main street versus wall street - schroders - schroders€¦ · given the conditions today,...

Given the conditions today, including the regulatory environment for consumer lending and banks, and the growth in corporate debt issuance, Main Street is in better shape than Wall Street. With this landscape, we think the consumer, housing and real estate debt is a more attractive way to seek income, return, and diversification using an asset class that many investors often overlook. We’d argue that it is critical to keep three key factors in mind: 1) the potential for change in policy 2) level of leverage in the different sectors, and 3) the level of outstanding debt and issuance. In doing so, we believe we can identify a defensive core allocation among more consumer-driven areas of the market and earn income while avoiding exposure to investments with imbalances, high valuations, weaker fundamentals and high sensitivity to shock as policy changes.

A brief recap of how did we ended up here Post Global Financial Crisis (GFC) there was globally coordinated easing which has provided substantial liquidity to markets. Ubiquitously known as QE, this policy pumped more than $14 trillion of liquidity into financial markets through 2018. In addition to QE, most central banks have embraced a very low interest-rate policy. These two components of an accommodative monetary policy have conspired to facilitate a very long credit cycle, with substantial distortion in financial markets.

So where did accommodation and QE have the most significant impact? QE had the most significant impact where it was easy to deploy capital (e.g., where regulation did not limit the capital flows by restricting lending or limiting issuance of securities). Post GFC, in the US there was a focus on de-leveraging for the financial institutions and for consumers. As a result, banks, consumer lending and mortgage finance became heavily regulated. Mortgage debt and financial corporate debt have declined since 2007, both outright and as a percentage of US GDP. Over the same period, US non-financial corporate debt has increased, substantially. Looking at debt outstanding over time, we have seen more than $4 trillion in growth in non-financial corporate debt during the QE era.

Figure 1: Record high corporate debt while single-family mortgages still below 2007 levels (in trillions)

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Source: Bloomberg, IMF, Federal Reserve as of June 2018

One of the beautiful things about the universe of Securitized debt is the diversification it provides and the ability for investors to pick their spots. If you believe aspects of the markets are in the later stages of a credit cycle, picking your spots can be quite advantageous. We believe Quantitative Easing (QE) has distorted financial markets and many traditional asset classes have become quite expensive. We contrast corporate debt or equity (what we call “Wall Street” finance), with the US consumer and housing finance (what we call “Main Street” finance). We think the latter appears to be in very good shape, making consumer-driven segments of securitized an attractive alternative to traditional income-generating investments.

For Financial Intermediary, Institutional and Consultant use only. Not for redistribution under any circumstances.

Main Street versus Wall Street: Why the consumer is king in Securitized credit

In focus

Anthony BreaksFund Manager, Securitized Credit

Michelle Russell-DoweHead of Securitized Credit

The annual growth in first-lien mortgage debt (the largest of all consumer debts) has been well below pre-crisis levels, even as population and wages have increased. This is owing to the regulation of lenders and more stringent lending standards.

More telling, post GFC the total US consumer debt (Figure 2, green line) has grown at a slower rate than wages and salary (yellow line), even as wage growth has arguably been a laggard in this recovery. Non-mortgage consumer debt growth (dark blue line) has also slowed over the last two years as this credit cycle has been longer compared to historical cycles.

Figure 2: Consumer debt growth has lagged wage growth (year-over-year growth)

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The impact of regulation on access to credit for consumers and specifically for housing, has substantially improved the fundamental position of housing and of the consumer today. Leverage, as measured by debt service ratio (DSR), has fallen sharply from pre-crisis levels, and remains low compared to longer historical averages.

While US household debt as a percentage of GDP has fallen, US non-financial corporate debt is at or reaching new highs, as shown below. Corporate lending has grown sharply in products like leveraged loans since the GFC, especially over the past two years.

Figure 3: US non-financial corporates debt, % of GDP

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This increase in corporate debt is a function of QE: demand for yield grew as investors in safer liquid assets like Treasury notes and Agency MBS, were crowded out by QE, when the Fed bought roughly $4T in Treasury notes and Agency MBS.

This led to an explosion in the percent of investment-grade debt issued as BBB, as corporations leveraged up, shown in Figure 4.

Figure 4: Value of corporate debt by rating (in $trillions)

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Source: Bloomberg as of December 2018

In contrast, regulations have dramatically impacted the quality of consumer debt / housing debt, included limits to lending based on loan characteristics, more stringent requirements for loan underwriting including strict “ability to repay” underwriting standards, and requirements for loan originators to retain risk. Much of this regulation sits in the Dodd-Frank Wall Street Reform and Consumer Protection Act, but there are substantial other regulations that limit lenders and buyers of Securitized debt, such as Basel III and Solvency II. Entities established to protect consumers such as the Consumer Finance Protection Bureau (CFPB), and the numerous lawsuits of originators, underwriters, and mortgage servicers have also had an impact on lending. And lesser known, but no less important, the Credit Card Accountability Responsibility and Disclosure Act has had a limiting effect on the offering of credit card debt.

Through greater regulation, far fewer debt products were offered exposure to consumers. With that the consumer debt-to-income ratio is close to 40-year lows (Figure 5).

Figure 5: Current consumer debt-to-income ratio (%) is close to 40-year lows

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Today, more than 75% of all mortgage loans originated are guaranteed through the US Government Sponsored Enterprises (GSEs) or Ginnie Mae (FHA/VA), with the remainder held on the lenders’ (bank) balance sheets. Very little of today’s mortgage origination goes through the former private label securitization

Main Street versus Wall Street: Why the consumer is king in Securitized credit2

execution channel. While this is likely something that could, and should, change over time, it is noteworthy in terms of the type of supply the market sees. As we know, the GSE and FHA/VA securities are not securities which carry traditional risk as their payment (that is, their credit risk) is guaranteed by the US government.

Figure 6: Mortgage originations by channel

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Sources: Inside Mortgage Finance and Urban Institute. Last updated October 2018.

There are other interesting issuance dynamics in today’s market versus the pre-GFC era. In the non-agency mortgage-backed securities (Non-agency MBS), there is no government guarantee, so these securities actually offer a credit risk premium. But, there is very little supply and, in fact, a negative net supply situation. What exists in these markets is secondary supply driven by the $400 billion market of outstanding and seasoned vintages of 30-year mortgage securities issued before the financial crisis. In terms of new issue markets for non-agency MBS, excluding agency MBS issuance, the amount of issuance is quite a bit lower than in the past. The non-agency market outstanding beyond the older pre-crisis securities is:

1 $50 billion market in GSE credit risk transfer

2 $25 billion market in seasoned re-performing or non-performing mortgage loans

3 $20 billion market in non-Qualifying Mortgages (non-QM loans not meeting agency standards).

Considering US mortgage debt is a $10 trillion market, the $20 billion in non-QM outstanding issuance is a far cry from the peak of non-prime mortgage issuance outstanding, which reached nearly $1.5 trillion in 2007, as shown in Figure 7.

Figure 7: ABS Net Issuance ($ billions)

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Owing to the much more stringent underwriting, the housing finance mortgage default risk is at the lowest level, recorded by the Urban Institute as seen below.

Figure 8: Default risk well below pre-crisis levels

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Consumer credit: the foundation is strong with Main Street, ignore the ‘fake news’In terms of leverage, supply and demand, the consumer seems to be at a much earlier stage in its credit cycle versus more traditional Corporate credit exposures (Wall Street). We think this view is supported by very favorable metrics in terms of delinquency, default rates, debt-to-income, net worth, disposable income and savings rates. In short, the consumer, or Main Street, feels like a defensive alternative.

In the following series of charts, we highlight the statistics around consumer debt and, by extension, ABS and MBS. There are low levels of consumer defaults and mortgage delinquency rates. Mortgage delinquency rates have recovered to pre-GFC levels. As well, we would like to specifically de-bunk some recent delinquency data related to auto delinquency rates ensuring an apples-to-apples comparison.

Figure 9: Mortgage delinquency rates move lower with unemployment

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Figure 12: Net charge-off rate for Securitized credit card debt versus bank receivables

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Source: JPM, FDIC, Schroders, January 2019

Recently, a widely reported FRBNY delinquency statistic caused some headlines and challenged the otherwise rosy picture we might paint of the broad US consumer. We will explain that story and underscore how important it is to understand the composition of these indices and metrics. We think the Fed series is a good example of “fake news.”

Figure 13 shows the FRBNY’s series on auto loans 90 days or more delinquent. This series (the blue line) has now risen to near-peak levels, with the prior peak occurring just after the worst of the financial crisis, when there was a much higher level of unemployment. Clearly, if we just reviewed this series we would worry, both about the quality of underwriting, as well as the rise in this number in what is an otherwise benign unemployment environment. However, we also illustrate the delinquency numbers for auto ABS securitization trusts, and the Fed’s reported levels are much higher than what we see reported in ABS securitization. So, how do we reconcile these conflicts?

Figure 13: Charged-off assets distort the picture among securitized assets, especially post-GFC

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Source: Federal Reserve Bank of New York, Wells Fargo, December 2018. Auto ABS 90+ DQ data is a weighted-average of our prime and non-benchmark subprime auto ABS indexes. The weights come from the FRBNY’s auto loan outstanding data of which about 75% is prime, and 25% subprime.

Consumer credit performance has been strong, as is evidenced by the S&P/Experian composite default index, which continues to decline to new lows in consumer credit default rates.

Figure 10: The S&P/Experian Consumer Credit Default Composite Index

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Source: S&P/Experian, December 2018. The Composite index measures the default rates across autos, first and second mortgages and bank cards, and also offers investors a broader benchmark combining and measuring the default rates of all four indices included in the S&P/Experian Consumer Credit Default Indices.

For credit cards, net charge-off rates are also at the lower end of normal historical levels.

Figure 11: Net charge-off rate for credit cards

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As well, credit card receivables in securitized trusts tend to perform better, post-GFC, than those on bank balance sheets. This debunks a popular critique that somehow ABS receivables are adversely selected.


From what we can decode, the FRBNY’s series includes in its reporting some loans that most delinquency indices would not include. The main culprit looks to be defaulted loan balances that have been charged-off (AKA already recognized as a loss). The rationale behind the FRBNY’s inclusion of these defaulted and charged-off loan balances (which have already caused a loss in the past and cannot represent future loss) is that the balances are still collectible from the borrower. Even still, these charged-off loans can remain collectible for long periods and the impact on the index can be accumulated over periods of time (worse now than a year ago). As such, the FRBNY’s picture is representative of a number that is impacted by the accumulation of charged-off and collectible debt, rather than a representative, current snapshot of delinquent loans over time.

For auto loan finance, a $1 trillion market, 20% of that market is non-prime lending and has gone through a tightening of lending standards over the past 2.5 years, as subprime in the sector was a growing concern. We see this reconciliation as a sign of a more disciplined, credit-sensitive process.

Figure 14: Fed survey of auto loan underwriting standards

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Picking the right spots: why active mattersThe main types of debt expanding within the consumer credit universe have been student loans and peer-to-peer lending. This type of lending is not dominated by banks and is therefore less regulated. That said, the more sizable debt within this group is student loan debt, at nearly $2 trillion outstanding. The state of the student loan market is obviously a concern from a consumer debt burden perspective, but the vast majority of this debt is held or guaranteed by the US government through the Department of Education.

This reinforces another interest aspect of Securitized credit, one we mentioned at the beginning of this article – picking your spots. While the overall numbers comfortably support our thesis about the consumer being earlier-cycle, it is important to consider there are pockets of strength and weakness. If we break down the consumer based on demographics, a determinant factor in debt repayment health seems to be age.

Figure 15: A noticeable cohort effect with serious delinquencies (90+ days) since the GFC

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Source: New York Fed Consumer Credit Panel/Equifax, December 2018. Note: 4 Quarter Moving Sum. Age is defined as the current year minus the birth year of the borrower. Age groups are redefined each year.

Figure 16: A similar trend among auto loan delinquencies (90+ days) …

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Figure 17: …and credit card delinquencies (90+ days) …

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Figure 18:… but less so with mortgage delinquencies (90+ days)

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While it’s clear there’s a relevant cohort effort across the various sectors in the securitized universe, these data also reinforce that overall the ABS markets are in a very healthy phase within their credit cycles. For those with the skill and expertise to navigate these dislocations, being able to identify – and sometimes avoid – these areas is a huge advantage for active securitized managers.

The best way to access consumer credit The high level of bank deposits mean that banks have retained a substantial amount of the mortgage loans and the unsecured credit card receivables that they have originated. But, outside of owning financial corporates, the main means of accessing exposure to the consumer is through securitized markets or through direct debt ownership. This investment exposure is directly supported by the consumer’s ability to repay the financial contract. This is a concept inherent to the ABS market. The debt is backed by repayments on financial contracts. So long as the consumer is healthy or stable, the primary exposure is to the consumer’s ability to repay the debt.

There is a secondary source of repayment, which would be the worth of any collateral that can be liquidated in the event of default. As well, a key tenet of ABS is the sale of the financial contracts to a trust, which then owns the receivables remote from the risk of the lender. In our view, aside from owning the financial contracts directly (as whole loans), ABS and MBS are the most direct way to access the consumer credit risk in the US today. About $2 trillion of consumer debt sits in the US non-agency MBS and ABS markets.

Post GFC, even with QE, non-agency RMBS, ABS and CMBS did not benefit from a material expansion in demand. The lack of expansion is likely due to onerous capital rules put in place for banks and for European insurance companies. As well, given that most non-guaranteed ABS, CMBS and MBS are typically excluded from the major fixed income indices (like Bloomberg Barclays). As such, there is little in the way of indexing or ETFs within these US securitized products. The principal securitized debt that is included in the large global benchmarks is Agency guaranteed MBS. As a result, consumer ABS and MBS seem to be one way to position a portfolio defensively from a technical perspective, given the lower level of growth of these markets and the lower level of distortion from QE.

Select ABS sectors can be a great way to accomplish this, with fewer late-cycle characteristics they have less exposure to the shift away from QE. In addition, ABS offers diversification to more traditional corporate credit risk given its underlying consumer-oriented fundamentals. As such investors can access a lower volatility asset class with:

1. stable income potential2. stronger fundamentals3. diversification from other traditional risks


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Important information The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument or security or to adopt any investment strategy. The information provided is not intended to constitute investment advice, an investment recommendation or investment research and does not take into account specific circumstances of any recipient. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. Information herein is believed to be reliable but Schroders does not represent or warrant its completeness or accuracy. No responsibility or liability is accepted by Schroders, its officers, employees or agents for errors of fact or opinion or for any loss arising from use of all or any part of the information in this document. No reliance should be placed on the views and information in the document when taking individual investment and/or strategic decisions. Schroders has no obligation to notify any recipient should any information contained herein change or subsequently become inaccurate. Unless otherwise authorised by Schroders, any reproduction of all or part of the information in this document is prohibited. Any data contained in this document have been obtained from sources we consider to be reliable. Schroders has not independently verified or validated such data and they should be independently verified before further publication or use. Schroders does not represent or warrant the accuracy or completeness of any such data. All investing involves risk including the possible loss of principal. Not all strategies are available in all jurisdictions. Exchange rate changes may cause the value of any overseas investments to rise or fall. Past Performance is not a guide to future performance and may not be repeated. This document may contain “forward-looking” information, such as forecasts or projections. Please note that any such information is not a guarantee of any future performance and there is no assurance that any forecast or projection will be realised.

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