The bad-debt business is in the midst of a buyers' market where few are buying thanks to a sluggish economy, skittish debtors and a lack of available financing.
While prices began to sink nearly two years ago, remaining historically low ever since, more potential buyers are waiting. Some are betting portfolios will come cheaper later; others are unable to get the financing they need to make purchases; still others are struggling trying to liquidate high-priced loans they purchased before prices dropped.
With unemployment and defaults on the rise, large public buyers such as Portfolio Recovery Associates (PRA), Encore Capital Group and Asset Acceptance Capital Corp. (AACC) are among those waiting to see if they can snag portfolios at deeper discounts in the first quarter.
Industry experts say fresh credit card charge-offs were selling for as much as 14 cents on the dollar in early 2008, a 10-year high mark, and since then have steadily declined. As of late November, fresh card debt was selling for 4 cents to 7 cents on the dollar.
"What we have seen is 50% to 60% price declines off their all-time highs, which were probably in late '07, early '08," says Mike Varrichio, president at Global Acceptance Credit Co. (GACC), an Arlington, Texas-based debt buyer. "The larger percentage declines have taken place in the past six months or so as the economy has continued to struggle."
That trend, Varrichio and other buyers say, applies to all asset classes, not just credit cards. "They are all behaving the same way. Prices are coming down and liquidation rates are lower than in the past," Varrichio says.
Al Zezulinski at NCO Group Inc., says that despite the downward price trends there appears to be a gap between what buyers and sellers believe debt portfolios are worth.
"Fewer deals are coming to the market. Pricing expectations on the part of the buyer are not matched by the pricing expectations of the seller," says the executive vice president at the Horsham, Pa.-based accounts receivable management company. "The gap in some cases is so large that it's hard to bridge it."
NCO is the top collection agency in Collections & Credit Risk's 2009 rankings with nearly $1.5 billion in 2008 revenue. The company is the No. 10 debt buyer with $18.4 million in revenue from purchased debt in 2008.
Lou DiPalma, managing partner at Garnet Capital Advisors, a Harrison, N.Y.-based debt broker, says the debt buying and collection industries were hit with a "double whammy" in 2007 and 2008, a lack of available credit and unemployment.
"People lived on credit and home equity [refinancing]. That game is over. They can't take home equity out. How much disposable income came out of a consumer's house? A lot," DiPalma tells Collections & Credit Risk. "The home equity business is not coming back any time soon but we expect unemployment to ease."
Varrichio agrees unemployment has had a huge impact on the bad-debt market. He believes the U.S. unemployment rate, which hovered around 9.5% in the summer, is the best barometer for the debt-buying industry.
"Not only does it indicate what the charge-off rate is going to be, it has a significant effect on collection liquidations rates," he says. "If you go back and look, you will notice similar trend lines for the charge-off rate and unemployment rate. Charge-offs go up to 10%, unemployment is right around 10%. While the supply side is affected by that, the liquidation rates and the demand side [also] are affected negatively because consumers can't pay their debt if they're not working."
Liquidation rates have declined 40% in the past year at GACC, and between 25% and 60% for the industry, Varrichio says. "It's pretty significant."
Further compounding the problem is that those lower liquidation rates could very well be on higher-priced debt. Not long ago, debt buyers paid steep prices for some portfolios and had to record impairment charges against their results as liquidation became difficult and they fell short of their financial estimates.
AACC's year-ago second-quarter earnings fell way below analysts' estimates, as the company recorded an impairment charge of 10 cents a share. PRA had to take a similar charge this year.
Under accounting rules, debt buyers have to take impairment charges when their collections fall short of expectations or slip below their purchase prices.
DiPalma points out that buyers are losing money on much of the debt that was purchased at 14 cents because of higher unemployment and consumers' inability to tap the equity in their homes to pay off their obligations.
But the economy is cyclical, the consumer will recover and debt purchased today has a long enough shelf life to give buyers time to monetize the asset, DiPalma reassures. "If you look at it as a long-term asset, it's a good time to buy."
There is even potential that collection companies may be more profitable going forward because today's cheap prices will boost incremental margins on whatever they recover, according to analyst Larry Berlin at First Analysis Securities Corp., based in Chicago.
Purchasing portfolios at low prices helps buyers limit their chances of needing to book losses on them. They could see their profits soar even if they can collect only a small part of the purchased portfolios.
Investors, perhaps, are taking note. Encore, PRA and AACC all saw gains in their stock prices since January 2009.
While many Wall Street analysts may believe collectors are becoming a better investment, they do not expect near-term earnings to reflect that improvement because of impairment charges.
Mark Hughes, an analyst at SunTrust Robinson Humphrey, based in Atlanta, says it will be unusual to see an acceleration in performance in the near term because consumers are still so financially strapped.
The fundamental principle behind most product pricing is supply and demand, and the theory holds true in this case for charge-offs. Currently, supply is high and demand is low, as is pricing.
"The charge-off rate is hovering around 10% for most of the major banks. That's twice as high, and approaching three times as high as it's been in better economic times. In essence, we have twice as much debt coming into the market," says GACC's Varrichio. "On the demand side, you have a credit crunch going on so it has become more difficult for debt buyers to get access to capital at reasonable rates. The drop in demand and the increase in supply are driving prices down."
Fresh charge-offs that are selling for what tertiary debt sold for just a few years ago is a sobering indicator illustrating the depths to which the economy has plunged. But, whether debt prices have bottomed out depends on whom you ask. While some industry experts say pricing hit bottom and stabilized in August, there are others who have a different view.
"As long as [buyers] are asking something, there's not a bottom," says Louise Epstein, president of Austin, Texas-based debt broker Charge-Off Clearinghouse. "But I am not suggesting people wait. It never pays to get greedy. A good company can make a decent return by buying debt now," Epstein tells Collections & Credit Risk.
Varrichio agrees, adding that the comparatively low pricing becomes a future benefit to anybody buying debt today. At some point, he says, the economy is going to rebound and when it does, consumers will go back to work and may pay off some debt.
"We have been through this cycle before from 2001 to 2005," Varrichio says. "We experienced low prices and an improving economy. That's what I believe will happen in the next few years. Prices will stay low for the next couple of years and we'll have an improving economy."
There is the rub. It takes money to make money and consumers are not the only ones affected by the credit crunch. Debt buyers, too, have found it difficult in this economy to secure financing for debt purchases.
In the fall of 2008, NCO's Zezulinski would have expected debt sales to have improved by now, but "we're not seeing it," he says. "Clearly, at some point the market will come back. I don't know if it will come back the way it had during the golden years, so to speak, but we still have to see how the consumer economy revives itself before we can really make any solid predictions with regard to the debt buying market."
Spending on credit cards has changed dramatically as issuers cut back on the amount of credit they grant to consumers. Zezulinski says this is a long-term trend that will be felt in the debt buying industry for years, as there will be less credit card debt to be sold in the future.
This shrinking market "might mean prices go up," Zezulinski tells Collections & Credit Risk. "On the other hand it also might mean there are fewer buyers."
Industry experts agree debt prices will remain low, if not sink lower, as public creditors rid their books of bad debt by the end of the year, resulting in a flood of debt hitting the market. The earliest that pricing will rebound is during the first quarter of 2010, they say.
"You are going to see a lot of paper on the market in November and December and it is going to drive bids down because debt buyers can't bid on every deal," GACC's Varrichio says.
After pricing bottoms out, Varrichio expects some stability for the next couple of years, with prices rising as the economy improves. " I don't believe we will see a quick recovery," he adds.
DiPalma says if optimism in the economy continues, prices could increase 15% from their current rates going into the first quarter. However, DiPalma says, prices will not completely rebound to their 14-cent level.