News & Views 10: Mar 10

 News & Views
 Debt Buyers & Sellers Resource 

These are well run public companies, which spent between them, over $161 million buying debt (over $4.4 billion face value) in the last quarter. They have efficient systems, good management, and a long history in the business. They also maintain substantial amounts of data and know how each portfolio they buy should recover. In addition, they pay far less for collections, than most debt buyers. (Some use oversees collectors to further reduce their costs). If the biggest companies in the business are averaging less than 38% annual returns (it is far less if you include the company that lost money), the small debt buyers who are in this business need to be doing business much smarter in addition to buying their inventory for less.

•  Collection Management Fees
• Portfolio Acquisition Fees (Broker)
• Monthly Coaching Fees
• Annual Membership Fees
• Interest Costs 

   

  The example also does not include any resale value of the portfolio. The example implies however that if you were to spend 4.5¢ to buy a portfolio, that you would get back 13.50¢ in collection returns. Given a simple statement like 3:1 returns, without providing a specific time frame, and without including all of costs, the ratio is of very little value.

   

  Looking at a Different Example

   

  As we have stated, many factors influence the actual returns for the debt buyer. The price paid for the file, the cost of collections, the recovery rate, the resale value, the broker fees and monthly fees for management or coaching in addition to general overhead expenses for the buyer, plus any interest the buyer must pay for the use of funds. So while the example below here uses real calculations, the results for each individual will differ depending on their overhead and interest costs.

   

  In the next example, we are going to use a portfolio of Fresh charge-off credit card debt. We will call this Bankcard A and we will assume that we were able to buy a $10.0 million National file for 4¢. (The 4¢ figure was near the low end of Fresh charge-off pricing as of the end of 2009 as reported by Kaulkin Ginsberg in a webinar hosted 12-2-09) For this example we will also include a 5% fee for acquisition of the portfolio. Since this is a Fresh charge-off portfolio, we assume we were able to secure a capable collection agency at 33% which included our professional portfolio manager fees. (We may have membership fees and monthly coaching fees but we will ignore those costs for the time being.) Let's assume that we did not borrow any funds to purchase the portfolio and we do not expect to compensate ourselves for any of our time spent in managing the portfolio.

   

  Let's also assume that our buyer has performed some research and has a good idea how the portfolio will liquidate in 12 months. Our buyer also knows that the resale value of the portfolio will diminish in time and has estimated the expected resale pricing for the portfolio at the end of 12 months. Our buyer has discovered that the approximate liquidation range for an average Fresh charge-off portfolio varies from 4.8% to 6.5% in 12 months, and that the resale value of their portfolio will be about 35% to 45% of the purchase price at the end of 12 months. Our buyer assumes that they can obtain the highest liquidation rate, and that they will also get the highest resale value for the portfolio. (This is not a conservative approach to the calculations for the buyer. A 5.5% gross recovery rate for 12 months would be a smarter number to use, but herein we are choosing to reflect the best case scenario.)

   

  Let's Run the Numbers

   

          Face Value of the Portfolio                   $10.0 million

          Purchase Price                                      4¢

          Broker Fees                                         5%

          Collection Cost                                     33%

          12 Month Recovery Rate                      6.5%

          12 Month Resale Value                         45%

          Brokerage Fee - Resale                        5%

   

  Purchase $10,000,000.00 x 4% = $400,000

  Broker Fees (5%) $400,000 x 5% = $20,000

                                                                        Purchase Cost = $420,000

   

  Gross Collections ($10,000,000 x 6.5%) = $650,000

  Collection Cost ($650,000 x 33%) = $214,500

                                                                       Net Collections = $435,500

   

  Resale Value ($400,000 x 45%) = $180,000

  Broker Fees Resale ($180,000 x 5%) = $9,000

                                                                       Net Resale Value = $171,000

   

  We now add take the net collections and add the resale value and subtract the purchase cost.

   

  Net Collections    $435,500

  Net Resale Value $171,000

                Subtotal $606,500

   

  Less Purchase Cost $420,000

                                                                       Gross Profit $186,500

   

  Total 12 Month Return ($186,500 / $420,000) = 44.40% return in 12 Months, or, to compare the numbers as we did for the public companies ($186,500 / $650,000) = 28.69% returns. (Considering that most debt buyers pay more for inventory and higher collection costs than the large public companies, this number makes sense)

   

  Note: If the buyer were to pay 4.5% for the file and 25% for collections, the return in 12 months is 43.89% using all the same criteria reflected in the above calculations. However, if the buyer were to pay 5.5% for the file and 25% for collections, the returns in 12 months are 25.13%. The returns will get worse the more that is being paid for the file, and these numbers do not include any monthly management fees, interest expense or overhead costs.

   

  Since the industry average is about a 30% annual return, this scenario appears reasonable for the buyer if they can hit the highest recovery rates and in fact resell the portfolio at the high end of its value. To achieve a 3:1 return as outlined earlier, either the one or a combination of things must change in the example.

   

  1. Paying less for the portfolio will change the returns. It's a great idea if a lower price can be negotiated. The 4¢ price outlined here is at the low end of what Fresh paper has been selling for if the buyer can even gain access at this price. Most paper is sold by brokers, resellers and through bids which try to bring the highest price.
      
  2. Improving the liquidation rates will have an impact on the returns. Unfortunately the recovery or liquidation rates are very low across all asset classes. The elevated unemployment rate which has hovered around 10% for some time is not forecast to improve greatly in the very near future. The loss of home equity, the tight policies of the lenders and a generally poor economy are not expected to recover anytime soon. Just because someone pays more for a file, does not mean the file will liquidate higher.
      
  3. Paying less for collections also will improve the returns. The rates used in this example are already at the lower end of the scale. (However, an argument can be made that higher returns can be generated for the buyer by paying the collectors higher rates and providing an incentive for the collector to work harder on your behalf.)
      
  4. Important Note: We very seldom buy Fresh charge-offs for our Loan Buyers Group because of the very low performance characteristics during our typical holding time. Fresh is attractive to the large institutional buyers with a much longer time horizon than our average individual buyer. Fresh from the major banks also has higher balance accounts generally, which may work well for a large buyers legal strategy, and Fresh typically has a longer shelf life because of the length of time remaining on the statute of limitations. Big buyers have access to large amounts of capital, often at very attractive terms and their shareholders have different expectations than the typical small debt buyer. Often times the institutional buyers will buy the larger national files on a forward flow to lock in pricing, and work those accounts for years using a combination of strategies, and may never resell the files. Some sellers also have placed restrictions in their contracts regarding when a file can be resold.

   

  Adjusting the Numbers and the Timeframe

  
  An alternative way to look at this sample portfolio, to see if you can increase your returns, would be to hold the file and collect for a longer period of time. 24 months is used in the following example. We should also look at the impact on the net returns by paying a higher price for the portfolio initially and a lower collection cost. So let us assume the following criteria in making a new calculation.

   

          Face Value of the Portfolio                   $10.0 million

          Purchase Price                                      4.5¢

          Broker Fees                                         5%

          Collection Cost                                     25%

          24 Month Recovery Rate                      8%

          24 Month Resale Value                         30%

          Brokerage Fee - Resale                        5%

   

  Purchase $10,000,000.00 x 4.5% = $450,000

  Broker Fees (5%) $350,000 x 5% = $22,500

                                                                                 Purchase Cost = $472,500

   

  Gross Collections ($10,000,000 x 8%) = $800,000

  Collection Cost ($800,000 x 25%) = $200,000

                                                                                 Net Collections = $600,000

   

  Resale Value ($450,000 x 30%) = $135,000

  Broker Fees Resale ($135,000 x 5%) = $6,750

                                                                                 Net Resale Value = $128,250

   

  We now add take the net collections and add the resale value and subtract the purchase cost.

   

  Net Collections    $600,000

  Net Resale Value $128,250

               Subtotal $728,250

   

  Purchase Cost $472,500

                                                                                Gross Profit $255,750

   

  Total 12 Month Return ($255,750 / $472,500) = 54.13% return in 24 Months

   

  Note: The collection costs will increase generally the older the file. In this example we used a 25% collection rate for the entire 24 months. The rate for the second 12 month period will be higher than the first 12 months and could be in the 40% or higher range, depending on many factors.

   

  From these examples, it is difficult to demonstrate a credible 3:1 return. If a buyer were able to obtain a Fresh charge-off at 3¢ and eventually collect 9¢ on the file that would be 3:1. All of the research that we have conducted and the experiences that we have had with files in addition to the numerous portfolios that we have modeled do not provide us with any validation that we can achieve those types of liquidation rates in a 12 month period of time.  

   

  Liquidation Rates

   

  Liquidation Rates are everything to the debt buyer, and good data can be very difficult to obtain. Many brokers will share how a file has liquidated before, but generally these numbers are hard to document and more typically, they may have been one or two good months of collections, and maybe some time ago. The industry publications discuss liquidation rates in such broad ranges that it is very difficult to determine performance history on most types of files. Other times liquidation rates are discussed as percentages of how certain types of products performed in the past such as; "liquidation rates are down 55% to 65% below 2008 levels" Most debt buying firms keep this information to themselves. Collectors however, may share performance data on files that they have worked.

   

  Finally, we do have to remember that the price we pay for a file and place for collection, does not determine how the file will ultimately liquidate. Two files with identical characteristics will generally liquidate the same, even if one file costs twice as much to acquire as the other. For the collection costs, if you were a collection agency, which file would your collectors work harder; the one that pays 25% or the one that pays 40%? If the 40% collector is recovering 50% more than the 25% agency, the debt buyer would realize about 17% more in profits by using the more expensive agency.

   

  Addendum:

   

  For our last example we will use what some may call the worst case scenario. We assume that we are buying a portion of a national file at 5.8% plus broker fees, and that our contribution to the purchase is $50,000. We are convinced that we want fresh files and that we are going to pay a monthly management fee of $1400. Our example buyer has decided to use the average collection recovery number of 5.5% to calculate their expected performance, and that they will be paying their collection agency 28%. Our buyer also assumes that they will collect for a year and resell they file at the highest price which they have determined is 45% of the purchase price.

   

  Let's Run the Numbers

   

          Face Value of the Portfolio                   $862,070

          Purchase Price                                     5.8¢

          Broker Fees                                         5%

          Collection Cost                                    28%

          12 Month Recovery Rate                     5.5%

          12 Month Resale Value                        45%

          Brokerage Fee - Resale                        5%

   

  Purchase $862,068.70 x 5.8% = $50,000

  Broker Fees (5%) $50,000 x 5% = $2500

                                                                              Purchase Cost = $52,500

   

  Gross Collections (862,068.70 $x 5.5%) = $47,414

  Collection Cost ($47,414 x 28%) = $13,275.92

                                                                             Net Collections = $34,138

   

  Resale Value ($50,000 x 45%) = $22,500

  Broker Fees Resale ($22,500 x 5%) = $1,125

                                                                            Net Resale Value = $21,375

   

  We now add take the net collections and add the resale value and subtract the purchase cost.

   

  Net Collections $34,138

  Net Resale Value $21,375

               Subtotal $55,513

   

  Purchase Cost $52,500

                                                                           Gross Profit $3,013

   

  Total Return in 12 months ($3,013 / $52,500) = 5.74% Gross Return

   

  Monthly fees of $1400 x 12 = $16,800 (Manager receives 32% return on our investment)

  Gross profit of $3,013 - $16,800 = a loss of $13,787 for the year

   

  If the initial investment amount was to double to $100,000, and all other calculations remained the same, our profit would also double to $6,026 which would only leave us with a loss of $10,774 for the year if we paid for the monthly fees. (The manager then would only receive a 16.0% return on our investment.)

   

  Buying more and more retail offerings will not improve our returns given the recent liquidation values of fresh portfolios. Portfolio pricing is far more important than collection costs in the calculation of returns for our portfolios. Excessive management fees, also negatively affect the overall performance of a portfolio, especially for the smaller buyer where there is less volume to offset these costs. Assuming that our own recovery rates will outperform the industry averages is probably not only foolish, but could potentially be a very expensive lesson.

   

  A final word about Fresh Charge-offs

   

  Some new buyers may expect that purchasing Fresh Charge-off accounts is like buying a new car. Good paint, the latest sound and navigation system, and the new car smell. They know that there will be some depreciation when they drive it off the lot, but hey, it's a new car. What new buyers must understand is these portfolios are nothing like a new car. This is charged off debt we are buying and it was charged-off because the customer did not pay on their account. Typically the customer did not pay because they could not, due to a loss of a job, health or family issues or plain bad luck or mismanagement. Seldom did the customer just wake up one morning and decide that they were just not going to pay their bills any longer.

   

  All of these accounts were worked by the banks before being charged-off and in many instances the banks offered very generous settlement plans prior to the accounts being charged-off. Bank of America was offering an 85% discount on the customer's credit card balance, with a payment plan of 4 months to 6 months to try to settle the accounts prior to charge-off. Other banks offered similar plans. When the customer could not take advantage of these options prior to charge-off, how can we expect that 30 or 60 days later we will be more successful. This is a different economy, and time will be required for customers to rebuild their lives and pay their debt. Maybe a year or two will be required for people to get back on their feet, we just don't know. But it is common for people who have fallen so far behind, to declare bankruptcy and if we happen to own those accounts, they become worthless. There is no exact prediction as to how many or when these portfolios may be subject to bankrupt customers, but they appear to occur with greater frequency within a year or so of charge-off, than any other time.