What You Need to Know about Investing in Consumer Credit

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With the developments different technologies and the internet, individual and institutional investors have the opportunity to invest in consumer credit directly.

But as with any form of investment, there is an element of risk attached. This article explores possible risks associated with investing in consumer credit and also compares investing in consumer credit with other asset classes.

What are some of the typical risks that could arise from investing in consumer credit?

1.     Borrowers may default on their loans

The first and most obvious risk of lending to consumers is that they may not pay back their loans – a risk that can occur even when lending to the most qualified borrowers.

In the world of consumer credit, such default risk is termed “charge off”. It means a debt, for example on a credit card, that is deemed unlikely to be collected by the creditor because the borrower has become substantially delinquent after a period of time. In fact, Federal Reserve has regularly published the charge off rate on their website for the investors to have a better understanding of the charge off risk of consumer credits.

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Source: Board of Governors of the Federal Reserve System

2.     There may be underwriting errors

Less-than-perfect risk assessments conducted by creditors could result in a higher risk of defaults. Methods of risk assessment are becoming more sophisticated; however, they are still imperfect, predicting likely outcomes rather than definite ones.

This is being increasingly offset by using machine learning to better calculate risk and reduce imperfection, and to reduce the possibility that loan applicants could submit false information or that the system can’t account for certain risk factors. General speaking, such kind of risk are gated by several different institutions: credit bureau, FICO, underwriting banks and lending platforms.

3.    Unforeseen macroeconomic trends could affect consumer behavior  

Consumer credit investment can be influenced by larger economic trends, increasing rates of default. These trends could include a number of scenarios, such as mass unemployment due to a recession, the impact of the bad weather that may affect the short-term spike of household borrowing, the rise of the personal and household spending due to the rise of the property prices and energy prices and so on, and so on.

Such situations can impact consumers’ ability to repay loans. Given consumer loans are generally in an averaged size of US$ 2,000- 20,000, most of the regional risks could be managed by the diversification of the loan portfolios. However, one major factor that may not be effective as a protection even with diversified loan investment is, when a large proportion of borrowers are simultaneously affected, in financial crisis. That said, consumer credit returned a profit in the US even during recession, with investors still seeing a small yield, despite a very high default rate.

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Source: Lending memo, “This Investment has 20 Straight Years of Positive Returns

4.   The fail of intermediary

After the fall of Lehman, investors tend to realise nothing is impossible. While investing directly into consumer credit loans is a good way for asset allocation now, it also comes into the risk of dealing with the intermediaries that provide such access to the investors, including the platforms that borrowers purchase loan from. To make sure the investment structure is done in the way that the investment is well protected, and the collection of repayment is not interrupted if any disruption events happens.

Investors must understand that capital is at risk not just as a result of borrower behavior but also due to the evolving nature of a new, disruptive industry.

5.     Unanticipated disasters may also have an impact 

Though investors may think it unlikely, catastrophes – both natural or human-made – may have a negative impact on investments. This year, the National Center for Environmental Information reported that in the first half of the year there were six weather and climate disaster events in the US, each with losses to property totaling over $1 billion. The longer the term of the investments, the greater the chance that a human-caused or environmental disaster could affect consumers’ ability to finance their loans.

6.     Liquidity risk

Since it’s impossible to recoup a loan before it runs its term, investors risk their liquidity by putting funds into loan investment. It may be possible to sell a loan portfolio on to another investor should the need arise; however, just like any other security traded in the market, no liquidity is a guarantee, so it’s essential that investors have access to more liquid funds and be confident that any money invested in consumer credit won’t be needed before the maturity. One thing that is more an ease in the investors’ mind is the repayment nature of consumer credit is not bullet but regular pay down of the principle. It offers better liquidity on the recovering investment basis and also reduce the risk of outstanding principle.

How do risks compare across consumer credit and other loan products?

There are many types of loan products you could consider investing in, each with its own associated risk that has to be carefully considered:

●     Government bonds

Issued by governments to finance their budget deficits, these are considered low-risk, low-yield bonds. Like all term bonds, they are subject to the risks of inflation eating into their returns, rising interest rates decreasing the value of the bond, and having to reinvest at a less favourable rate after the completion of the term of the bond.

●Investment-grade corporate bonds

Issued by financially strong companies, these bonds typically yield a higher return than government bonds. However, during economic downturns, these bonds tend to underperform when compared to government bonds due to lower credit rating and may be downgraded. There can also be a liquidity risk that can see investors struggle to sell these as compared with government bonds that tend to have a ready market.

●     High-yield bonds

While these bonds promise a high return, they are offered by companies or other financing vehicles with poor credit ratings, so the risk of default is higher.

●     Mortgage pools

A mortgage pool is a group of mortgages held in trust as collateral for a mortgage-backed security. Mortgage pool funds are generally considered a low-risk investment as they are backed by real estate rather than just the creditworthiness of the borrower. However, it also means the investor will need to face the repayment risk of the borrower and also the liquidity risk of disposal of the properties. The volatility of the property price is another risk factor of investing in mortgage pools.

Almost every investment product carries some risk. It’s important to perform due diligence to understand what risks are possible – and which are likely – with any type of investment, and then weigh them against your portfolio and tolerance for risk. By carefully weighing the risks and benefits, investors can match their risk appetite to the right kind of investment.

Click here for more information on investing in consumer credit.

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