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The article appeared in the February issue of Collections & Credit Risk.
Bad-debt prices are down across the board yet buyers are having trouble capitalizing on the discounts as creditors retrench and rethink the bottom-line benefits behind selling.
From credit cards to consumer loans to mortgages, charge-offs and delinquencies are up in all sectors, a supply glut that has lowered the prices secondary buyers are willing to pay.
What's more, collecting from cash-strapped consumers is more difficult than it has been in decades thanks to the economic downturn, further depressing bad debt prices.
For potential sellers, the only sure business bet nowadays is that the amount they can expect to recover quickly by selling debt is falling.
"Selling charge-offs in a down market is a little like selling your furniture to make the mortgage payment. It hurts, but you have to deal with today's problem today," says Sean McVity, managing partner at debt broker Garnet Capital Advisors LLC. "For the banks, it's an agonizing decision."
Creditors are more reluctant to sell when prices are down but end-of-year balance-sheet pressures can convince them to do so regardless of price. Traditionally, creditors choose December to shed a large portion of bad loans. Anecdotal evidence from debt brokers and buyers indicates the year-end strategy did not die in 2008, although many say volumes slowed. The industry does not track total sales.
Says Phillip Slater, program manager at Ascend United, a Seattle-based broker of credit union debt, "Those who found themselves further from their recovery target probably sold despite the startlingly low pricing I've seen."
Newly charged-off card accounts are currently fetching 7 cents on the dollar, on average, dropping by more than half since peaking at a weighted average of 14.75 cents on the dollar in the first quarter of 2007, says Dave Ludwig, president and chief executive at debt broker National Loan Exchange Inc.
Ludwig predicts prices eventually will rebound and settle at around 10 cents on the dollar.
"So far the banks are being somewhat selective in what price they will sell at," he says. "We've seen banks that are not willing to take the market price" and prefer relying on "internal or outside collection efforts."
Whether banks can stick to the philosophy is in question, he adds.
"If they are heavily involved in subprime mortgages, the bank overall probably will be taking the losses where they have to raise as much money as they can," and their recovery departments "will have the directive to sell immediately to raise the cash."
McVity, who brokers debt sales for companies like Chrysler LLC, Wells Fargo & Co. and Navy Federal Credit Union, agrees that more issuers eventually may succumb to pressure to sell.
"We are seeing more senior management and corporate-level decision-making involved in the collections market, which is typically not the case," says McVity. "I see a lot of banks struggling, with poor earnings, with loan losses. Within collections at banks, collection managers don't want to sell their accounts if they're super cheap, so we see banks having slowed down their sales a lot."
However, "because charge-offs are a source of cash in earnings, there's kind of a movement to sell charge-offs to generate earnings," he says. "Collections guys don't want to sell them, but sometimes it's a management decision."
Brad Bradley, chairman of the board at debt buyer Asset Acceptance Capital Corp., based in Warren, Mich., added, during a recent conference call, "Sellers are sophisticated in the way that they look at managing their charged-off debt and they look at what their third-party agencies can recover for them."
Nevertheless, "with as much as $100 billion in credit card debt flooding the market in 2009, ... that's going to put some stress on the capacity to service that charged-off debt throughout the industry," he said. "And that can help lead to better pricing for debt buyers."
With recoveries dropping in the down economy, many issuers and creditors are responding by selling less inventory and boosting internal collection efforts instead, says McVity.
Sameer Gokhale, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., says that for the time being "a lot of the banks have put a lot of resources on maximizing their own collections" for the debt in their portfolios.
"They're scrubbing and working the portfolios a lot harder than they were in the past, realizing they were leaving a lot of meat on the bones," he says.
Brian M. Greenberg, managing director at Milestone Advisors LLC, agrees, "In the past few years, we've seen a swing among credit grantors from placing charged-off accounts with third-party agents to selling the accounts as pricing increased, but in the past year the pendulum has begun to swing back the other way again, as pricing has come down."
"Credit grantors will continue to rebalance their recovery strategies to maximize returns from internal collections to third party placements and debt sales," he adds.
Still, selling will remain an important part of most issuers' account exit strategy, he says. "They simply need the liquidity, especially in this market."
Strategies vary among issuers and creditors. American Express typically does not sell charge-offs. "We make that decision by regularly assessing the economics of handling them ourselves versus selling," but "we certainly have invested in the collections area of the business," says Joanna Lambert, a spokesperson for AmEx.
Discover Financial Services prefers internal collections to debt sales. "We do very little sales of charged-off accounts," Roger C. Hochschild, Discover's president and chief operating officer, said last fall. That policy "has not changed within the last year" to 18 months, though Discover continues to use some third-party collectors.
JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc. and Wells Fargo would not discuss their respective debt-sales and account management strategies. Capital One Financial Corp. did not return calls.
Many issuers have shown a greater interest in "forward-flow" contracts to sell a set amount of debt and "lock in better pricing" as the rising supply of charge-offs continues to weigh on pricing, Bradley said.
"Over 90% of our purchases in terms of dollars invested during the third quarter were from forward-flow arrangements, a significant increase from historical rates for us" of 30.3% in the second quarter and 15.4% a year earlier, he said. "Even though the prices are attractive today ... we believe pricing will become even better over the next six to 18 months."
But with concerns about declining liquidation rates and the economy, buyers more often moved away from 12-month forward-flow deals in favor of three or four month contracts, says Al Brothers, a senior executive at Cavalry Investments, a debt buyer in Hawthorne, N.Y.
"Buyers can't pay 10 cents or more on the dollar for charge-offs anymore because they're not going to be able to collect enough to recover expenses. They don't want to take the additional risk of entering into a longer forward-flow contract," he says. "Margins for buyers really haven't improved and that seems to be widespread across the industry."
There is no consensus among insiders about how the debt-buying market will look in 2009.
Greenberg, who arranges mergers and acquisitions of debt-buying and collection firms, says many banks, credit issuers and debt buyers are "hurting these days and seeking resolution to their liquidity issues," so now is "a very good time for well-funded buyers to acquire assets under terms that, until now, have not been possible. We are seeing many attractive opportunities in this market."
Buyers count on financing to support their purchases (see cover story on page 20), but access to credit is limited as the credit markets wither in the wake of capital liquidity woes straining most large financial institutions. In other words, banks have little money to lend and that is not expected to change in early 2009 – or probably long after it.
For a typical buyer, "it's not a bad time to be buying but it's a tough time to get capital," confirms Edward J. Barton, chief executive officer at B-Line LLC, which specializes in buying bankruptcy debt. "Day to day what we've done is dial back our purchases to preserve the capital that we've already committed."
Adds Irving Levin, chief executive at Genesis Financial Solutions Inc., a debt buyer in Beaverton, Ore. "The leverage has gone ridiculously expensive. It has a huge [downward] impact on pricing and on what I can bid to hit the same hurdle rate if I'm a buyer."
At Asset Acceptance, one of a half-dozen publicly traded debt buyers, Rion Needs, president and CEO, confirmed during a conference call that the company is hoarding capital until prices fall even more.
"Our choice in this market is don't play at all or play selectively about what you think are really good opportunities," he says.
With some larger buyers choosing to wait and gamble on when prices will bottom out and just as many would-be sellers holding tight, the state of the debt-buying industry might just boil down to which side blinks first. CCR
