Consumer Credit Resists Volatility: Key is Positioning

Highlights:

  • Three key indicators that determine an individual’s sensitivity to job loss due to the outbreak of Covid-19 are geography, industry and income
  • US government actions demonstrate that there is a coordinated effort to shield the US consumer
  • Pagaya working closely with lenders to make sure that any borrowers faced by hardship can receive relief
  • Pagaya is less impacted by the recent moves because of our positioning, but we continue to monitor data and trends closely

Pagaya stands in the middle of consumers, banks and financial investors, providing us with unique insights into the current environment. Our portfolio consists of consumer loans, which are short in duration, insensitive to interest rate changes, self-amortizing and exhibit low correlation to traditional capital markets. Through these factors Pagaya’s portfolio is structurally protective to investors and especially resilient during times of macroeconomic stress. Over the last five years since Pagaya was founded, the company has steadily delivered consistent and high returns, including in these past couple of months.

We have singular access to proprietary information about the consumer and are very adaptive to changes in the behavior of markets. We recently published an in-depth report on the impacts of Covid-19 on our portfolio and on the markets, and we thought it would be helpful share some of our key findings.

Key Findings:

Population Disproportionately Impacted: Not all job losses are created equal. Pagaya’s research identified that there are 

three key indicators that determine an individual’s sensitivity to job loss due to the outbreak of Covid-19:

  • Geography

Along with the state level data, we have also analyzed cities and counties, looking at risk, zip code by zip code. One of our analyses involved examining Google trends as a predictor of unemployment, looking at the relationship between Google search increases and unemployment claims as a percentage of the civilian labor force. Through this study, we identified the highest risk states as well as states where we expect an increase in unemployment. Indeed, initial claims have risen in those states:

  • High risk states: Rhode Island, Nevada, Pennsylvania
  • Medium – high risk states: Massachusetts, Minnesota, Louisiana, New Jersey, Washington, District of Columbia, Ohio
  • Expected increase in unemployment: Maine, California, New Hampshire

 

  • Industry 

 

The industries that are at highest risk from Covid-19 include service-related industries such as leisure and hospitality, transportation and travel arrangements, most of which have been ordered to shut down. In fact, the leisure and hospitality sector accounted for two-thirds of total unemployment last month. Pagaya’s exposure to those industries is small. In transportation, travel and leisure it is just 0.43% and in food and dining it is 2.49%. The total percent of high-risk occupations out of all loans is 10%.

 

  • Income

 

Unfortunately, the current disruption is disproportionately impacting lower wage workers since many of the industries shutdown for social distancing are not high skill jobs.  The vulnerable industries today are accommodation and food services, retail trade and transportation and warehousing – also industries where incomes are lower on average. Pagaya generally does not see a lot of activity from this segment of the population, as the average borrower in Pagaya’s portfolio is in a much higher income bracket. 

Mitigating Risk: Understanding the risk factors, as well as daily monitoring and analysis of incoming data, has allowed us to mitigate these risks in our portfolio. In light of the unique environment we are in we have taken several actions to further limit the vulnerabilities in our portfolio during this period and firmly believe that our year-end performance will stay consistent with historical returns. 

Moreover, consumer credit is an asset class that has a low correlation to the broader market, exhibits very low volatility and has much higher excess spread to absorb losses. In general, we are less impacted by the recent moves because of our positioning, but we continue to monitor data and trends closely.  

 

Hardship Relief: We have been working closely with lenders to make sure that any borrowers faced by hardship can receive relief. This includes working with lender partners on new programs to make it easier for borrowers to request to be placed on their lender’s hardship program. 

 

Government Intervention: The efforts of the US government demonstrate that there is a coordinated effort to shield the US consumer and the amount resources in our view are unlimited and they will try to defeat this disruption to the economy no matter the cost.

 

Looking at the monthly budget of the average household in America provides insights into where they may need the most assistance. According to the latest data from the Bureau of Labor Statistics’ Consumer Expenditure Survey, the average American consumer unit (comprised of 2.5 people on average) made $67,241 in post-tax income in 2018. That’s $5,102 per month. The table below looks at the how the average American budget is broken down. 

Item

Monthly cost

Percentage of spending

Housing

$1,674 

32.80%

Transportation

$813 

15.90%

Personal insurance and pensions

$608 

11.90%

Health care

$414 

8.10%

Groceries

$372 

7.30%

Restaurants and other meals on the road

$288 

5.60%

Entertainment

$269 

5.30%

Other

$169 

3.30%

Cash contributions

$157 

3.10%

Apparel and services

$156 

3.10%

Education

$117 

2.30%

Personal care

$64 

1.30%

TOTAL SPENDING

$5,102 

100.00%

The largest expenses by far are housing (33%) and transportation (16%), together making up about half of the average American budget. With many U.S. residents currently out of work or working reduced hours because of Covid-19, making mortgage or auto payments may be difficult at this time. Fannie Mae and Freddie Mac, as well as other lenders, are encouraging those under financial stress to take advantage of forbearance agreements that can suspend or reduce monthly payments by up to 12 months. Additionally, foreclosures have been halted for 60 days and, in many places, evictions for renters are suspended. Several banks are also offering auto or personal loan forbearance.  If people get back to work faster than their forbearance expires it could potentially be a boost to the economy by putting additional income in the consumer’s pocket that they can now use to purchase goods and services.

 

Other monthly expenditures such as restaurants (6%) and entertainment (5%) are no longer an option as those businesses shut down and more people are urged to stay home. This leaves groceries and healthcare as the main expenses needed to be covered and this is what the government is trying to help with. While this does not solve the whole problem, it helps cover shelter and food while people are unemployed or have a reduced income.

 

Selective Investment Opportunities: We have found that sometimes the best opportunities come from the biggest disruptions.  We believe in these types of environments you need to be very selective, but if you have the ability to underwrite at a very detailed loan-by-loan level, the recent market dislocations have provided some attractive investment opportunities with asymmetric risk return profiles.

Over the last month virtually every individual in the world has been impacted in one way or another by COVID-19. Our priority is to make sure our portfolio is well protected. In general, we are less impacted by the recent moves because of our positioning, and we continue to monitor data and trends closely. As we have demonstrated, we are doing a great deal of effort on surveillance and are continuously uncovering insights into to the consumer. Because of our close position to the consumer, we are singularly capable of providing some of the best insights on this market. We are happy to share more of our insights. Please reach out to us at contact us