Credit Risk Assessment
We undertake Credit Risk Assessments to consider the risk that a borrower will not make payments due under a loan. We assess information in relation to the borrower, the proposed loan and relevant facts and circumstances presented to us.
How we assess our borrowers
Assetz Capital has a team of pro-active Relationship Directors who are happy to meet potential businesses that require funding. They are supported by a highly experienced, time served, Credit team, and between them they look to apply real world, common sense principles alongside financial metrics.
There are some key questions that we look to ask when lending:
- Do we understand the entity to whom we are asked to lend and do they have relevant experience?
- Are we secured at an appropriate level for the deal proposed?
- Can we follow the monies advanced to its intended purpose? Is the amount sufficient? And the purpose acceptable?
- Can the borrower service the repayments with sufficient headroom?
- Is the proposed exit deemed realistic and achievable?
Once in possession of this information we will decide if this is an appropriate risk to place to lenders. In the vast majority of cases we will have met the potential borrower and viewed the asset offered as security.
When considering development funding we prefer to fully fund from the outset including interest costs. The questions above will apply although equally important is whether we are building the right property for the location, and how long it will take the properties to be absorbed into the marketplace through sales.
Risk models, categories and pricing
Before the start of a loan and during its life we use credit risk models to allocate a risk category to it. Credit risk models use various data inputs and measures to forecast risk across loan portfolios. The risk category for each loan is shown on the loan dashboard page.
Credit Risk Models
There are several measures used in the credit risk models to allocate risk categories to loans:
- Expected Loss (EL) - is the amount expected to be lost on a loan from a potential borrower default occurring.
- Probability of Default (PD) – is the percentage likelihood of a borrower default occurring over a 12-month period.
- Loss Given Default (LGD) - is the amount of money lost when a borrower defaults on a loan as a percentage of exposure at the time of default.
- Exposure At Default (EAD) – is the outstanding loan exposure at default.
As a calculation, EL = PD% x LGD% x EAD
The EL percentage is a risk forecast to enable us to fairly price an appropriate interest rate for a loan and for loan revaluation. It does not represent the actual loss that may occur following a loan default (which could be significantly higher).
When assessing PD, we use three different PD models depending on loan type and size to determine PD percentages for:
- Property development loans
- Loans to companies with an annual turnover exceeding £500,000 (if suitable financial information is available).
- Loans that do not fit either of the models above.
These PD models use various information sources including in relation to the borrower and its business, financial data, market sector and conditions.
When assessing LGD, we apply percentage recovery rate discount factors to the market value of the loan asset security (based on the type of asset security, loan distress, passage of time, costs of recovery and any prior ranking security).
LGD will vary over the life of a loan as the loan is made and repaid. Amongst other factors, the borrower may suffer financial distress, market conditions may change, and the value of loan asset security and costs of recovery may fluctuate. We will also apply indexation adjustments (initially every six months) to residential property security values determined by reference to suitable and available indexes.
Due to Coronavirus and the limited number of transactions occurring, The Office of National Statistics (“ONS”) and its joint producers temporarily suspended the UK House Price Index (HPI) publication from the April 2020 index. As a result, we decided to defer the indexation exercise which was due in June 2020. Publication of the HPI resumed in August and we announced that it was our intention, subject to review, to conduct the indexation exercise in November 2020. Following further consideration and recognising the current Government interventions in the market following the lockdown period, such as the stamp duty holiday, we have decided not to undertake the exercise at this time and we will review this decision on a quarterly basis.
Property Development Loans
Development loans have different characteristics to other property secured loans and every development follows a different path to completion. In a typical development loan facility, an initial loan advance is made to the borrower followed by further tranche loan advances as construction work progresses. Professional advisors are engaged to advise on:
- Market value (MV) of the land or property before commencement and gross development value (GDV) on
completion of a development;
- Construction programme and costs and progress against them;
- Sums to be paid to the borrower as advances under the loan.
This advice is to help manage the risks involved in development projects.
PD is higher at the outset of a development, only changing when enough progress is made to enable the PD to steadily reduce.
LGD usually starts at a low percentage with the initial loan advance secured against the land or property to be developed. It rises rapidly during early site preparation and groundworks as further tranche loan advances are made. As construction progresses and buildings become watertight and serviced the LGD steadily decreases as the development moves to completion.
EL follows a similar trajectory as LGD and can vary considerably as the value of asset security and construction works (and the value that could be recovered after a loan default) changes relative to the amount of the loan advanced at different stages during the life of a loan. Therefore, we forecast a Peak EL by using an anticipated PD profile and multiplying it by the LGD to forecast the expected highest point for EL during the life of the development loan assuming that the development progresses without any issues.
In doing this we consider the type of development, the different stages of development and apply potential recovery rate discount factors against the land, property value and construction works undertaken as determined by approved loan advances made.
We will also assess the actual EL when the loan is drawn down and re-assess this throughout the life of the loan.
The Peak EL percentage is a risk forecast to enable us to fairly price an appropriate interest rate for a loan and for loan revaluation. It does not represent the actual loss that may occur following a loan default (which could be significantly higher).
The Peak EL is also based on the presumption that ongoing funding is provided for the loan advances to be made under the development loan facility.
The following risk categories are provided to assist your understanding and assessment of the risks to the loan investment opportunities. They are based on the outputs from our credit risk models and take into account variables such as the type of loan and probability of default, together with the nature and value of the available security for each loan. They will be updated during the life of the loan based on information obtained externally or from the borrower.
Lenders should be aware that in order to achieve a rate of return beyond inflation as with most forms of investment peer to peer lending carries a risk of loss to your capital should Borrowers be unable to repay their loans.
|Category||EL or Peak EL||Definitions|
|Low||<0.1%||At the time of the latest assessment loans within Risk Category “Low” are considered to have the lowest risk of loss either due to a low PD rating and/or a strong level of security cover.|
|Medium Low||0.1% - 0.2%||At the time of the latest assessment loans within Risk Category “Medium Low” are considered to have a modest risk of loss either due to lower than average PD rating and/or a high level of security cover|
|Medium||0.2% - 0.5%||At the time of the latest assessment loans within Risk Category “Medium” are considered to have a moderate risk of loss either due to an average PD rating and/or security cover at standard written down percentages.|
EL 0.5% - 1.5%Development loans
EL 0.5% - 6.5%
Peak EL 0-6.5%
|At the time of the latest assessment loans within Risk Category “Medium High” are considered to have a higher than moderate risk of loss either due to a higher than average PD rating and/or testing levels of security cover. This may be entirely normal with certain types of loan, e.g. Development, where the asset value will fluctuate throughout the course of its build period.|
EL >1.5%Development loans
Peak EL >6.5%
|At the time of the latest assessment loans within Risk Category “High” are considered to have the highest risk of loss due to a challenging PD rating and/or a weakening level of security cover.|
|Default||Variable||Refer to the Default section below.|
During the life of a loan its risk category may change. Should we receive information that we consider material to make the loan more or less risky we will use the relevant credit risk model to determine whether a change to the risk category is required. In any event, we will review the risk category of each loan at least every six months. If a risk category is changed, the revised risk category will be shown on the loan dashboard page with a lender update sent to explain the change. Whilst considering a risk category change, we will temporarily suspend the loan.
How interest rates are determined prior to drawdown
Prior to the drawdown of a loan we use the output from the credit risk models to help determine the interest rate to be paid by the borrower and the interest rate to be paid to lenders. Different loan types with different risk profiles have appropriate differences in interest rate.
As shown in the above table, each risk category (except Default) has a minimum to maximum percentage range for EL or Peak EL (for development loans). So, the EL or Peak EL informs the risk category to which a loan is allocated.
Each risk category is linked to a risk premium which is a percentage intended to exceed the expected loss on that loan (so compensating lenders for the loss risk) and this makes up part of the interest rate – the higher the risk category the greater the premium - along with:
- a term premium related to the planned timeframe to repayment of the loan – the longer the loan the higher the premium;
- a liquidity premium based on the size of the loan – the larger the loan the higher the premium.
Consequently, the interest rate to be paid to lenders incorporates the EL or Peak EL risk to their capital – this risk is priced into the interest rate at loan origination.
In addition to the three components which make up the lender interest rate, Assetz Capital charges a fee to manage the loan which is included in the rate the borrower pays – this varies on a loan by loan basis but reflects the type of loan and level of work involved in managing the loan.
The following table provides a summary of these components, the range of the premiums involved and how they work together to determine the interest rate for lenders and borrowers:
|Risk Premium||0.25 - 1.50%||4.75 - 8%||3 - 8.50%|
|Term Premium||3 - 5.50%||0.25 - 0.50%||0.25 - 0.50%|
|Liquidity Premium||0 - 4%||0 - 4%||0 - 4%|
|Lender Rate||6 - 11%||6 - 12.50%||6 - 13%|
|AC Monitoring Fee||0.90 - 2.50%||2 - 4%||1.40 - 3.50%|
|Borrower Rate||6.90 - 13.50%||8 - 16.50%||7.40 - 16.50%|
What happens when circumstances change during the life of a loan
During the life of a loan its price is a combination of its interest rate and its capital value.
The interest rate on a loan is set prior to drawdown as described above. The only prospect of changing the interest rate paid by the borrower is if the loan defaults. In the event of default, default interest may be charged to the borrower which, if paid, leads to an enhanced interest rate for lenders (excluding Investment and Access Accounts holders) reflecting the increased perceived risk.
As a result, in order to vary the “price” of a loan during its life, to reflect a fair and appropriate representation of the risk of loss, the capital value of the loan would have to change. If the risk profile of a loan, measured by EL percentage or as indicated by its Risk Category, changes during the life of the loan, then following a change in EL in excess of an amount we consider material and in the case of Development loans only if the Peak EL percentage is exceeded , then we will disclose an associated discount to the loan’s capital value. Following a loan Default the capital value disclosure will be based on the actual loss that may occur.
We will disclose on the loan page dashboard a capital value discount, along with information supporting the change of risk category, and the loan will be temporarily suspended whilst this information is clarified. The capital value discount which is disclosed represents our estimate of the increase in the level of expected loss on the loan. The capital value discount is not enforced on the secondary market, but all buying and selling lenders will need to confirm they have read the relevant information prior to completing a sale or purchase of Micro Loans where a capital value discount is disclosed. It is expected that any trades which do occur in such loans would likely occur at the discounted capital value, but lenders may conclude trades at a different discounted value or indeed with no discount at all if a buyer is willing to purchase at that capital value.
The factors we use to inform the price and any revaluation (such as risk categories, premiums and materiality) are reasonably formulated but may be subject to change over time.
Monitoring the loan portfolio
We monitor each loan to check the borrower makes the loan repayments on time. We allow seven days from a loan payment due date before we regard the payment as late to provide for any banking system delays and processing.
If the borrower is performing, we classify the loan as Normal.
If we become aware that the borrower has breached a term of its loan, we may classify it as a:
- Monitoring Event; or
- Credit Event
A Monitoring Event is a technical breach of the loan terms which is generally capable of being remedied. Following a Monitoring Event on a loan, we'll post a notice on the loan dashboard page and monitor the loan more closely and more often. We may also suspend trading in the loan to review the circumstances relating to the Monitoring Event and to decide whether it should be classified as a Credit Event.
A Credit Event is a more serious breach of the loan terms which may or may not be capable of being remedied. Following a Credit Event on a loan, we’ll post a notice on the loan dashboard page and monitor the loan more closely and more often. We will also suspend trading in the loan.
We will also provide information in relation to a Monitoring Event or Credit Event in our lender updates and any lender vote that may be required. We may also change its risk category and/or capital value
If we conduct a lender vote in respect of a loan, we temporarily suspend trading in the loan.
A late payment in respect of a loan is a Monitoring Event. We would issue a Reservation of Rights letter to ask the borrower make payment to remedy the breach. Should late payments become persistent we would review the facts and circumstances known to us and may classify a loan as a Credit Event. We would again issue a Reservation of Rights letter to ask the borrower make payment to remedy the breach.
We would also seek to liaise with the borrower by telephone and/or email to obtain an understanding of the reasons for a breach of the loan terms and to avoid any misunderstanding.
Should late payments or other breach of loan terms persist unremedied we may issue the borrower with a demand for repayment of the loan in full. We would do this if we consider that the borrower is unlikely to pay its obligations under the loan in full without us enforcing any security in respect of the loan or taking other steps with similar effect.
Our assessment of whether a loan has had a Monitoring Event or Credit Event or whether to change risk category or to make demand for full repayment can be subjective based on applying experience to the facts and circumstances known to us.
If a loan has had a Monitoring Event or a Credit Event, it can go back to being classified as Normal if the borrower remedies the breach – for example, by catching up on missed payments.
A Default is an event where:
- in respect of a loan that is not secured on property, the borrower is past the contractual payment due date by more than 90 days; or
- in respect of a loan that is secured on property, the borrower is past the contractual payment due date by more than 180 days.
Consequently, we classify a loan as in Default if the borrower fails to:
- make a payment of loan capital or interest due during the loan term; or
- repay the loan on expiry of the loan term;
and the borrower does not remedy the failure before 90 days (non-property secured loan) or 180 days (property secured loan) has passed.
Additionally, we also classify a loan as in Default if we make demand for full repayment of the loan following an event of default under the loan terms.
We use our lender updates and any lender votes that may be required to inform lenders in a loan if we consider that the borrower is unlikely to pay its obligations under the loan in full without us enforcing any security in respect of the loan or taking other steps with similar effect. We will consider that to be the case should we classify a loan as in Default.
When we classify a loan as in Default its risk category will also be shown as Default on the loan dashboard page.
If a borrower has a Receiver appointed to its property or enters into liquidation, administration, bankruptcy after us enforcing any security in respect of its loan or otherwise, we will also internally classify the loan as being in Recoveries. This is not a classification that appears on the loan dashboard page in respect of a loan but for the purpose of lenders’ tax statements it is used as a determiner that there is no reasonable prospect of the recovery of the loan.
We will liaise with any Receiver, Insolvency Practitioner or other office holder appointed in relation to any sale of the asset security.
When we classify a loan as in Default, we will also make an assessment of whether or not there is likely to be a loss to lenders taking into account the facts and circumstances known to us, costs of recovery and any available estimated outcome forecast from a sale of the asset security provided by prospective or appointed Insolvency Practitioners or Receiver.
If there is a likely to be a loss, we will notify lenders on the loan dashboard page and in lender updates.
It is important to remember that a Default does not necessarily mean that there will be a Loss. We take asset security on loans which, following a Default, can be enforced to sell the asset to provide a recovery for lenders.
If the net sale proceeds after the costs of security enforcement and sale are more than the amount of loan capital outstanding at Default, then there may not be a Loss. If the net sale proceeds are less than the amount of loan capital outstanding at Default a Loss may occur and lenders may lose some or all their investment.
This explains why Default rates can appear higher than Losses rates in our Loan Performance information.