experienced in the marketplace and the fact the company now has seasoned loan buckets means that the company now has a more securitization friendly asset. “Because you can actually see what defaults and losses have come in as that makes the assets much more predictable, from an investors perspective, ” said Hodges. “That seasoning also makes it an assets that you can securitize and get a rating on it and broadens investor access.”
Weilamann believes that such funding ventures between peer-to-peer lenders and institutional investors highlight a level of sophistication that allows the sector to mature and develop more rapidly “Those are all good things from an ability to create something that might ultimately be securitizable,” said Weilamann.