The nonperforming segment of household debt, while relatively small as a percentage of the $4.95 billion total household debt outstanding, is now becoming its own marketplace.
Several factors have contributed to a recent increase in nonperforming and charged-off debt. Banks and nonbank finance companies redirected their commercial lending in the early '90s toward the consumer market.
The growth of this segment was certainly fueled by the low interest rate environment and the mortgage refinance wave of the early '90s, which contributed to the temporary reduction of revolving debt during this time.
In pursuit of greater market share and increased receivables banks and nonbank financial companies have been pursuing two avenues for growth. First, they have staged a huge increase in preapproved mailings for credit card solicitations. Second, they've stepped up lending of all product types to subprime borrowers.
In 1995 alone there were about 2.7 billion credit card solicitations mailed to consumers. Although response rates averaged a low 1.4%, this still led to 40 million new accounts.
The average American now carries 10 to 12 revolving charge cards. As the balances on these cards increase and borrowers become overleveraged, any hiccup in economic circumstances can cause default on this debt.
The growth of the industry in lending to subprime borrowers has been exponential, resulting in drastically lower prices and easier terms to consumers as more lenders compete for customers.
The negative impact of the easing of credit to this segment of the population is increased defaults as many of these borrowers become unable to meet their obligations.
Bad debt and chargeoffs are on the rise. Along with loan growth card issuers are experiencing the effect of adverse credit selection as they moved across the credit spectrum for portfolio growth.
The rate of credit losses has been masked by three factors; rapid balance growth which keeps chargeoff rates artificially low; sales of high- risk portfolios by banks to nonbank financial institutions to avoid future chargeoffs; and a large increase in receivables generated by convenience users now using their credit card to earn frequent flier miles and similar benefits.
I believe that loss rates will continue to rise as new originations level off.
The accumulation of problem assets is driving lenders to consider alternative methods for dealing with bad debt. Many have moved into the secondary market to finance these assets.
As was the case with the original thrift industry crisis of the 1980s, and the advent of Resolution Trust Corp. in the early 1990s, a substantial secondary market is developing to purchase these assets as lenders seek to reduce exposure to charged-off assets, raise cash, and eliminate costly collection operations.
The secondary market for charged-off loans began in 1983 with a sale by Bank of America. The first auction of receivables was done in 1988. In the early '90s, the RTC entered the market.
There was anecdotal evidence of astronomical returns for early purchasers. This attracted capital to the distressed-debt market - investors generally teaming with collection firms in joint ventures.
Supply from the RTC was plentiful for several years until the agency dissolved last December. Private distressed debt is now being sold both directly by credit grantors and also through brokers.
The type of sale is either bulk sale or forward flow. Sellers typically dispose of archive accounts first, sell tertiary and secondary accounts next, and then enter into a forward flow relationship.
Buyers of nonperforming or charged-off consumer debt now fall into three general categories: those who buy and collect their own portfolios; those who buy and repackage to sell on a local or regional basis; and those who buy to securitize and service the debt.
Of the $4.95 trillion of consumer debt outstanding in 1995, there was a chargeoff rate of about 2.97% - or about $147 billion of chargeoffs as estimated by the Federal Reserve. In the first quarter of 1996 there was approximately $41.4 billion of distressed consumer debt (delinquent 90 or more days) held by issuers.
This does not include the several hundreds of billions of dollars previously charged off.
The private-sale market really developed in the early 1990s. The first year private sales topped the $1 billion mark was 1992. The market doubled in 1993 and then again in 1994, when there were approximately $4 billion in private sales.
1995 was a breakout year in the secondary market for charged-off loans, with over $5 billion in advertised sales, plus numerous negotiated sales and the final sales of the RTC.
The fourth quarter of 1995 was marked by downward pressure in pricing for these assets due to the tremendous amount of supply on the market. Prices have now stabilized and even increased from mid- 1995 levels.
Although the market is more than 10 years old, it is still inefficient, with the perceived values of packages still quite varied.
Determinants of the value of a loan include:
*The amount of time since chargeoff or last payment.
*The historical cash flows.
*The size of portfolio and average account balance.
*The location of borrowers and creditors.
*The number of times the loan has been placed with collection agencies and average settlement offered.
*How the loan was originated and its original credit quality.
*The type of debt.
*The availability of documentation.
*Provisions of the sale agreement; and the quality of data.
The market also is affected by outsourcing. As banks agressively cut back their staff, they are outsourcing many functions and the sale of chargeoffs dovetails with this strategy.
This may lead to increased supply and the availability of product much earlier in the delinquency cycle.
The consolidation of the collection industry is another factor. In 1994 there were over 4,000 collection agencies in the United States, many of them mom and pop shops. There has been a flurry of M&A activity in the past two years with the larger agencies buying out both smaller ones and each other.
The theory here is that the larger agencies can become more efficient, invest more in technology, and be lower cost service providers in order to increase market share.
Those who have invested in advanced collection technology are able to service more accounts with greater efficiency. This process is now under way and expected to continue.
The secondary market for charged-off debt, although quite young, has undergone major changes in the past few years. I believe this market will become more efficient and much bigger in the next four to five years.
The bank consolidation and outsourcing trends will serve to increase supply. The concurrent consolidation in the collection industry and the impact of greater technology will give certain players the opportunity to establish themselves as market leaders.
Credit issuers will concentrate on loan generation and the active management of early delinquencies. The secondary market will then be available to finance nonperforming assets on a quick and efficient basis.
Mr. DiPalma is vice president of Cohane Rafferty, a consulting firm based in Harrison, N.Y.