Lending startups were in vogue in 2015, but fell out of favor in 2016. Yet many have pushed along. These companies range from SoFi, to RealtyShares, to LendingHome, and others.
While venture capitalists and public markets have tempered their valuations of these companies — these businesses face an even larger and more urgent issue: the assets these companies think they are secured against might not be as valuable as they initially thought — or that they initially lent against. Because of this, we may see a collapse of many of the lending companies you’ve heard raise large rounds at high valuations. Lending at LTV instead of the Effective LTV could be the main culprit. What does that mean?
In 2008 the banking system hurt a lot of people. The main culprits of this disaster were the mortgage originators (the people who make loans and collect the repayments, but sell the loan to someone who actually holds the risk) or the economy’s drug dealer who peddled impossible to repay loans to unknowing borrowers and then sold those faulty loans to financial institutions (think Lehman Brothers, Morgan Stanley, etc.). These very financial institutions passed on the risk to investors (you, me, your grandma, etc.), with a similar ease of conscience to passing on a Netflix password to a close friend. As these loans began to default, it became clear that the high LTVs on each of the loans was going to be a major issue.
What is LTV? Why Does it Matter? Why is it Misunderstood?
LTV is a fairly straightforward concept: at what percentage of the underlying collateral (home, automobile, etc.) are you willing to lend to a buyer. Example: If your house is worth $100, and I lend you $90, I made you a loan of 90% LTV (the amount of the loan divided by the value of the asset I can collect if you don’t pay me back). The bad originators (the salesly characters you may remember from the movie “The Big Short”) who profit regardless of whether loans are paid off, made loans to borrowers for 100% of the value of the home! In cases where the value of the home dropped even slightly, all of a sudden the value of the home was less than the cost of the mortgage.
This ends up being a problem for both the borrower and the financial institution making the loan. For the borrower, they are stuck with an expensive mortgage that cost them more than the value of their home. For example, you buy a house for $100 at 90% LTV (your mortgage is therefore worth $90) and the value of your home drops 20%. Now you have a home that is worth $80, but a mortgage on the home which is worth $90. What became clear to many borrowers was that defaulting on their mortgage (i.e., stop repaying the loan and leaving the home permanently), made more sense financially than being stuck with a mortgage that was worth more than their home. Even though this would have a severe impact on their credit score, the borrower realized that the $10 would be such an overhang on their financial situation, that it was worth it to default on the loan and move in with their parents, or a friend or downsize and rent. Now the lenders are stuck with a home that is worth $80, even though they lent the borrower $90. Before the cost of re-selling the house, the lender is already out $10.
Much in the same way you cannot trust online dating profile pictures, it became clear in the financial crisis that the value that the banks could collect on, was not the prettiest picture of value, but rather the candid shot on a morning after a night out. So, with that in mind, how should lenders then value the homes that they are making mortgages for? Should the amount of the loan only be made against a downside value of the home? These are tricky questions to answer because borrowers want money for a chance to buy a new home and strict regulation could significantly impact that very access to money.
The Consumer Financial Protection Bureau (CFPB) is a government agency that was born out of the financial crisis with the purpose of protecting borrowers from abusive lending practices. They have imposed restrictions on certain debt-to-income ratios (amount of debt that a borrower can take on compared to their yearly or monthly income) and usury caps (max interest rate that a financial institution can charge). But one measure the CFPB has not taken a view on is the valuation of underlying assets (home, car, etc.) of secured loans (meaning if a borrower defaults, the lender can collect on the underlying asset).
In the case of auto lending for new vehicles, value is especially tricky, as there is an immediate decrease in value the moment the car is driven off the lot. Average LTV is around 80–90%. That means as soon as the car is driven off the lot, the actual LTV rises well above 100%. A $100 new car could be worth $80 the moment it is driven off the lot, and the value of the loan could be $90, meaning the new LTV is $90/$80 or 113%. Obviously this is an issue, because if the borrower defaults and the lender takes possession of the vehicle, the lender is left with a car that is worth less than the original value of the loan they made.
This is particularly alarming because the financial institutions that were unloading the asset-backed mortgage securities (a type of financial security that is made up of future interest payments from a pool of loans), are now selling those same asset-back securities, but for subprime auto loans. This exposes not only the lenders, but everyone who invests in these types of financial instruments (which we may unknowingly own through managed funds, etc.). All of this comes at a time when auto-loan balances topped $1 trillion for the first time ever, with ~$110 billion (an 11% increase from the previous year) of that trillion coming in the form of subprime loans.
Ally Financial, the second-largest auto-loan lender by volume behind Wells Fargo, announced last week that they wrote off an annualized 1.37% of its outstanding loans in the quarter, up 1.01% from a year earlier, and the highest charge-off rate since 2012. This write-off charge is largely credited to the softening used-vehicle market, which has been flooded with supply from the high number of leased cars coming on to the used car market. Values of used cars up to 8 years old are down 3.6% in 2016 versus the same period a year earlier, according to the NADA Used Car Guide. If these loans were made at 100% LTV and the borrower defaults, these investors will be out a significant amount of money, because the vehicles are not worth what the loans were made at. In fact according to the Wall Street Journal, auto lenders on average recovered 54.3% of outstanding loan balances that were in default, bankruptcy, or charge-off status in September, down from 56.4% a year prior. This perfectly highlights the importance of the value in the Loan-to-Value equation.
For this very reason we should create a new standard for LTV, called effective LTV. Effective LTV would take the future value of the underlying asset and would vary depending on the amount of movements of the asset price, how quickly the asset deteriorates, etc.
Let’s think about this in the context of a car. You take out a 5-year loan on a $100 car, at an LTV of 90% (no cheat sheet calculation here, let’s see if you’ve been paying attention ;)), cars tend to lose 10–20% of their value each year due to wear and tear. So for a car or other type of vehicle, the company could make a loan at a two-year forward effective LTV (or more plainly put, the expected value of the car they are loaning against two years after the start of the loan). So for a $100 car, if we use a two-year forward effective LTV and assume annual depreciation of 10%, the value of the vehicle we are lending against is $81 ($100 current car value*(1–10% annual depreciation)^2). As we look to become more precise for particular types of lending, we also aim to add in other variables such as repossession cost (how much it costs to retrieve the asset — can be around $500 for cars), remarketing costs or costs associated with the makeover to convince someone to buy what you just collected and even the wide-spread introduction of autonomous vehicles, which could radically shake-up used vehicle values.
For homes, understanding future value may be trickier, as the values are much more cyclical and not as dependent on length of use. But as lenders begin to be more careful with the values of the assets that they lend against, savings will be passed on to the borrowers. If lenders make better loan decisions, they lower the number of borrowers who are unable to repay them. With lower default rates from their borrowers, lenders can charge lower APRs and still maintain a good business.
As the CFPB continues to ideate ability-to-repay restrictions for lenders, meaning that lenders cannot make loans to borrowers that they knowingly cannot repay, they often look directly at interest rates and APRs rather than the value of the underlying asset. If we can adjust our mindset around the realistic value of the assets lenders are lending against, we could in the process lower the interest rates that they charge.