In a new report, Moody’s Investors Service examines several credit risks in securitizations backed by loans to small businesses which are originated  by US marketplace lenders (MPLs) that focus on lending to businesses with less than $10 million in revenues. These key risks have been recent topics of discussion and debate among sector participants. As small business MPLs originate more loans, they are likely to continue to turn to asset-backed securities (ABS) to fund their loans. 
                                                 
Moody’s report focuses on four credit risks in transactions backed by MPL loan to small businesses: limited performance history of the loans in the sector, the possible misalignment of interests, the uncertain regulatory landscape and the potential for payment disruption.

“As with consumer-based MPL securitizations, the lack of performance history on the underlying loan pools backing small business MPL ABS is a key risk when estimating delinquencies and losses in the sector,” co-author and Moody’s Vice President –Senior Credit Officer Tracy Rice says.

The report “Key Risks in US Small Business Marketplace Lending Securitizations,” says as a result of the short history of MPLs, the lenders often have not calibrated their proprietary credit models for a long enough period of credit history, such as a full credit cycle, to be considered dependable.

To mitigate risk arising from limited performance history, small business MPLs have sometimes made available their overall historical credit performance data, which allows market participants to estimate the likely performance of the collateral in the securitization based on that data. MPLs have also provided greater credit enhancement for senior notes than what might be found in typical non-MPL SME ABS transactions and structured securitizations in ways designed to reduce performance uncertainty, for example with fully amortizing bonds. In addition, certain features of the collateral will serve to mitigate such risks, such as the short duration of the loans.

Lack of alignment of interest between the MPL and securitization investors could pose risks to the securitizations. If the MPL does not have “skin in the game” in terms of having a financial stake in the performance of the transaction, the portfolio’s credit quality can be weak as a result of loose underwriting criteria and weak servicing practices. To mitigate this risk, MPLs have typically provided representations and warranties to the deal sponsor, such as conforming with the credit policies of the MPLs, including no adverse selection clauses.

Moody’s says the regulatory environment with regards to small business marketplace lending is relatively new and susceptible to change, which creates uncertainty for securitizations backed by these loans.  There is a risk that regulators could view some of the lending to small businesses as consumer lending and increase their scrutiny of the industry, especially given the small size of many small businesses.

“If MPLs are negatively affected by regulatory scrutiny or changes, a weakening of their financial strength could damage their securitizations in a scenario in which that outcome leads to servicing disruptions or leaves MPLs unable to honor obligations to repurchase ineligible loans from the transactions under their representations and warranties, among other potential risks,” co-author and Moody’s Vice President – Senior Credit Officer Madhur Duggar says.

The ability of small business MPLs to carry out servicing responsibilities through a credit downturn is a risk in small business marketplace lending transactions because MPLs have short operating histories and may be financially vulnerable in a credit downturn if loan origination volumes deteriorate significantly. In most transactions, the MPL is the primary servicer. To ease the worry of payment disruption risk, small business MPL securitizations typically appoint back-up servicers with experience in servicing business loans as well as loans from other asset classes.