Independent lenders who provide asset-backed credit to small and medium-sized businesses face widespread failure in the coming months as funding markets seize up and borrowers struggle to pay their loans.
Small asset-backed finance companies, which originate loans and package them together for sale to banks and insurance companies, are being squeezed by a business model that has little capacity to absorb a tidal wave of loan payment deferrals or defaults.
Should these lenders begin to fail, small and medium-sized enterprises, from trucking companies to dentistry practices, could lose a crucial source of funding. That would undermine businesses already hit hard by COVID-19 restrictions and make it tougher to kick-start the Canadian economy once physical-distancing measures end, industry participants say.
“I’ve already had a couple of my members call me and say, ‘We’re done,’" said Michael Rothe, chief executive officer of the Canadian Finance and Leasing Association (CFLA), an industry group that represents companies involved in asset-backed finance.
“They’re dealing with your main street lending, these small guys," Mr. Rothe said. "They’re dealing with truckers who are financing their vehicles. They don’t have huge margins ... and we weren’t coming into this crisis strong, there were a lot of headwinds already.”
Small and medium-sized businesses frequently finance their equipment through loans secured against the equipment itself. In 2019, about a quarter of these loans in Canada were made by independent finance companies, many of which specialize in specific industries, such as transportation or oil and gas, or smaller-scale loans that banks aren’t interested in. Banks, credit unions and equipment manufacturers provided the other asset-backed financing.
All commercial lenders are getting requests to defer loan payments. A survey conducted by the CFLA in early April found that a fifth of their members had deferral requests for more than 50 per cent of their asset-backed loan portfolios. But unlike banks or credit unions, independent lenders have little in the way of capital buffers to accommodate deferrals and absorb losses.
Small loan and lease companies typically have slender balance sheets. They originate hundreds of loans, then package them into pools known as asset-backed securities that they sell to funders, usually banks or insurance companies.
They fund new loans by selling old loans or by issuing commercial paper, a kind of short-term debt. Even after they’ve sold the loan pools, they manage billing and collecting for the loans, passing the payments along to their funders.
“Originators don’t have any cash flow for themselves unless they’re originating, because they’ve pledged it all to the funders," said Moe Danis, an industry veteran who ran asset-backed securitization programs for Sun Life Financial and Canadian Western Bank, among others.
“So if they can’t cover their overhead through new originations, they’re stuck,” he said.
To make matters worse, most securitization deals involve “prompt payment” or “perfect payment” clauses, meaning the originators have to pay the funders a guaranteed amount, even if they can’t collect from borrowers.
“The structure is built for normal delinquency rates, and sometimes elevated credit delinquency because of a downturn. It’s not designed for a full shutdown of the economy," Mr. Danis said.
Lenders now face the additional risk of equipment prices plummeting.
If borrowers default on their loan payments, lenders can repossess the equipment and sell it at auction. The concern is that the used equipment market will have a glut if distancing measures drag on and a wave of companies go bankrupt.
“There’s a downward pressure on used trucks and trailers and all of that," said Bav Malhi, director of sales at Lantern Capital, a Mississauga-based equipment finance broker. “What they thought they were lending against was one-to-one security to loan. But now the resale value is reduced, and therefore they’re at higher risk.”
As asset-backed loans become riskier, it has become more difficult to sell asset-backed securities and raise new funds. One of the CFLA’s principal concerns is that funding markets will seize up entirely, as investors refuse to buy asset-backed securities or refinance asset-backed commercial paper.
This happened during the financial crisis of 2008, when fears that toxic U.S. mortgages had been bundled into Canadian asset-backed securities caused investors to flee the market.
The federal government stepped in with a $12-billion program to buy asset-backed securities and provide the funding to lenders that the private sector would not. Only $3.7-billion from that program was used, but its existence helped restore confidence in the market, Mr. Danis said.
The CFLA is lobbying for a similar program. They are also pushing for their members to be able to access the federal government’s wage subsidy program. Because revenue is amortized over the life of outstanding loans, many lenders won’t yet show the required revenue drop. According to Mr. Rothe, a lot is at stake in the short-term.
“One member, in their hospitality portfolio they have 9,000 restaurants across the country. So if they go under, now you’ve got 9,000 restaurants, who are already struggling, that are going to have their loans called because the lender is gone," he said.
The survival of the independent finance industry is crucial for small- and medium-sized business, said Brent Keenan, president and managing partner of Canadian Equipment Finance, based in Breslau, Ont.
Independents are willing to fund deals that are too small or risky for banks. That’s become more important in recent years, Mr. Keenan said, as banks pulled back from riskier commercial lending after the 2008 financial crisis.
“All of that risk is now dumped onto our industries and our small independent companies, so that the next time a financial crisis hits, it will be guys like us that are the Bear Stearns," he said, referring to the U.S. investment bank that collapsed in the previous downturn.
“And the saying is ‘too big to fail.’ Well, they won’t care about us. They’ll just say, ‘Hey that’s a small operation,’ if it goes it down. But we’ve taken the risk out of the big banks."
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Mark Rendell