Margin Call: Can Alumni Lending Survive the Current Rate Environment?

In the last three years, there has been significant growth in the peer-to-peer lending space, particularly within the student loan segment.  While we applaud the entrance of new funding sources into the student loan market, there are increasing signs that some of these lenders might face challenges in the current interest rate environment.  These challenges stem from their use of market-based funding sources, rather than deposit funding sources like traditional banks.  Market funding, particularly through the use of “warehouse” credit facilities, can be particularly unstable because market lenders can demand more collateral against their loans as asset prices fall – what is known as a “margin call”.  If a borrower cannot provide additional collateral, typically within 24 hours, then the market lender can seize and liquidate the existing collateral in order to cover their lending position – a positive feedback loop that amplifies losses.  Traditional deposit holding institutions are insulated from this loop because they can hold their loans to maturity and fund them through both customer deposits and the Federal Reserve’s discount window.  While these traditional banks are still subject to bank runs and mark-to-market losses, they typically happen much more slowly than market based borrowers.

To demonstrate how this type of market based lending can go wrong; let’s take an example where the Student Lender uses alumni investment to fund a portion of their portfolio and borrows from a Market Lender for the remaining portion.  In this example, let’s assume that the Student Lender funds their initial portfolio with 20% alumni investment and 80% debt from a Market Lender.  Let’s further assume that the portfolio of loans has a fixed coupon rate of 6.25% and a maturity of 10 years.  So, for a $100 million portfolio, the Student Lender would use $20 million of alumni investment and $80 million of debt from the Market Lender.  If we assume that the Student Lender has accurately priced the risk of the loan portfolio, then we can determine the market value of the portfolio by calculating the spread over the equivalent Treasury security; in this case, the 10 year Treasury yield.  

Because the Student Lender’s portfolio has a fixed interest rate, the market value of the portfolio is subject to change based upon changes in the equivalent Treasury security; in this case, changes in the 10 year Treasury yield.  If 10 year yields go up, then the market value of portfolio will go down, because investors could readily achieve the same fixed rate return while buying less risky securities.  The figure below shows how the market value of the loan portfolio would change if the Student Lender had originated the loans in May of this year. 

There are a few very notable points in this figure.  First, we note that 10 year Treasury rates have increased from 1.75% on May 3, 2013 to 2.88% today – that is a very large and rapid increase by any historical standard.  Correspondingly, we note that the market value of the Loan Portfolio has fallen ~8% over that same timeframe; however, due to leverage the value of the alumni investment has fallen by almost 40%.  Even more notably, the ratio of Debt to Portfolio Value has increased significantly.  In the third set of rows, we outline a potential 85% Collateral Requirement; in other words, the Market Lender may stipulate that at no point can the ratio of Debt to Portfolio Value increase beyond 85%.  In order to rectify any imbalance in this ratio, the Market Lender could force the Student Lender to post greater collateral through a margin call.  We note that, under these assumptions, the Student Lender would be faced with a $1.6 million margin call at today’s rates.  If the Student Lender is unable to post that amount –within 24 hours of the request – then the Market Lender would seize the portfolio and liquidate it in order to recoup its investment, effectively wiping out the entire Alumni Investment.

Finally, in the last two columns we have forecasted out the same calculations based upon the prevailing assumptions for the 10 year Treasury yield.  As you will notice, the implications are not pretty for Alumni Investors: by March 2014 the Alumni Investors have lost nearly 60% of their investment and are facing a margin call of nearly $5 million.  Now, to be fair, if the Student Lender were a traditional bank then the equity investors in the bank would face the same market losses on their investment; however, they would be largely exempt from a potential margin call, which is the ultimate destabilizing factor in a market based lending system.  Further, from a borrower perspective none of this may matter: regardless of whether the Student Lender makes or loses money, the borrower has already locked in the terms of their loan and will be largely unaffected.  However, borrowers who sign up for alumni lending programs because of the social aspect of the loan product might find themselves in a sticky situation if those alumni start seeing their investments evaporate.