Loan Books/ Securitisation Warehouses
Financial Services businesses that originate loans (or loan-like products) gravitate to wholesale funding to fuel their growth and profitability; this is warehouse lending.
A wholesale warehouse facility (also known as a ‘monoline’) enable the Originator to write loans using mostly credit rather than their own balance sheet funds. The Financier and Originator agree in advance on the characteristics of loans that may be funded by the facility (eligibility criteria) and this clarity permits the Originator to write substantial volumes of new loans in the knowledge they are ‘eligible’, while giving the Financier comfort on the use of their funding and resulting exposure to credit risk.
Warehousing refers to the act of collecting a significant volume ($200m+) of eligible loans in a Special Purpose Vehicle (SPV) in order to reach the critical mass required for a public market securitisation issuance. Residential Mortgage Backed Securities (RMBS) are the best known of these issue types and the same model equally applies to consumer, auto, business and property loans.
The Originator will typically fund a ‘first loss’ tranche of the book, which can range from under 10% to over 30% depending on the risk profile of the underlying assets and track record of the Originator. Aside from the resulting loss buffer, this also serves as ‘skin in the game’ to ensure the parties are aligned in their incentives, since the Originator incurs material losses before the Financier is at risk of capital destruction.
Because the SPV is technically the ‘owner’ of the loan assets and the senior Financier holds a first ranking security, the risk profile is relatively predictable via the analysis of the loan book spanning fundamental attributes (e.g. size, tenor, security, yield, first loss %) and performance data (e.g. arrears rates, migration matrices and loss curves by cohort or ‘vintage’). Combined with the statistical benefits of diversification, these legal and economic concepts facilitate relatively low cost funding.
Case Study: SME Loan Book
An SME lender originating secured property-backed business loans requires additional funding to meet demand and grow the book. The loan origination criteria spans $100k-$500k loan sizes, 12-36-month tenor with 14-22% interest rates based on internal risk-weighting models. All loans cash pay interest and principal on a monthly, straight line amortisation basis.
The existing loan book of $25m, contains c. 120 loans (i.e. $208k average loan balance), with a weighted average contractual IRR of 18% including establishment fees. Loss rates over the prior 4 years have held around 1.5%. The existing book is funded by $10m equity and $15m unsecured HNWI notes paying 12%.
Raising additional equity is undesirable (dilution) and the 1st and 2nd degree network of HNW’s is delivering only a fraction of the additional capital required, hence an institutional debt solution is preferred.
While the book is yielding c. $4.1m per annum in cash yield (after losses), after paying $1.8m of interest on the HNW notes, and $1.4m of operating costs, there is only $925k remaining for reinvestment or dividends. $925k on the $10m of equity capital tied up in the book is just 9.3%, less than half the 20% return on equity target.
Several steps are involved to optimise this structure and improve the bottom-line yield, including structuring of a new senior debt facility with a >$30m limit, higher advance rate and <10% interest rate. A portion of the unsecured noteholders remain in the structure via a junior note and the equity first loss is reduced from 40% ($10m of $25m) to 10%, releasing c. $8m of capital back to the company on completion and reducing the WACC from 15.2% to 11.3% overall.
Explore the Neu Capital lender network to see how our investor relationships match your loan book/ securitisation funding requirement.
The Neu Capital network of institutional lenders span several hundred Family Offices, Credit Funds, Pension Funds, Hedge Funds and Banks.
With few exceptions, Warehouse funding is the optimal structure for loan books in the $20m to $200m range due to the low cost of funds and certainty of the funding base.
The evolution of funding structures through the growth of a loan book can be summarised into the following stages: