Understanding the importance of evaluating all asset classes, including whole loans, when constructing a financial institution’s balance sheet is always important. However, in the current economic environment this evaluation may prove even more critical as many depositories are finding themselves with excess liquidity. Just like a securities investment or loan origination, incorporating the secondary whole loan market into balance sheet strategy can often improve institutional performance.
What Key Characteristics Should Be Considered?
The most direct drivers of a loan pool’s price are the collateral characteristics. These include:
- Coupon (WAC)
- Credit quality
- Weighted average maturity (WAM)
- Servicing type
When analyzing a pool, everything starts with the coupon. Higher coupons drive higher yields (assuming a constant price), and vice versa for lower coupons. The gross weighted average coupon (GWAC) is the starting point from which servicing fees are netted out, if applicable. It is from these cash flows that the yield and loss-adjusted yield are calculated. Coupons that are too low for the risk will look unattractive on a loss-adjusted basis.
How Are Institutions Evaluating Risk?
An obvious concern for any investor in a loan transaction is the ability to be repaid. Evaluating the credit riskiness of a loan pool is at the top of the list when seeking to assess its relative value. Important metrics to utilize include:
- Loan-to-value (LTV)
- Debt-to-income (DTI)
- Debt-service coverage ratio (DSCR)
Historical loss rates serve as an important anchor to the credit loss assumption in the pool pricing. High and/or volatile loss rates may indicate a need to dive deeper and could adversely impact the price due to increased uncertainty regarding loss rates.
What Other Factors Impact Marketability?
The WAM on a pool can impact marketability, and it also plays a direct role in its estimated weighted average life (WAL). Typically, depository institutions need shorter assets, since credit exposure increases with increasing WAMs.
Servicing execution plays a role in marketability as well. Servicing-released execution in many cases increases the marketability of a loan pool and increases the number of potential buyers. However, the loan participation market is also relatively deep and can offer an outlet for those looking to execute on a servicing-retained basis. The tradeoff in value ultimately depends on the seller’s/servicer’s reputation, the nature of the investor/servicer relationship, and the investor’s ability to service.
In a participation arrangement, the investor’s rights to interact with the borrower may be limited and will depend on the agreement between the two parties. However, this is a necessary evaluation in a servicing retained agreement where consideration for both the assets and borrowers is critical. A poor servicing record, financial instability, or bankruptcy can severely reduce or eliminate the return to the investor. Although, if the investor’s cost to service is prohibitively high, servicing-retained execution could lead to more favorable economics.
Why is Counterparty Reputation Important?
Counterparty considerations may be important for buyers from a marketability and compliance standpoint. If a seller/originator has a proven track record in the secondary market and significant servicing experience, its pools will more likely translate into increased marketability. The financial health of the seller can also play a role as it can instill confidence and help expedite the due diligence process. Additionally, a more qualitative factor is the evaluation of the key employees of the selling institution. This can range from lending officers all the way to the executive management team and serves to provide a more thorough picture of the seller and its reputation.
Counterparty and reputation considerations also arise from a compliance standpoint. Buyers want to know lenders have procedures in place to maintain compliance with the CFPB and other lending regulations. Indirect lending programs come with a host of additional considerations, including managing dealer relationships and pricing.
Lastly, servicing reputation, if applicable, is also a big factor. How experienced is the seller in servicing? If the seller is retaining servicing, it is important that it demonstrates proficiency in servicing the loans. Does it have appropriate collections procedures in place? The collections operation is important to managing credit losses.
What are the Benefits of Tapping the Whole Loan Market?
Assessing the relative value that whole loans and participations can provide, we believe, is a must for all shrewd balance sheet managers. Not only can this exercise potentially enhance performance, but it can also tap into the secondary whole loan market to address a bevy of institutional needs, including:
- lack of organic loan growth
- alleviation of liquidity or concentration risk
- expansion of asset and revenue diversification
We believe, regardless of the avenue, secondary loan markets should be viewed the same – as an important and necessary tool for well-rounded depositories.
ALM First’s team of experienced professionals works with hundreds of financial institutions nationwide, providing unbiased advice as a strategic partner. Learn more about our Loan Transaction Network at www.almfirst.com.
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Alec Hollis joined ALM First Financial Advisors in 2012. As a Director for the ALM Strategy Group, Alec performs asset liability management strategy research for financial institutions. He also implements firm-wide ALM modeling procedures, and assists in the execution of client balance sheet hedging programs. Alec holds a bachelor’s degree in finance from the University of Notre Dame, as well as the Chartered Financial Analyst (CFA) designation.
Michael Oravetz joined ALM First Financial Advisors in 2016. Michael assists in delivering holistic balance sheet strategies across a variety of funds managementdisciplines including loan and deposit pricing, portfolioand liquidity risk management, as well as profitability andfunds transfer pricing. Michael participates with implementing firm-wide strategic initiatives and modeling procedures. In addition, Michael conductsresearch for asset liability management strategies, interest rate hedging strategies, ALM model validations, loan pool valuation, and credit analyses. Prior to joining ALM First, he worked as an analyst in the Acquisitions and Capital Markets Group for Reef Oil & Gas. Michael holds a bachelor’s degree in bothFinance and Accounting from The University of Texas at Dallas, where he graduated with honors.