Whole loans versus securitisation : Which is better?

Investors wanting to access the private loan market may be faced with the choice between investing via whole loans or securitisation. Both stem from the need for financial institutions to find alternative funding sources to free up capacity on their balance sheets. 

The development of both markets has opened up additional opportunities for investors. Which is more appropriate will depend on the investor’s risk tolerances hence a solid understanding of the pros and cons of each is essential.

What is securitisation?

At a very high level securitisation can be thought of as where an originator ‘pools’ loans then raises finance backed by those loans, where the security represents a claim on the income from the loans. The process of securitisation comprises three key steps.

The first step is a company with loans or other income-producing assets—the originator—identifies the assets it wants to remove from its balance sheet and pools them into what is called the ‘reference portfolio’.

The second step is that the reference portfolio is then transferred to a special purpose vehicle (SPV) which is an entity set up specifically to purchase the assets and realise their off-balance-sheet treatment for legal and accounting purposes. The transfer of the reference portfolio to an SPV is a common feature of all securitisation programs.

Thirdly, the SPV will then be ‘broken up’ into difference risk sections or tranches according to differing priorities regarding the cashflows (‘CFs’) and defaults as set out by what is termed the ‘waterfall’. Both investment return (principal and interest repayment) and losses from defaults are allocated among the various tranches according to their seniority. The most senior (least risky) tranche will have first call on the income generated by the underlying assets, while the most junior (riskiest) tranche has last claim on that income; i.e. income flows down the waterfall. Likewise losses in the event of defaults will flow up the waterfall from most risky to least risky tranches.

Where the characteristics of securitisation may differ is with respect to how the SPV funds the transfer of the reference portfolio. One alternative is direct funding via a single investor. In this case the investor will take the senior exposure with the originator constituting a first loss buffer via an equity tranche. The second is the structuring of the CFs from the SPV into a larger number of tranches of varying risk profiles which can then be sold either directly to different investors or via interest bearing securities into the public market. Where the funding is via a series of tranches the conventional securitisation structure assumes a three-tier security design—junior, mezzanine, and senior tranches.

A key characteristic of securitisation is that the originators will either directly assume responsibility for loan servicing (ongoing loan management post origination) or be responsible for appointing a third party to service the loans. For this reason it is normally required by investors in securitisation vehicles that the originator holds onto the initial risk of origination non-performance. Accordingly, the originator normally is expected to hold all, or part, of the first loss position to ensure an ongoing alignment of interests as they retain responsibility for origination and servicing of the reference loans.

What are whole loans?

Unlike securitisation, whole loans, as the name implies, are not ‘broken up’ and entail the complete sale of a single loan or ‘reference portfolio’ of loans from the originator to an investor. As part of the sale process the investor would review the loan or portfolio of loans offered to determine the likelihood of default when deciding how much to pay for the whole loans. The buyer then assumes full responsibility for the loans including ongoing loan servicing as well as the risk associated with any defaults. Through the sale of whole loans the originator is able to sever all ties with the loans. As the originator does not provide a buffer via first loss capital whole loans tend to be bought at a discount to face value with the discount reflecting the level of risk assumed by the investor.

The whole loan market is growing and while well developed in the US is beginning to develop in Europe and Australia. The driver behind this has been changes in banking regulations. Traditionally banks have been the largest whole loan investors due to their historical familiarity with the asset class, affiliated loan origination/servicing channels and funding advantage. More recently banks have pulled back from investing in loans due to concerns about the stickiness of deposits, which have been used traditionally to fund a portion of loan purchases, and proposed bank capital regulations that would make it more costly for banks to hold whole loans. Stepping in to fill this void are other institutional investors.

Benefits of whole loans versus securitisation

For the originator there are several benefits from utilising whole loan sales versus securitisation.

First and foremost the originators are able to sever all links to the loans with respect to balance sheet exposure. The ability to completely separate their balance sheets from the loans has positive implications for the originator’s equity costs.

Secondly, the originator only needs to deal with one party as the investor. Dealing with only one party has several advantages for originators. For one thing it can simplify and speed up the entire process of selling loans. This becomes particularly important when the originator may be dealing with larger size loans and/or less generic classes of loans. For example dealing with a single investor simplifies the ability to lend on forward flows. Lending on forward flows is where the loans to be sold are not actually in existence. 

In such a scenario the investor and originator agree on the price and eligibility criteria for the loans in advance of their origination. Once originated the loans are then purchased by the investor. Such arrangements can work more efficiently with whole loans given the higher level of flexibility as each loan is subject to greater due diligence by the investor prior to purchase. By contrast securitisation places greater emphasis on predefined eligibility criteria to filter deals which may create limitations when applied to less generic loan structures.

From the investors perspective the ability to take on all the risk associated with whole loans provides the potential for materially higher returns. Yet the potential for materially higher returns comes with one major catch.

Disadvantage of whole loans

The main disadvantage of whole loans is the greater degree of due diligence required to understand and manage the credit risk associated with a loan. Whether they be whole loans or securitised facilities investors are primarily focused on two risks, namely credit and prepayment risk, which can materially impact on the return ultimately earned. Credit risk is the risk that an investor will incur a loss if the borrower defaults and is typically evaluated using many different scenarios to evaluate both expected losses and “tail event” losses. This risk is typically expressed as projected lifetime credit losses. The other is prepayment risk which measures the speed at which a loan is repaid and is commonly evaluated using loan cash flow computed measures like option adjusted duration and convexity under various scenarios related to the potential direction of future interest rates (interest rate shocks). The absence of a third party standing in a first loss position or a waterfall associated with tranching means that investors in whole loans, unlike those in securitised facilities, do not have structural buffers to insulated against default or prepayment risk. The result is that a greater degree of due diligence and modelling is required to appropriately price the risks associated with whole loans. The greater level of due diligence is particularly important when originators, such as those in the Fintech sector, are adopting new underwriting models which make it harder to determine how these techniques will perform longer term.

A potential by product of this is that whole loan exposures may be less diversified given the greater level of due diligence required to price and approve each loan. By contrast securitisation will tend to place greater reliance on collateral standardisation, high levels of loan diversification and tranching to manage the risks associated with default and prepayment risks.

For investors interested in investing in private loans they may face the choice between investing via securitisation or whole loans. The benefits of accessing via whole loans are (a) ability to customise loans, (b) extraction of higher returns and (c) greater control over the investment outcome via loan selection/filtering. The main disadvantage of whole loans is the greater level of due diligence required given the full assumption of risks associated with the loans. A lower risk alternative approach is via securitised structures. The advantages of a securitised structure is that it facilitates (a) tranching of sleeves into different risk profiles, (b) access to a more diversified pool of loans and (c) increased liquidity if publicly traded. The disadvantage of securitised structures is that (a) pooling of loans requires a higher degree of collateral standardisation so returns tend to be lower and (b) focus is more upon a large pool of standardised loans and tranching of sleeves to manage risk rather than deal selection. Given the differing pros and cons which approach to accessing private loans is superior comes down to the preferences of the individual investor. That said all else being equal investing in the senior tranches of securitised structures is likely to remain the preferred investment choice for risk averse investors looking for a modest level of yield enhancement.