Jan. 16 2019 — S&P Global Ratings expects continued economic growth and low unemployment in the U.S. in 2019 to support the credit quality, funding, and earnings prospects of most of the finance companies we rate. However, rising interest rates and volatile financial markets could threaten those benign conditions, particularly if the U.S. economic expansion is in its latter stages.
S&P Global economists expect U.S. GDP growth to slow to 2.3% in 2019 from 2.9% in 2018, the unemployment rate to drop to 3.5%, and the Federal Reserve to raise its target range for the Fed funds rate by 50 basis points (as a result of two rate hikes). We expect those economic conditions to support the credit quality of most types of consumer and commercial loans and therefore earnings. That said, stiff competition in certain lending areas, like residential mortgages in recent years could ultimately result in a significant rise in loan losses if the economy does not perform as well as we expect.
Although the number of expected interest rate hikes in 2019 has been lowered to two from three by our economists, we believe rising interest rates represent a threat to most finance companies. For instance, higher rates continue to limit residential mortgage originations and could lead to increased capitalization rates (cap rates) on commercial real estate properties. Also, the recent rise in rates and the concurrent market volatility could slow economic growth and weaken funding availability for finance companies.
Entering 2019, we have stable outlooks on 49 (77%) of the nonbank finance companies we rate. (We classify finance companies as either nonbank finance companies [NBFI] or financial service finance companies [FSFC]. The former have more significant balance-sheet risk while the latter depend more on cash flows). We have positive outlooks on six (9%) companies and negative outlooks on 9 (14%) companies. Four of the companies on negative outlook are residential mortgage companies struggling with lower origination volume, a heightened competitive environment pressuring profit margins, and elevated expense bases. Two of those companies, DiTech Holding Corp. and Stearns Holdings LLC, said they are considering distressed debt exchanges.
Rating trends on rated subprime consumer lenders are probably the most idiosyncratic. There are four companies with a positive outlook because of improving leverage and debt ladders, and three with negative outlooks because of bespoke regulatory issues. In the last three months, we have also taken two subprime consumer lenders to default/selective default, Community Choice Financial (now CCF Holdings LLC) and Sterling Mid-Holdings Ltd.
Vehicle Finance: Delinquencies Stabilizing As Underwriting Standards Improve In Subprime
Auto loans have been the fastest-growing consumer segment since the end of 2010, increasing at a 7.8% annual rate over that period. Total consumer auto loan debt increased by $554 billion, compared with growth of $1.8 trillion across all consumer debt, according to the Federal Reserve Bank of New York's Quarterly Report on Household Debt and Credit from November 2018. Growth in originations peaked in 2015, at a time when we believe competition was particularly intense, leading to relaxed underwriting standards. Over the past three years, however, lenders have pulled back on subprime originations as credit conditions worsened despite lower unemployment. Growth since 2016 has slowed and been led by higher FICO loans.
We see the greatest risks in leases and nonprime, particularly deep subprime. We believe previous loosening of credit standards, lower residual values, and rising interest rates are posing challenges for vehicle finance companies, though used car values have held up better than expected. Longer loan terms, however, widen the gap between the outstanding loan amount and the vehicle value, thereby increasing loss severities.
Overall, our current ratings anticipate that earnings will soften as losses for auto lenders persist, but not enough to erode lenders' capital positions. Positively, we believe that underwriting standards have now tightened for most of the companies we cover, particularly for subprime loans, as lenders adjusted their risk appetites in the face of increasing delinquencies and defaults, and recoveries that were then expected to decrease going forward. Through a recession, we would be vigilant of a company's ability to retain access to bank funding for warehouse lines as credit quality deteriorates, as well as its ability to continue to issue debt in the asset-backed securities (ABS) market.
Auto loan delinquencies of more than 90 days increased 30 basis points in the third quarter of 2018 compared with the same period in 2017, per data released by the Federal Reserve Bank of New York. Similarly, over the past year, delinquency rates have also risen across all other consumer segments other than mortgage by an average of 41 basis points. With 4.27% of loans 90+ days delinquent, auto loans are at their highest delinquency rate since the first quarter of 2009, when economic conditions were much worse. We believe delinquencies were driven higher primarily due to loosening credit standards, particularly in 2015 and 2016 vintages. If economic conditions worsen meaningfully in 2019, the "risk layering" some auto lenders have employed in recent years (higher loan-to-value ratios, longer terms, and lower FICOs) could cause delinquencies and losses to spike higher than the peak during the last recession, which was led by subprime.
However, while delinquencies continue to rise, auto lenders have tightened their lending standards, which the FICO distribution of auto loans demonstrates. That trend could help offset some of the impact from the weaker underwriting in prior years. The median FICO of loans originated was 704, as of third-quarter 2018, up from 696 three years ago. The last time the median FICO for auto loan originations was above 705 was in the first quarter of 2011. Similarly, 25th percentile and 10th percentile FICO scores are also modestly higher from three years ago and stable from a year ago, according to the Federal Reserve Bank of New York, which demonstrates tightening lending standards over the past couple of years.
We believe the companies we rate vary in their ability to navigate deteriorating credit quality. Some saw higher credit provisioning from 2015 and 2016 vintages significantly erode profits or result in losses. Others have been able to navigate higher provisioning with a material, but less significant, impact on earnings. Importantly, all of the companies we rate were able to continue to tap the ABS market with no impact on the availability of bank provided warehouse funding. We downgraded Drivetime Automotive Group in August, in part due to proximity to covenants from increasing delinquency, though it did not see a decrease in warehouse funding. We expect 2017 and 2018 vintages to be of better quality, helping to improve provisions across the sector.
Residential Mortgage: Survival Of The Fittest
We expect a tough residential mortgage origination market to continue into 2019, further pressuring earnings and leverage for the companies we rate. We currently have negative outlooks on five of the mortgage companies we rate. We do not expect the recent dip in the 30-year mortgage rate to provide any meaningful support to origination volume, especially because we are entering the seasonally weaker winter months.
Overall, the industry is still grappling with too much supply of companies willing to originate mortgages and not enough mortgage demand from consumers. This places downward pressure on gain-on-sale margins. The Mortgage Bankers Association (MBA) expects total origination volume to remain relatively flat in 2019 at $1.62 trillion (24% refinance/76% purchase) from a forecast of $1.64 trillion for 2018 (28% refinance). The 2019 forecast is based on the 30-year rate rising to 5.0% in 2019. This activity is down drastically from the $2 trillion of activity in 2016 when interest rates averaged 3.65% and refinance volume constituted 49% of total volume. S&P Global economists expect the 30-year rate to reach 5.1% in 2019 from the current 4.5%.
As interest rates rise, we expect to see diminishing valuation gains to mortgage servicing rights (MSRs). Generally speaking, MSRs increase in value as interest rates rise because homeowners are less likely to refinance their mortgage. However, as the 30-year mortgage rate gets further away from the average interest rate on the unpaid principal balance of mortgages serviced, the mark-to-market gain on the associated MSR diminishes; this is because if consumers are unlikely to save any money by refinancing at today's current interest rates, then they are just as unlikely to refinance at any rate higher than today.
Moreover, delinquencies on mortgage payments are at cyclical lows. If delinquency rates normalize to higher levels, MSR valuations will fall. Although we do not expect 90+ day delinquency rates to return to the last recession's peak of 8.9%, we also do not expect them to remain at their current 1.06% level. Higher delinquencies will lower MSR valuations because they can decrease the expected life of the loan, are more expensive to service, and incur increased carrying costs from advances that servicers have to provide to the mortgage investor. Rising delinquencies could also pose some capacity issues for an industry that is in consolidation.
Although industry consolidation is occurring, it is at a slower pace than we originally expected. We still expect larger servicers and originators to look for economies of scale, and smaller players look to sell or close while under pressure. Over the last three months, Mr. Cooper (formerly known as Nationstar) acquired mortgage company Pacific Union Financial and Seterus Inc., a servicing platform, from IBM Corp. DiTech Holding Corp. remains for sale and announced in December that it elected not to make a $9 million cash interest payments on its second-lien notes because it is in active discussions with certain of the company's creditors and other parties regarding the evaluation of strategic alternatives (due to a 30-day grace period we did not view it as default).
In addition to these midsize deals, stronger mortgage companies are likely to poach broker talent from their competitors while smaller firms shed jobs or close shop. The Bureau of Labor Statistics reported that mortgage banking firms cut 3,100 jobs in November, while mortgage brokerage companies cut 900.
At a policy level, the White House nominated Mark Calabria to head the Federal Housing Finance Authority (FHFA), the federal agency that is responsible with managing Fannie Mae and Freddie Mac while they are under conservatorship by the U.S. Treasury. Mr. Calabria was most recently the chief economist for Vice President Mike Pence and is said to favor a stronger role of private capital in the housing sector. We remain uncertain about the prospects for government-supported entity reform in 2019 and even beyond that.
Separately, the Federal Housing Administration (FHA), which provides mortgage insurance on loans made by FHA-approved lenders, has expressed concern that underwriting standards on mortgages have become riskier over the past two years. Inside Mortgage Finance reports that the share of mortgages made to homeowners with FICO scores below 700 and debt-to-income ratios above 43% rose to 45.6% at the end of 2018, up from 35% in the first quarter of 2017. We believe select originators are stretching their underwriting standards in an attempt to bolster origination volumes--a practice that could lead to higher mortgage delinquencies down the road. In anticipation of a tougher economic environment, Ginnie Mae's chief credit officer sent letters to the agency's largest servicers, including several of the companies we rate, requesting their contingent liquidity plans to address a scenario where delinquencies rise and the cost to service a mortgage increases.
Payday Lending: Softer CFPB Rules Seem Likely, But State Regulations Could Pose A Challenge
Rolling into 2019, we believe there are tailwinds for better-positioned payday companies because of lighter federal regulations and no pending debt maturities for the year. That said, we still believe that the narrow product suite and homogenous customer base lends itself to significant competition, which could pressure earnings.
In the latter half of 2018, the pendulum oscillated back in favor of payday companies. The Consumer Financial Protection Bureau (CFPB) said it will propose changes to the underwriting provisions of its payday lending rules (anticipated to be announced this month) and delay its effective compliance date (currently August 2019). Specifically, the CFPB is reconsidering the ability-to-repay underwriting provisions and not the remittance provisions. We expect the revised rules to benefit payday companies because they will reduce underwriting requirements and compliance costs, and allow companies greater flexibility to maintain their current origination volumes and profit margins.
At the CFPB, Kathy Kraninger was appointed as the new director. Departing director Mick Mulvaney, in turn, became the acting White House Chief of Staff for President Donald Trump following the resignation of General John Kelly. We expect Ms. Kraninger to continue down the path of a softer stance for the CFPB that is more business friendly. This is in stark contrast to the CFPB under the Obama Administration when director Richard Cordray actively created new consumer protection policies and levied monetary penalties against businesses.
Even with the positive momentum of lighter federal regulations, we remain cautious as new state laws are being created to curb high-cost short-term lending, such as:
- In October 2018, the Ohio legislature implemented House Bill 123, which is applicable to loans made after April 26, 2019, and limits permissible fees and charges on short-term loans and eliminates the Credit Services Organization (CSO) model. Absent an alternative product, we expect companies such as ACE Cash Express and Curo Group Holdings Inc. to exit the Ohio market.
- In November 2018, Colorado voters passed Proposition 111, a ballot measure that will cap the annual interest rate on payday loans at 36% and eliminate all other finance charges and fees, effective February 2019.
- In Georgia, short-term payday is currently banned and a lack of reform to the pawnbroker statute could hurt lenders. Without a change in law, the lenders would need to obtain Georgia licensed industrial loan licenses to continue operating. This would have the greatest impact on TMX Finance.
We still favorably view companies transitioning to more installment lending from short-term lending and streamlining their business operations by reducing retail footprints. Those companies would be in a better position to adapt to regulatory changes.
In 2018, we revised our outlook to positive from stable on Curo Group Holdings Inc., CNG Holdings Inc., and ACE Cash Express Inc. and to stable from negative on Enova International Inc., driven by steady operating performance and reduced financial leverage expectations. Nevertheless, given the ongoing product transition, we still expect companies to have increased compliance costs, higher charge-offs, margin compression, and an increase in loan loss provisions, which explain why our ratings remain concentrated in the low 'B' and 'CCC' categories.
In 2018, we also saw capital markets relatively open to payday companies as Curo Group Holdings Inc., TMX Finance LLC, and Enova International Inc. refinanced their debt stacks. We also experienced market gyrations affecting weaker performing payday companies' ability to refinance debt. These companies either missed an interest payment or restructured their capital structure through exchanges, which we view as tantamount to default, resulting in downgrades to 'CC' or 'SD' (selective default). In December 2018, we saw CCF Holdings LLC (f/k/a Community Choice Financial) and Sterling Mid-Holdings Ltd. issue new payment-in-kind (PIK) notes to satisfy their debt obligations. Looking forward, there is about $315 million of debt maturing in 2020 collectively for the payday companies we rate, which is significantly down from $1.3 billion last year due to these recent debt exchanges.
Commercial Real Estate: How Close Are We To An Inflection Point For Credit?
For the commercial real estate (CRE) finance companies we rate, losses continue to be relatively minimal as the underlying economy supports CRE fundamentals. However, provisions have started to tick higher among some of the companies we rate as vacancies rose across U.S. metro areas. Barring a significant decline in credit quality, we expect higher interest rates to boost margins in the short term on the back of floating-rate transitional loans held on balance sheets. Over the longer term, rising rates could increase funding costs for borrowers and lead to increasing delinquencies and charge-offs. We also believe rising rates could cause cap rates to rise, which could decrease real estate values.
During the past couple of years, companies such as Ladder Capital Finance Holdings LLLP and Starwood Property Trust Inc. have expanded their use of unsecured funding because of surging demand in the capital markets. We have seen CRE finance companies also increase their use of collateralized loan obligations (CLOs) over the past couple of years to fund further origination growth. The CLO nonrecourse structure allows for more diverse funding and greater leverage compared to advance rates for repurchase facilities while complying with risk-retention rules. If the CLO market remains open to CRE finance companies, it could fuel further origination growth and higher leverage through 2019.
We remain vigilant about the potential impact of strong competition on the quality of loan portfolios, especially given that many companies we rate have not gone through a downturn and many of them still use a significant amount of repurchase facilities that could impose margin calls if credit deteriorates. We will also remain vigilant about how companies can further origination growth in a more competitive environment and if this leads to diversification into new areas.
Vacancies for multifamily real estate appear to have troughed in 2016, with multifamily vacancies at 4.8% as of third-quarter 2018, up from 4.2% as of fourth-quarter 2016, according to Bloomberg data provided by REIS Inc. Retail vacancies have remained relative steady at 10% since 2015, though they remain substantially higher than precrisis levels as demand for retail space has fallen because of growing online sales. Office vacancies also have not recovered to prerecession levels and are now at 16.6% as of third-quarter 2018, up from their precrisis trough of 12.6%.
We remain watchful of property prices, which have more than doubled since the last trough and are currently led by multifamily. Multifamily cap rates continue to head lower and were at 5.6% as of the end of the third quarter of 2018, compared with 6.0% in the year-ago period. Retail cap rates are higher at 8.1% as of third-quarter 2018, compared to 7.6% in the year-ago period. Office cap rates have been relatively stable at close to 7% over the past couple of years.
Commercial Real Estate Services: Solid Footing Supports Momentum
We expect another healthy year from the CRE services companies we rate, following what was already a very strong 2018. Last year, we upgraded CBRE Services Inc., Jones Lang LaSalle (JLL), Cushman & Wakefield, and multifamily originator Walker & Dunlop. We also assigned a new rating to Newmark Group Inc. in October. That said, all of the CRE services firms we rate have stable outlooks because our favorable view of the sector and individual issuers are largely reflected in our current rating assessments despite growing positive sentiment around the shared workspace industry.
Thematically, we see many common trends in the issuers we rate:
- Leverage is declining due to strong operating results. Many companies we rate have targets to keep their net debt to EBITDA comfortably below 2.0x, a level we view favorably since some revenue streams are more sensitive to economic cycles.
- Across the board, CRE services companies are reporting strong performance in their leasing segments, typically the largest revenue segment for all CRE services companies, as the industry has plenty of white space to grow into. Rising employment also supports leasing. JLL reported that global office leasing markets volumes were at the highest levels since 2007, with year-to-date totals 8% higher than in 2017.
- Capital market-making remains strong as the industry benefits from strong investor demand and liquidity. Multifamily housing and the U.S. lead the pack for investment activity.
- Companies are also reporting healthy profit margin expansion from a combination of higher operating leverage and cost savings.
- Lastly, strategic recruiting and infill acquisitions remain a preferred way for issuers to reinvest their capital.
Notwithstanding these tailwinds, we enter 2019 with rising rates and increased capital market volatility--two factors that investors fear could derail the momentum. Companies, however, are confident that momentum will remains on their side.
Although we believe CRE issuers enter 2019 on strong footing, S&P Global economists expect economic growth to decelerate over the next two years. Though higher interest rates have not led to higher cap rates so far, we do expect cap rates to rise eventually, which will dampen capital markets activity. We also expect CRE services companies to continue to pursue acquisitions, which creates the possibility of incremental leverage and execution risk. Nevertheless, we expect CRE services to be better-positioned compared with the 2008 recession, as they have transitioned to more contractual fee revenue sources relative to more volatile capital market revenues.
Student Lending: Private Loan Originators Would Benefit From Any Regulation That Tries To Slow Federal Loan Growth
As of the third quarter of 2018, there was over $1.4 trillion of student loans outstanding, according to the Federal Reserve Bank of New York. Student debt now contributes 11% of all consumer debt and is the largest segment of consumer debt after mortgages, which totals 68% of consumer debt, or $9 trillion outstanding. As of the first quarter of 2003, by comparison, student debt totaled $241 billion outstanding, or just 3% of total consumer debt.
If student balances continue to grow, student loan servicers would probably see limited benefit based on historical data, in our view. Servicers like Nelnet and Navient receive recurring allocations of new student loans to service from the Department of Education based on certain performance indicators such as delinquencies and consumer surveys.
In theory, as student debt accumulates, the amount of servicing Nelnet and Navient have to do should also grow, and revenues should follow. However, despite the growth in student lending that has occurred, Nelnet and Navient have not seen comparable growth in servicing revenues in recent years, excluding acquisitions. While there have been other factors limiting growth of servicing revenue, such as run-off on Nelnet and Navient's Federal Family Education Loan Program portfolios and a more fractured servicing market, it is still difficult to conclude that a growing federal student loan market will necessarily result in an equal rise in servicing revenues for all servicing companies. This is especially true since the federal government is likely to migrate to a single servicing platform that could affect costs across the servicing business as servicers have to abandon their own servicing platform that was essentially a fixed cost and pay to use the government-approved platform that will likely have a cost per loan.
Were the federal government to pull back on student lending, the addressable market for private student loans would grow significantly--and could as much as double or triple given their relative size ($105 billion of federal loan originations compared with $10 billion for private loans in the 2016-2017 academic year). Sallie Mae, which has over 50% market share in the student loan space, would likely be a meaningful beneficiary.
A growing private student loan space would also make entering the market easier. On the other hand, if the federal government were to increase limits or take any other action that would increase originations, the serviceable market for private student loans could shrink by 50% or more due to the same relativity. This would likely result in downgrades. We view this as less likely because this would contribute to the growth in student debt that has already been identified as a problem by most stakeholders. Lastly, were the federal government to make private student debt easier for consumers to discharge--whether in bankruptcy or some other means--credit quality for private originators would likely suffer.
Finance Company Ratings Already Incorporate Our Expectations For Next Year
S&P Global Ratings expects the credit quality, funding, and earnings prospects of most of the finance companies we rate to hold firm in 2019, on the back of continued economic growth and low unemployment. However, rising interest rates and volatile financial markets could affect finance companies we rate negatively, principally by decreasing credit quality and increasing credit costs, possibly leading to downgrades. Upgrades are less likely, given where we are in the economic cycle and the unlikelihood of improving credit quality in most of our sectors.