Lending carries a risk of loss in the event of default, so we have a model which indicates expected defaults and losses on our platform.
Lending carries a risk of loss in the event of default, so we have a model which indicates expected defaults and losses on our platform.
When a borrower takes out a loan, there are many conditions within the loan agreement that the borrower will have to adhere to.
The simplest of these is that they make the agreed loan repayments on time without fail. Breaking these conditions is commonly known as defaults, which trigger further conditions in the loan agreement, allowing the lender to take action. The lender has the right to ask for immediate repayment of the loan, recognise the default but take no further action at this point, or to renegotiate the terms of the loan.
Losses can occur after defaults, but not necessarily every time. It is important to understand the difference between the two.
If a default is triggered and the borrower cannot cure the problem, then the lender could take legal action to recover the money from the borrower. If subsequently the borrower does not have enough assets or security to repay the outstanding amount then the lender could lose some or even all of their investment.
Together, our lenders have funded loans valued at £176,867,500 over 289 loans.
Around 24% of that has been funded in the last 3 months and 52% in the last 12 months.
So far, our lenders have earned approximately £14,900,000 in interest since April 2013 (when we started lending), including £866,000 of interest recovered from loans that have defaulted.
We have completed the recovery of 9 loans to date, recovering £5,670,000 of capital and £372,000 of interest due after the loan defaulted.
That is 100.00% of capital and 100.00%* of interest recovered on these first 9 loans.
*Lenders agreed to reduce default interest on one loan.
We are working to recover monies on a further 15 loans.
We expect to recover £7,265,500 of capital and £494,000 of interest that has accrued after the loans defaulted.
Our conservative estimate is that there will be a loss of £1,359,234 of capital from these loans, but this may be less as we continue to work to get the best outcome for our lenders and past recoveries have been well above our initial worst case assessments.
Even though we have asset security, sometimes the security value will change in value over the life of a loan and that could mean that there is not enough value recovered to repay the loan in full. This is always a risk of lending and a prudent lender should always make an assessment as to what the expected loss from the portfolio could be in more extreme circumstances, even if it has full asset security at the outset of the loan.
For a single loan, we look at the latest value of the security that we hold and see if it is worth more or less than the outstanding balance of the loan. Where asset value is less than the loan, there could be a loss.
A portfolio could be made up of hundreds or thousands of loans. Not every loan will suffer a loss, even in severe economic conditions, and it is important to understand the likelihood of the loan defaulting (encountering difficulties) in order to make an assessment of the expected loss on the whole portfolio.
At Assetz Capital we make an assessment of each loan and decide how likely it is to encounter future problems. This is based on many factors including the financial performance of the borrower, the loan structure itself, the management team of the business and so on. We compare this against industry data and rate the borrower and their probability of defaulting accordingly. In extreme economic conditions this probability of default rises and in SME business lending this can be three times higher in a recession than in benign economic conditions. Nonetheless a loan with good security that also defaults may still suffer no loss.
At Assetz Capital we believe that just under 7 in every 100 loans will have future problems in normal economic conditions and this is in line with credit rating agency data for SME business lending. This is known as the probability of default. Some of our borrowers have as high as a 15.00% chance of having problems, some as low as 3.50%. On average it is currently around 6.25%.
As we have described, some loans could suffer a loss if security recovered on a defaulted loan fails to cover the loan capital outstanding at that time. In order to make an assessment of the likely loss on a portfolio we test what would happen if the value of the asset security on each loan falls by a set level and see if it creates a loss should that loan default. This is known as a stress test.
Loan 1 was for £800,000 and has £1,000,000 of security (This is far higher risk than a typical Assetz Capital loan but is used for example purposes).
Loan 2 was also for £800,000 but has £1,500,000 of security.
We then assume that the security on both loans suffer, for example, a 30% fall in security values in extreme economic stressed conditions, leaving Loan 1 with £700,000 of security remaining and Loan 2 with £1,200,000 remaining. Loan 1 will have a £100,000 loss, which is 1/8th of the loan (or 12.5%). Loan 2 has no losses due to the security still covering the loan balance.
If we had 100 loans like Loan 1 and we apply our estimate that just 6.25 loans in 100 will have problems, we can work out the expected loss of the portfolio. 100 x £800,000 is £80,000,000 of loan book. 6.25 x £100,000 is £625,000 of expected losses under these stress tests. £625,000 / £80,000,000 gives a 0.78% expected loss on the portfolio under these stress tests.
100 loans like Loan 2 would have no losses at all because £0 loss x 6.25 is £0. It can be seen why security cannot always protect against losses but more conservative lending can reduce or eliminate those losses even in bad economic times.
So a portfolio of loans like Loan 1 can expect to lose 0.78% over their life and a portfolio of loans like loan 2 should have no losses at all.
Whilst a single loan can sometimes have a large loss, investing across a diverse portfolio will reduce the average loss because the majority of loans should have no loss at all. Our automatic Investment Accounts can auto diversify your investment daily to save time and reduce risk.
In working out our expected loss we have used Bank of England Stress Test assumptions of the economic conditions likely to be encountered in the worst of recessions and applied those stressed assumptions to the security that we take on loans and also consider the effect of those conditions upon the probability of default of those loans.
As described above, we expect losses to happen. This can be due to, for example, an economic downturn lowering the value of property security that we took on a loan. In calculating the expected loss on the loan book, in stressed economic conditions, we make assumptions of a reduced recovery value for every piece of security that we hold. These tests also use worsened economic condition assumptions and are commonly used by the Bank of England to test the resilience of UK Banks to the effects of another severe downturn.
We use two tests, the first is the 'Assetz Capital Stress Test' which is largely based upon the Bank of England’s 2014 stress test assumptions for UK banks. We also test against the even more stringent assumptions in the latest 2016 Bank of England Stress Test (the 'BOE 2016 Stress Test'). These stress tests can change both the ability of loan security to cover any losses in the case of a default and also the probability of that default happening on a particular loan.
There is currently £93,321,000 of capital outstanding on our loan book, paying an average interest of 10.60% pa. On average, we expect 6.25 loans in every 100 to have problems and default with the security taken on each loan intended to protect against any losses but subject to the economic conditions not devaluing that security in some way.
We have analysed our loan book under the Assetz Capital Stress Test in order to see how well the security protects the loans under worse conditions than in the recent benign economy. Under these theoretical stressed conditions our future expected loss (the losses expected from loans after recovery of the reduced security value) on the current live and performing loan book is just 0.31% of the loan book. As described above this is a lot lower than the 6.25% default rate (the percentage of loans that will have repayment issues for us to manage) because we expect a large majority of loans to repay in full with no issues.
Under the extreme BoE 2016 Stress Test Conditions, the loss is expected to be 0.64% of the loan book. Again, in many cases we expect the majority of loans not to have any losses and we talk below about how the Provision Fund would intend to absorb such losses on our automated Investment Accounts.
No automatic Investment Account (Quick Access Account, 30 Day Access Account, Great British Business Account or Green Energy Income Account) has suffered a loss for investors to date, nor has there been call to use the Provision Fund that protects them.
£Nil Losses To Date and £Nil Use of Provision Funds.
Regardless of the good results to date, Assetz Capital also regularly reviews the level of capital held in the Provision Funds versus the potential losses on the stress tested portfolio of loan parts in each Investment Account. We do not publish the coverage of potential losses on our portfolio in benign economic conditions as apart from losses being close to zero this resulting large loss coverage ratio would be misleading given economic cycles happen with regularity.
Instead we apply two levels of stress tests. Based upon the loan portfolio remaining static until repaid / recovered over a 5 year cycle and the application of the Assetz Capital Stress Test assumptions the Provision Funds have at least 4x coverage of any expected losses on the loan holdings in each Investment Account.
We then stress our security values right up to the latest BOE 2016 Stress Test levels. Under these conditions the provision funds still have capital of at least 3x coverage of expected losses based on our current probability of default. In a downturn, for the types of borrowers we have, the probability of default can triple on average. Tripling the expected losses still means each Provision Fund is still expected to cover the expected losses of all of the loans currently held in each Investment Account.
We aim to continue to fund the Provision Fund for each Investment Account to ensure 3x coverage of expected losses under the BOE Stress Test of security held by each loan in each account and will publish the current coverage ratios in the table below.
Date of last stress test was June 2016
|Investment Account||Assetz Capital Stress Test||BoE 2016 Stress Test|
|Expected Loss||Coverage||Expected Loss||Coverage|
|Quick Access Account and
30-Day Access Account
|Great British Business Account||0.27%||4.33x||0.39%||3.00x|
|Green Energy Income Account||0.06%||4.00x||0.08%||3.00x|
When a potential event of default is identified on a loan, we will first of all clarify the situation with the borrower to avoid any misunderstanding and avoid unnecessary costs.
If an event of default has occurred, in most cases the borrower will be allowed a short window to rectify and cure the default.
When a loan is declared in default it will become repayable by the borrower, technically on demand and interest will accrue at our default rate which is usually around 4% per annum above the published rate on the loan.
Lenders will be advised promptly through the website. If the event of default is of a serious nature (such that no mitigation window is deemed appropriate) or the borrower does not rectify the default within the allowed timescale, then the loan will be formally declared in default and the default procedures set out in our terms and conditions will be enacted.
If a borrower's loan repayment is not credited to their account within seven days of the repayment date it will be categorised as a late payment. This allows for potential delays which routinely occur within the banking system and in uploading transactions to the database.
At Assetz Capital, our team have over 20 years of experience of dealing with distressed loans and businesses. Our Operations Manager is a qualified Insolvency Practitioner - a person licensed to deal with insolvencies of individuals and companies. From the very start of a loan we will have included covenants (special conditions), that if broken act as an early warning for possible problems. We act as soon as a default occurs. We do not wait for several payments to be missed before we move to protect our lenders; we act straight away. Depending on the circumstances this may involve engaging lawyers and accountants to provide advice on the best course of action.
We also take security in assets pledged to support every loan, so that if the borrower cannot repay, the assets can be sold to reduce or avoid losses. We cannot guarantee that there will never be a loss — lending money via any peer-to-peer lending platform carries some risk of capital loss — but our experience, our processes and the fact that we take asset security on every loan should help to reduce losses for our lenders.
Peer-to-peer lending carries a risk of loss in the event of default, so we have a model which indicates expected defaults and Expected Losses on our platform.
To calculate the Expected Loss we use two factors: Probability of Default and Loss Given Default.
Probability of Default is a qualitative function that converts to a quantitative output. It looks at a number of factors including but not restricted to the market sector, the people in the business, the customers, the suppliers, and the financial strength of the business. All these factors convert to a percentage figure of how likely the business is to default. In poor market or economic conditions, Probability of Default can be very high; in good conditions, it will be low.
The Loss Given Default is a quantitative function of how much money would be lost if the loan defaults. This is calculated by assessing the amount of money recoverable by the security held. Assume we have lent £80,000 against an asset valued at £100,000 (80% Loan To Value). In poor market conditions we may only recover 60% of the security value, £60,000. This would mean £20,000 of the £80,000 loan is lost, or 25%.
Expected Loss is a function of these two. So in a poor market at 15% Probability of Default and a 25% Loss Given Default, we would expect a loss of 3.75%.