“Where do babies come from?” My kids are always trying to get me to tell them. At seven and five years old, they sense that the answers I give them to this question are sketchy and incomplete. I’m sure that they’ve figured out that I am being obtuse on purpose, but don’t care strongly enough to push for a clearer answer. Of course, the time will come when all becomes way too clear – in the meantime I can enjoy the fact that they simply do not need the full answer right now.
The opposite is true when it comes to fund returns. “Where do fund returns come from?” should be something each of our investors understands. On the surface, a monthly return number is simple -- it reflects the income earned in the book minus the capital losses and expenses incurred. Why, then, does the monthly return number move up and down more than a small amount? Our monthly coupon stream is fairly consistent and our expenses do not change wildly from month to month, but returns are not predictable.
To understand the variation, we need to take a deeper look at the assets that we own in the fund. Each asset that we own is a loan made to a specific consumer or small business. Attached to each of those loans is an interest rate, which for US consumer loans can be as low as 6% and as high as 35%. Each loan is expected to make a monthly payment, is free to prepay or pay their loan in full at any time without penalty and can become delinquent at any point. To calculate a monthly return, we need to accurately put a price on each of these loans based on the following characteristics:
- The primary rate – defined as the rate that would be charged to make the same exact loan today, which moves up and down over time.
- Loan status – current loans are marked near “par” or $100, while delinquent loans are marked significantly below par. For example, US unsecured borrowers that are 31 days late on their loan are marked at $51, which represents a likelihood that 1 in 2 borrowers who miss a payment will default. After 60 days loans get marked at $38, after 90 days at $19 and after 120 days get written down to $0.
- Survival probability – all current loans are not expected to stay current. The higher the rate charged for the loan, the riskier the borrower. This means that on day one, a borrower with a 35% loan is less likely to pay the loan back than a borrower with a 6% loan and therefore should have a lower dollar price.
In a very simple world where interest rates never moved and no payments were ever missed, the return of a portfolio of loans would be almost the same every month. Unfortunately, this is not the way borrowers behave. Every month, we have loans that prepay, move from current to delinquent, move from delinquent to current, and loans that default. At the same time, we make new loans at the current market rate. Month end is a snapshot of the information we have on each borrower on the last business day of the month. Very simply stated, the fewer missed payments in any given month, the higher the return.
Since we know that there will be defaults in the portfolio, we can build models that tell us when those defaults are likely to occur. Most borrowers make their first few payments, and our data suggests that the most likely period for default is between six months and one year into the life of a loan. In other words, a loan that is three months old is worth a little less than a newly issued loan of the same quality and rate, since it has moved closer to the risky period. Once a loan passes the one year point, it is worth a little more again, since it is mathematically more likely to pay.
Another issue that we need to deal with is the likelihood of becoming current again after missing a payment. Generally speaking, good borrowers do not miss payments in the US, as it immediately impacts your credit score in a negative way. To handle this, we immediately write down 49% of a loan’s value if it goes past 30 days delinquent. This isn’t a random number – about half of all loans that miss one payment will go on to default. In any month where a large number of borrowers miss a payment, returns for that month are going to be noticeably lower.
If we knew with certainty how every loan would pay, we could mark the book perfectly and a relatively smooth return profile. In fact, if we knew how every loan would pay, we’d never buy a loan that wouldn’t pay us back in full! Since that isn’t possible, we need to make sure that our month-end marks reflect the most likely outcome for each loan given the current data set. Not one of our investors has ever bought into a delinquent loan that wasn’t marked down significantly. While this does cause monthly volatility, it ensures that investors moving in and out of the fund are doing so at a fair valuation.
I’ve kept this relatively simple, but we are happy to discuss this topic further. Heck, if it keeps me from having to answer questions from my kids about where babies come from, I’m happy to discuss almost anything.