This post is part of Cadence’s 2020 Private Credit Yearbook, taking a close look at private credit in 2020 while discussing what’s to come for this year. Stay tuned for the full Yearbook and more posts from the Cadence team.
The past year has been an eventful one for fintech and traditional lenders alike, almost entirely because of COVID-19. Some effects of the pandemic were indiscriminate. Take, for example, COVID-19’s implications for monetary policy and its geographic scope, at least within the Americas. Meanwhile, other effects were much more significant for particular products or sectors.
In many respects, COVID-19’s impact on the economy was more severe for businesses — particularly small businesses — than it was for consumers. Many of the hardest-hit businesses failed to benefit from fiscal stimulus measures while unemployed consumers saw stimulus checks and enhanced unemployment benefits that often exceeded lost incomes. Surprisingly, data on real personal incomes in the United States released by the Bureau of Economic Analysis revealed that Q2 2020 saw a 10% year-over-year growth in incomes, the largest growth since at least 1960. The positive effect of stimulus had more than exceeded the negative impact of job losses and reduced hours.
Nonetheless, Cadence noticed that many lenders took a pause on originations during the pandemic, including both consumer and small business lenders. In some cases, this was the result of reduced access to capital. In many instances, originators were grappling with rising delinquencies, choosing to adjust underwriting criteria or dedicate more resources to servicing. A common example of COVID-induced changes to underwriting criteria were the introduction of COVID-19 screeners to approval processes. Many small business lenders completely avoided the hardest hit sectors, such as restaurants and bars, during the spring and summer.
Consumer lenders had to adjust to the new environment as well. Much of the pandemic’s impact on these originators resulted from regulatory changes. The CARES Act in the U.S. had the result of allowing some mortgage and student loan borrowers to request forbearance under favorable terms — an act which provided secondary support to other lenders facing the same borrowers who now had the resources to reduce other debt. The Paycheck Protection Program (PPP) loans had a similar second-order effect on businesses, even if PPP loan proceeds themselves could not be applied to repay debt.
There were still other regulatory changes affecting consumer lenders, including state-level moratoria on repossessions and foreclosures. Auto lenders and loan servicers, for example, had to navigate an array of state-by-state limitations on repossession abilities that came into effect and expired at different times.
Another consequence of the pandemic on originators, particularly in more credit deprived sectors, was the phenomena of higher quality borrowers falling further down the “credit waterfall.” Typically, as prospective borrowers look for the cheapest loans, they usually settle for the lowest rate loans they qualify for. To simplify, this means that sub-prime lenders see few prime borrowers accept their loan terms because such applicants typically have better options. The phenomenon exists to some extent in business and consumer lending alike.
The pandemic, however, changed this too. At least in some sectors, lenders markedly reduced their origination pace, as mentioned previously. This meant that prime borrowers that could normally qualify for loans from lenders, accepting only the highest quality applicants could no longer find credit from the sources they could usually expect to approve them. This also meant they fell further down the “credit waterfall,” receiving loan approvals only from lenders usually targeting lower credit quality borrowers.
Many originators saw their average borrower credit score or internal risk tier improve, even without changes in marketing or underwriting. It also meant that those lenders willing and able to put money out during the pandemic have “won” both in terms of market share and in terms of borrower credit quality relative to portfolio yield (as compared to originators who paused or sharply curtailed originations).
On the portfolio surveillance front, the pandemic also accentuated the importance of frequently refreshing performance data. A servicer tracking collections and delinquencies intra-month was able to assess the impact of the COVID-19 recession more quickly, adjusting underwriting or servicing practices accordingly.
Investors also benefit from frequent reporting. In evaluating performance, when there is a high degree of opacity or delay in performance data, investors assume the worst. Better transparency and real-time data enable investors to more accurately draw conclusions in terms of the value of their portfolios and the sufficiency of collateral. Cadence was able to provide its platform investors with granular data on a daily or weekly basis for many originator programs. Contrast this with business development companies (BDCs) and their investors who had to wait a month or longer to receive updates on performance.
Lastly, another trend Cadence noticed in 2020 had relatively little to do with the coronavirus pandemic. The importance of tech and data integrations in underwriting has only continued to grow, especially among capable fintech originators and aspiring lenders looking to become more technology-enabled. Some of this is the result of the growing availability of alternative data sources, as well as the appeal of such data-driven underwriting models among credit and equity investors in such companies. We expect this trend to only continue into 2021 and in the years to come.