Many loan sales are new or nearly new loans, but some consist of seasoned loans, sometimes several years old. Because prepayment and default likelihood change as loans age, evaluating seasoned pools means accounting for that aging, and the effect can be material.
The loss-timing curve
Start with when loans tend to default. For most products, both prepayment and default rates rise in the early months and then reach a peak or plateau. New borrowers rarely refinance right away; near maturity many simply pay off the loan. Newly underwritten loans rarely fail, and near maturity the remaining payments rarely burden the borrower. In between, there are many reasons a borrower may stop paying.
From original balance to annual loss rate
For a seasoned purchase, think in annual losses, not losses as a share of original balance. Divide the remaining cumulative losses by the pool balance at that point, then by the weighted-average life (or better, modified duration). With a 30% CPR and 9.7% cumulative losses on a new pool, a buyer at point B, after most losses have occurred, sees lower annual losses than at any earlier point, even origination. A buyer at point A, after some paydown but before the steep part of the curve, sees higher annual losses than at origination: most losses are still ahead, spread over a smaller balance.
This assumes past-due loans are excluded at purchase, a standard LoanStreet practice, modeled by excluding losses expected in the next six months.
Six steps to an expected annual loss rate
First, build loss-timing curves for each asset type from your own history, originator diligence reports or rating agency data. Then:
- Estimate the pool factor (remaining share of original principal) from amortization plus a prepayment assumption.
- Divide the remaining loss share from the curve by the pool factor to get the loss factor.
- Estimate the pool’s cumulative losses as if the loans were new.
- Multiply cumulative losses by the loss factor to get losses as a percent of the current pool.
- Divide by WAL or modified duration (both on LoanStreet offering sheets) to get the annual loss rate.
- Subtract the annual loss rate from the no-loss yield to estimate loss-adjusted yield.
Most of this can be built once in a spreadsheet and reused.
The pattern to remember
Annual loss expectations rise slightly in a pool’s first months, level off, then decline as the pool seasons. As a rule of thumb, significantly seasoned pools can expect materially lower annualized losses than new pools and can be compelling purchases.