Asset-Based Finance: A Credit Check on the Consumer
The finances of U.S. consumers who own their homes and have strong credit scores have proven to be resilient even through this period of high inflation and rising interest rates. Those same economic conditions have posed a serious challenge for younger consumers, renters, and those with lower credit scores (Exhibit 1).
EXHIBIT 1: Income and Inflation Growth in 2022: Young, Low-Income Renters vs. Homeowners
Income and Inflation Growth in 2022
We have seen attractive opportunities in consumer lending to prime borrowers over the past 18 months, and we are heartened by plateauing inflation and strong job growth in the United States, which should help all consumers. As banks pull away from certain types of consumer lending, we think there is a growing need to provide credit to high-quality borrowers with resilient finances. As we discussed in our recent piece, “Beyond Corporate Credit: Exploring Asset-Based Finance for 2024,” we have seen opportunities within high-quality consumer credit come to market as banks have looked to shed assets. These kinds of assets normally would not be available to private lenders.
A Tale of Two Consumers
Home ownership has been a significant factor in consumer resilience in a turbulent economy. In the United States, fixed-rate mortgages protected existing homeowners when interest rates started to rise. More than 95% of U.S. mortgages have fixed interest rates, and the average existing mortgage rate is at a 45-year low. Many focus on rates of 30-year U.S. mortgages, which sat above 7% for much of the second half of 2023 and now sit at 6.63%. However, the average effective rate for existing homeowners is about 3.5%, about 50 basis points lower than the pandemic (Exhibit 2). In fact, some 80% of U.S. mortgages have an interest rate under 5%, while some 40% of American homeowners own their homes outright.
EXHIBIT 2: Lower Mortgage Expense Has Helped Contain Borrowing Costs for Mid-/High-Income Consumers
Debt Service Costs as % of Disposable Income
A rally in asset prices has disproportionately benefited higher-income consumers. The wealthiest 10% of Americans owned 89% of equity and mutual fund shares at the end of the second quarter of 2023. The 20% increase in the S&P 500 over the past year likely has been broadly helpful for those who own shares in public companies.
A strong labor market has also been helpful for consumers in both the U.S. and Europe. In the United States, our macro team expects unemployment to hit 5% in 2024, which would imply a trough-to-peak increase just over half that of a typical recession at 1.4% compared to 2.7%. Even as growth slows, a global structural shortage of labor is forming due to a combination of demographics (aging populations), relatively low participation rates among women and older workers, a trend toward reshoring, a recent slowdown in immigration in many countries, and a mismatch between the demand for workers with particular skills and the supply of those workers.
Younger consumers and those with lower incomes, however, spend a far greater share of their incomes on essentials, making it more difficult to cut expenses meaningfully when inflation hits. Lower-income borrowers are also more likely to be renters at a time when rents have risen dramatically. Rents were some 7.2% higher as of October 2023 than they were a year ago. Our macro team also points out that low-wage employment grew more rapidly than employment in higher wage categories after the pandemic but is now tapering off (Exhibit 3).
EXHIBIT 3: Low-Wage Employment is Coming Out of a Period of Rapid Growth, But Now Running Closer to Trend
Employment Recovery Since 2020
Pandemic stimulus funds temporarily boosted the credit scores of many younger and lower-income borrowers, but some recent data shows that lending to this group may have increased more than warranted. Credit card balances among lower-income consumers have risen sharply. Younger consumers stepped up their borrowing the most during the pandemic and are now driving a recent uptick in credit card and auto defaults (Exhibit 4). Indeed, defaults for subprime credit card and auto borrowers are already above pre-pandemic levels, though unemployment has yet to meaningfully increase.
EXHIBIT 4: Unsecured Consumer Debt Delinquent by more than 30 Days
Percent 30+ DQ
The upshot of these trends is that consumer defaults are ticking higher and are likely to continue doing so as economic growth slows. Our Global Macro & Asset Allocation team, however, expects that subprime borrowers will make up a disproportionate number of defaults.
Where Do We See ABF Investment Opportunities in Consumer Lending?
As the name implies, asset-based finance investments are secured with collateral. In the consumer world, this could be a residential mortgage secured by a piece of property or an auto loan.
The dichotomy among consumers has led us to focus on opportunities where the ultimate borrowers have high, steady incomes and high credit scores. In our experience, these borrowers are not only reluctant to strategically default, but now more than ever have resources to avoid doing so. We also prefer loans that are a high priority for borrowers. Auto loans are a good example. Cars are an essential form of transportation in many markets outside major cities and have become more expensive since the pandemic. For most car owners, the cost of paying a car loan is likely lower than either the cost of a new car or the consequences of losing a source of reliable transportation.
A few examples of opportunities that we think are attractive in the consumer space lately include:
• Home improvement lending: We recently invested in a platform that finances loans for home improvement to homeowners with top credit scores (average FICO score of 780). Because mortgage rates have risen so much, we have seen that people with existing, low-rate mortgages are more likely to stay in their homes than look for a new one. We think this trend will support home renovation for some years to come.
• Recreational vehicles: RVs are the ultimate discretionary purchase, and as it turns out, the people who buy them tend to be quite creditworthy. We recently bought a portfolio of RV loans from a bank in which 80% of borrowers were homeowners with deep credit history and the weighted average of the group’s FICO scores was 773, compared to the U.S. average of 715 in 2023, according to Experian. The requirements for title, lien, and insurance are similar to auto loans, as are the recovery proceedings in the event the owner doesn’t make payments.
• Solar panel loans: These loans tend to go to homeowners, provide an essential service (electricity), and contain disincentives to stop payments. In one recent transaction, for example, borrowers had an average FICO score of 769. Customers who take out a loan to install solar panels don’t pay much more during the life of the loan due to the savings on electricity. Ultimately, they should permanently lower their utility bills. Stopping payment does not eliminate energy bills; it simply means that homeowners have to pay utilities for the energy they use.
The number of investment opportunities backed by highly creditworthy consumers is increasing as banks pull back from consumer lending. In the wake of the U.S. regional bank failures of early 2023, banks have been looking to shed portfolios of loans with longer durations, including some consumer loans.
The segment is certainly not the only area with compelling opportunities in this market, but it is the one we feel is most misunderstood. By choosing borrowers and assets carefully, we think there are very attractive opportunities within the consumer space.
