The explosion in unsecured lending was triggered when the cap on interest rates was scrapped in 2007 and the subsequent scrap for market share spurned some dangerous practices.
This month some unpleasant consequences of the massive growth in the unsecured lending market became clear when African Bank announced surprise provisions for bad debts. Its share price fell 40% between a profit warning and the results announcement, damaging sentiment in the sector as a whole. But some sober reflection indicates that the fall has created opportunity.
Unsecured lending has exploded over the past five years. Figures from the National Credit Regulator show the total amount of unsecured lending has grown from R7bn to R29bn, a fourfold increase.
On interrogation, the growth has been driven by certain subsectors of the market.
“Unsecured lending” has a technical definition that includes loans for which the lender holds no security, but excludes “credit facilities” such as overdrafts, credit cards and short-term credit, none of which have seen much growth. While we tend to think of unsecured loans as being synonymous with microloans, the growth is partly due to the fact that loans have been getting bigger and longer.
By far the biggest growth has been in loans of longer than three years, which has gone from 30% of the total to 62%. Also, the biggest growth has been in loans of larger amounts, with loans of more than R15 000 now accounting for 78%, from 42% five years ago. In fact, the typical microloan, of less than R3 000 and shorter than a year in duration, has not seen much growth at all and is now a small proportion of the total.
There is yet another feature: much of the growth has been to wealthier middleclass borrowers who earn more than R15 000/month.
Why is it that lenders have been making larger and longer loans? There are various reasons, related to regulation and the basic economics of the business of lending.
On the regulation front, the key driver has been the replacement of the Usury Act by the National Credit Act in 2007. This abolished the previous rules which capped interest rates on loans of more than R10 000 and terms of 36 months.
So the growth since 2007 has naturally been in the areas outside of this zone where most unsecured lending was previously forbidden. But there are some basic economics too. Issuing a one-year loan five times is far more expensive than issuing a single five-year loan. The risk is also higher – over five years, the chances of something going wrong, like unemployment, are higher.
But that tradeoff of lower costs for higher risk has worked in favour of longer terms, especially as lenders have built their databases of client performance metrics with which to undertake credit scoring.
That is, until things started to go wrong.
But more on that in a moment.
A second major factor is the growth of consolidation loans. Consolidators take clients near to default and “cure” them by consolidating their various exposures into a single, larger, longer-term loan.
Existing lenders are often forced to accept a certain level of write-offs by the consolidator.
Most of the existing operators entered the consolidation space partly to protect their existing client base. A Google search for consolidated loans finds offers from Old Mutual, WesBank associate DirectAxis and countless specialist consolidators. The impact of that activity is to accelerate the shift of loans from short-term small amounts to long-term large amounts.
While existing lenders were lengthening and growing loan sizes, another factor was at play. A flood of new entrants began offering loans. Retailers, insurance companies such as Old Mutual, countless other specialist lenders and, particularly, the big banks, noticed the large margins African Bank and Capitec, the two listed and most public lenders, had been earning.
The big banks have been particularly eager to find new ways to boost interest margins as their traditional retail lending businesses like home loans and credit cards have done poorly amid weak consumer confidence and property prices. For the banks, unsecured lending became the only area of growth in the market.
This was not universal though. Absa has held back while FirstRand and Nedbank have dived in, though they started backing off late last year.
Standard Bank has also been steadily building its exposure.
Those that have gone in have seen improving margins in their retail books. FirstRand, for example, earns an average margin of 16,6% on its unsecured personal loan books compared with 1,5% on home loans and 5,0% on vehicle finance.
With those sorts of margins on offer it is no surprise that FirstRand grew its unsecured lending by 27% last year while home loans grew only 2%. At Nedbank personal loans grew 28,7% while its home loan book shrunk by 5,5%. Margins there are 14,1% on personal loans compared with 1,7% on home loans and 4,6% on vehicle finance.
Apart from the obvious margin enhancement, the banks also benefited from the shorter-term nature of unsecured loans which made it easier to meet some of the balance sheet liquidity requirements of the Basel 3 capital rules.
Was all this increased activity to new borrowers or were old borrowers simply becoming more indebted? The answer is both. The size of the borrower base has been growing as employment has grown, particularly in the public sector. But there were also factors that led the existing market to borrow more. Above-inflation wage increases has certainly been a factor.
But banks’ weariness in lending for homes and cars meant consumers found it harder to fund asset purchases and turned to unsecured loans instead. This is a key driver of the swing of unsecured lending into the middle classes.
A crack in the dyke
For 2011 and much of 2012, this was a good news story. Books were growing and margins were increasing. For a sector still trying to recover from the devastating losses inflicted by the property collapse in 2009, retail banking finally was showing some life. Investors lapped it up and bank share prices responded positively.
But some stresses were creeping into the system. One of the most difficult was the consolidation loan trend. Big, established players found themselves losing clients to consolidators, who then forced them to write off parts of their loans under threat of default or entering the legal route of debt counselling. They responded by launching consolidation products themselves, which increased the risk of their books while lowering yields.
Lenders also started becoming more aggressive on the collections front. One big trend is to sell non-performing books to outside debt collectors. A lender might sell a portfolio of loans to another collector for a certain number of cents in the rand. The collector then attempts to recover as much as possible from the defaulting borrowers.
Some of the tactics have included the fraudulent use of emolument attachment orders, often called garnishee orders, that force employers to make deductions off employees’ salaries. Others have confiscated borrower’s bank cards, ID books and PINs to withdraw cash from accounts themselves.
Such abuse has caused serious distress in the collections space, making life difficult for those lenders who did not engage in such activities (and some, as a matter of principle, do not use outside collectors). They found their clients being taken out by such collectors, leaving them unable to service their other debts.
Some operators also encouraged borrowers to close bank accounts and open new ones, so axing the debit orders existing lenders were making.
On top of that, there were troubling trends in the broader economy. The unsecured lending market now depended on heavily indebted consumers to keep paying their larger, longer-duration loans.
But consumer confidence began to sink and unemployment ticked upwards as companies struggled to support increased pay demands, energy costs and other administrative prices.
Combined with the trends in the underlying market, lenders found themselves in trouble, particularly the larger banks, insurers and retailers.
Those reporting to the National Credit Regulator revealed a sharp drop in payment behaviour. In the fourth quarter only 66% of unsecured credit accounts were current, meaning payments were up to date, compared with 71% the quarter earlier.
That trend seems to have become sharply worse in the first quarter of this year, judging by the limited data so far available. Capitec’s Reserve Bank returns show it grew credit impairments between December and end-February by 14%.
African Bank grew its by 3,5% over the same period, but then levied major additional write-offs in March. By all accounts, the first quarter has been dreadful for unsecured lenders of all hues.
Investors start to feel the pain
When African Bank revealed its additional write-offs and cut its dividend, it was punished by investors. The share price fell 17% on a profit warning announcement and then another 24% when it announced results a week later. The share price was showing some signs of recovery by the time Investors Monthly went to press.
African Bank’s move surprised the market. Investors had been expecting earnings as usual, with the I-Net Bridge consensus forecast indicating profit growth of 15%. African Bank reported numbers far from that. Headline earnings per share fell 26%. As one sell-side analyst told us, “the violence to the share price was the surprise factor”.
It was a surprise to African Bank too.
“In early to mid-April the March business data became available and we took the decision to take additional conservative actions to provide for what we saw at that stage was a worse-than-expected decline in the macroeconomic environment,” says Gavin Jones, who manages African Bank’s treasury. “We were, however, in a closed period at the time and so could not communicate this action openly with shareholders.”
Perhaps the bigger surprise was a cut in dividends from 85c in each of the previous three years to 25c. Says Jones: “It seems that some investors believe that the large dividend cut came because we have other risks in the business which had not been disclosed.
This is simply untrue. People have read too much into this. We cut the dividend in order to be conservative about our levels of capital going into the next reporting period.”
There were a few reasons beyond the underlying problems of repayments on unsecured loans. It was also hit by a spike in insurance claims, many in the form of credit insurance tied to retrenchments.
Sales in its Ellerines furniture division worsened sharply. But the unsecured lending book was the source of most pain.
The bad debt charge grew by 42% as it increased provisions for bad debts. Actual write-offs increased to 11,5% of the book from 8,4% a year earlier. Despite that growth in write offs, it held the value of its written off book constant, such that it is valued at 14,6c in the rand, down from 18,4c.
The shareholder response was swift and brutal: the share’s 24% plunge was the largest daily fall in African Bank’s history.
The questions investors should be asking is whether the problems are unique to African Bank. The other obvious candidate is close competitor Capitec.
The large banks also have been growing their exposures substantially. Capitec’s share price had fallen 10% in May at the time of going to press against African Bank’s 40%.
Shareholders should be focused on the future rather than the past. So a key question is whether African Bank has taken all the pain and been honest about how difficult the market is.
To answer that we need only look at management’s track record. Of all the banks, African Bank has proven it takes all the bad news on the chin and that it anticipates shifting market trends. The last major crisis was in 2002 when Unifer and Saambou collapsed following the closing of government’s civil service payroll to deductions. African Bank saw it coming and aggressively restructured its book to avoid the problem.
Then, in 2008 when retrenchments spiked during the recession, African Bank had anticipated and substantially de-risked its book by shifting into higher-quality, lower-yielding loans. It has done the same this time. It has already moved its average loan size smaller and term length shorter.
It has reduced its rate of positive offers to applications down to 66% from 73% six months ago. Already its vintage graphs look better than they did in late 2008, with fewer loans migrating into the non-performing loan bucket as they mature (although worse than any other period). This de-risking process is continuing.
“We are there with it by and large,” CEO Leon Kirkinis told us in an interview after the results announcement. “There is a bit more to be done in the next month.” The share price fall puts it on a trailing 12-month PE of 6,8 against a banking sector average of 13,6. Its dividend yield is on 4%.
Institutional shareholders are backing it. Momentum Asset Management fund manager Sam Houlie is relying on management’s track record. “Think about how African Bank has acted over time.
They have acted in anticipation. They are acting cautiously, conservatively and prudently. We began buying at R30 [the share price is now R17,20], and even adjusting for deteriorating conditions, we think the sell-off has been overdone.”
Of course, Capitec’s management has proven itself equally adept at managing its way through tricky market conditions, but investor nervousness is understandable.
Its annual report for the period to February 2013 shows its arrears were slightly higher than expected and that it too has tightened up on risk appetite.
Its vintage graphs do not indicate that loan performance is deteriorating. It also earns more from transaction income than African Bank, providing some earnings diversity.
Nervousness to persist
But it is clear that African Bank’s problems became suddenly worse in March, which is after Capitec’s last reporting period. It is unlikely to make any further comment to the market until after the first quarter, so some nervousness is likely to hold for a while.
Risk in unsecured lending comes with the territory. Many operators have tried to use it as a short cut to easy profits and have come unstuck. It remains to be seen whether the big banks have mastered the space after years of missteps. But if anyone has proven themselves adept it is African Bank and Capitec.
*This article was first published in Investors Monthly