Covid-19 and the Provision Fund
Although the impacts of Covid-19 have been evident in our economy for a number of weeks, we have not yet seen a significant increase in the number of borrowers falling into arrears on their RateSetter loans.
Nevertheless, we have determined that it would be prudent to update our approach to estimating credit losses on the RateSetter Lending Platform loan book and to update our Provision Fund coverage ratio accordingly.
Expected economic impacts of Covid-19
In March much of the information about Covid-19 focused on the health impact of the disease itself and the important changes to how Australians were to work and socialise. While there were some attempts at projecting the economic impact, the rapidly changing infection rates combined with different government responses meant there were significant swings in the expectations of commenters, economists and our own credit team. However, over the last week, and in light of additional data and increased certainty of the Government response to this epidemic, a consensus on the expected economic impacts of Covid-19 has begun to emerge.
Most relevant to the performance of the RateSetter Lending Platform loan book, there is now greater consistency in views on the likely increase in unemployment in the Australian economy this year, from the 5.1% reported in February. Across the Big Four banks, for example, estimates of peak medium-term unemployment now range between 7.8% and 9.5%, with an average of 9.0%.
With this growing consensus on economic outcomes, we are now better able to estimate the impact of Covid-19 related events on the credit performance of the RateSetter Lending Platform loan book.
Impacts on loan book to date
The RateSetter Lending Platform loan book is made up of over 25,000 loans, with an average amount outstanding of less than $12,000, from borrowers who on average are 43 years of age and approximately 65% of whom own their own home.
We have not yet seen a significant impact of recent events on borrower payments, with arrears rates consistent with seasonal trends and almost identical to this time last year. This is not entirely surprising, as a lag can be expected. Additionally, according to analysis released by credit bureau Illion in March 2020, titled “How Australians pay their bills”, Australians prioritise the repayment of personal and automotive loans above all other obligations analysed, including residential mortgages.
However, we have experienced an increase in the number of borrowers making enquiries about financial hardship, many of whom have completed hardship applications, which may allow the borrower to reduce their monthly repayments or have a repayment holiday, typically of around three months depending on their circumstances. Currently, fewer than 2% of RateSetter Lending Platform borrowers are subject to financial hardship arrangements, although we currently expect this to increase to around 4% over coming months.
In relation to our new lending, we have amongst other things, tightened our lending criteria, reduced the average amount we are lending to borrowers, and increased the amount that new borrowers must pay into the Provision Fund.
Changes to expected credit losses
We estimate future credit losses similar to other credit businesses that manage consumer loans. Estimates of credit losses are based on, amongst other factors, the value, term and purpose of the loans outstanding, as well as the credit characteristics of borrowers. In estimating credit losses, we first estimate the probability different cohorts of borrowers have of defaulting on their loan obligations (probability of default), and then estimate the loss expected to be incurred in the event of default after accounting for recoveries and any security interests that may be held (loss given default).
To account for the expected increase in unemployment from 5.1% in February to the now estimated 9.0%, whilst also taking into consideration factors such as the possibility that the duration of unemployment is extended and the amount of Government stimulus provided to consumers, we now expect additional losses on the RateSetter Lending Platform loan book of around $2.8 million due to Covid-19.
Provision Fund coverage ratio
As at 14 April 2020, the Provision Fund buffer is $17.6 million. Expected credit losses were previously $10.9 million, so combined with the additional $2.8 million of Covid-19 related losses set out above, expected credit losses are now $13.7 million. Accordingly, the Provision Fund coverage ratio is now ~128% of expected credit losses.
We are pleased that despite the significant economic shock to the economy caused by Covid-19, the Provision Fund coverage ratio remains above 100% and the Provision Fund continues to compensate investors for all borrower late payments and defaults, though we note that the Provision Fund is not an insurance product nor a guarantee. Read the PDS for more information on the Provision Fund.
Importantly, we are taking steps to help the Provision Fund coverage ratio increase over time. Most notably, we have materially increased the amount new borrowers must pay into the Provision Fund relative to the amount of their loan.
Expected loss and Provision Fund coverage ratio reporting
Previously the Provision Fund buffer, expected credit losses and the Provision Fund coverage ratio were updated in real-time on an automated basis. However, the automated calculations do not adequately account for the assumed economic impact of Covid-19 as set out above. Accordingly, we will now update these metrics on a monthly basis following a manual review that takes into account actual credit losses relating to Covid-19 as well as any revised outlook for the economy.
We continue to believe that the RateSetter Lending Platform is well-positioned to absorb the economic impacts of Covid-19, and that our investors will continue to benefit from attractive returns, whilst other asset classes suffer significant changes in both prices and returns. Additionally, we continue to believe that RateSetter is operationally well positioned to withstand the current turbulence. In this regard, you may also wish to read recent blog posts by our CEO Daniel Foggo and our Head of Credit Simon Cordell.
The information contained in this blog is accurate only at the date of publication. Expected losses and the performance of the RateSetter Lending Platform loan book cannot be known with certainty and expectations are subject to change. The Provision Fund is not an insurance product nor a guarantee. Past performance and investment returns are not an indication of future performance.