News & Views 15

Editor's Message As Fall hits the air there is continued confusion about debt pricing in the industry, so we've made pricing the main theme of this edition. Gary leads of with an analysis of how the Public Companies are doing and what prices they are paying, in The Public Companies - 2^nd Quarter 2010. He follows that with challenge to the logic of higher pricing in a piece called Paying Too Much is a Fool's Game.  Jill addresses the debt Buyer perspective in this economy in her editorial, Frustrations Mount for Debt Buyers. And Gary includes his Charge-offs chart for July in Charge-offs Decline and Unemployment Rises.

The Public Companies - 2nd Quarter 2010

Every quarter we assemble the data from the company reports filed with the SEC for the publicly traded debt buyers and compare the results to previous quarters. NCO which is not a public company does report on some areas of their business so those results are included as well.

 

In the second quarter of 2010, two of the public debt buyers show a sharp increase in gross collections. Portfolio Recovery Associates (PRAA) increased from $83.4 million in the first quarter to $128.4 million in the second quarter, while Encore Capital (ECPG) showed an increase from $87.5 million to $156.8 million in the same period. NCO Group dropped from $413.1 million in the first quarter to $386.2 million in the quarter ending June 30. Gross collections for Asset Acceptance (AACC) were essentially flat for the quarter.

 

 

 

Portfolio purchases declined for PRAA in the second quarter and there was very little change in purchases by ECPG. First City bought some new real estate portfolios which averaged about 56¢ on the dollar. AACC increased purchases from $29.8 million in the first quarter to $48.6 million in the second quarter and ASTA Funding bought $100,000 in new loans for the quarter.

 

 

 

 

Portfolio pricing was the largest surprise. We had heard so much about price increases over the past 6 months that when the most recent reports came out we were expecting to see higher purchase pricing for all of the public debt buyers. That was not the case at all. In fact all of the public companies paid slightly less for portfolio purchases than the first quarter of 2010.

 

 

Impairment charges were virtually unchanged for the quarter with the exception AACC which increased from $0.1 million to $6.8 million and Encore Capital which decreased from $7.8 million to $2.8 million for the quarter.

 

 

Paying Too Much is a Fool's Game 

Credit card recovery rates have trended down for the past nine months, yet the price to acquire portfolios has increased during the same period. With this divergence between the cost of the inventory and the recovery through collections, the overall profitability of the typical call center model has declined throughout 2010.

 

The banks have held more than half of the inventory of fresh charge-offs from reaching the market during the past year. This has put upward pressure on the prices for fresh paper that reaches the larger buyers and brokers who were not under forward flow agreements. This fresh paper is trading on a spot market price which is significantly elevated from the forward flow pricing. As small amounts of fresh paper find desperate buyers, new baseline pricing is being established which has no correlation to the real value of the paper as it will collect in the current market environment. Higher pricing for fresh has also raised the price of other ages of paper, again without any relationship to the collect-ability of the assets.

 

The public debt buyers are actually paying 3% to 10% less for paper in the most recent quarter, with prices varying from 1.5% to 5.2% and the volume of purchases has increased slightly. The fresh paper that has reached the spot market for sale has increased from about 5.5¢ at the beginning of the year to over 7¢ recently, and there are sales that have occurred at even higher prices. This is an increase of over 25% in the acquisition price and the recovery rates for the same time period have actually fallen about 21% for fresh, one agency and two agency paper, and over 35% for three agency paper in the same time frame.

 

Banks Holding Back

 

The banks have held back from selling their paper simply because they have viewed the practice more profitable than selling at current market price. After charge-off, the banks may indeed be getting better recovery rates by using outside agencies instead of their in-house collectors, and since they have so much volume, they can put pressure on their agencies to work the accounts for lower contingency fees.  The most recent quarterly report from Bank of America shows that the recovery rate of their post charged off accounts was 4.71% for the first six months of 2010 and 5.17% in the most recent quarter. (There is no breakdown available as to what percentage of these recoveries is coming from debt sales verse collections of their own accounts. There was also no mention of the starting volume of accounts or the time frame that they worked the accounts). This is a significant increase over the 2.56% recovery rate they reported for the same period in 2009 when they were selling far more of their inventory. So while the strategy may appear to be working, we thought it would be useful to compare the alternative for the current market environment.

 

In the most simple analysis, if the bank could get more than 5.17% on the sale of their charge-offs, they would make a better return. Consider that to achieve their current rates from collection efforts, the bank is collecting these accounts for a long period of time and is spending internal resources to manage the collections. Even with sales prices of less than 5% the bank would probably have a better rate of return than their current operating model. The problem for the bank has been maintaining the higher prices. With the amount of inventory that they are carrying, and will continue to carry, the market price would probably fall well below the 5% price since the recovery rates do not support a higher price for the accounts.

 

The other consideration is that because all of this inventory of fresh charge-offs has been off the market, when the resale of these accounts is offered they will be in very large lots where there are fewer buyers and the price for the seconds and thirds being sold will drop. That drop will be a good thing for the debt buyers. With recovery rates ranging from less than 3% for tertiary paper and about 4% for one agency accounts as of the second quarter of 2010, lower pricing is justified and may well keep more buyers in the game. Buyers need to be profitable to attract capital and sellers need buyers. Artificial scarcity may have provided a short term boost to the banks but it will not be sustainable because of the shear volume of accounts that are being held will have a significant impact of the secondary sales pricing which ultimately will dilute the value for the banks.

 

Price Relationships

 

Many sellers have tied the pricing of various types of older agency paper to the price of fresh charge-offs. While the concept makes very little sense from a buyer's perspective especially when the supply of fresh paper is being artificially manipulated, it is widely practiced. The price of the paper should be tied to what it is currently worth based on the estimated recovery rates over a specific future time frame.

 

For example, if a buyer believes that they can collect 4% gross on a product in a year, and estimates that they can resell the file for 50% of the purchase price a year later while paying 40% for collections, they can back into a purchase price knowing what level of return they will expect. In this example, paying 3% for the file would produce a 17% return at the end of 12 months using a call center model. The 4% is a one agency recovery rate for the current 12 month period. This 17% profit for a year of work and risk, assumes that the future recovery rate will be at least the same as the previous year. But buying prime paper today at 3¢, is rather difficult. This is one reason we are seeing so much more emphasis on a legal collection model, where the accounts are screened for assets and sued.

 

Just because fresh pricing rises, does not justify all ages of paper to rise in concert. Some sellers, who may have paid too much for their paper, are just trying to get whole on a transaction during resale, by using the overpriced fresh paper price as an excuse. A rising tide floats all ships mentality misses the underlying facts that the fresh paper market is being artificially manipulated because more than half of the volume of charged-off accounts is not on the market. Smart buyers will only pay what these files are worth and that is primarily determined by how well they collect. Paying more than they are worth is a fool's game and that fool will have a very short life in this business.

 WHO IS THE NDAC?

Editorial
Frustrations Mount for Debt Buyers

It is clear that even when you think you have a rudimentary understanding of economics, and believe you are wise to the lessons that history has taught about supply and demand, recessions and high unemployment, there are always new twists to the plot as the modern dynamics of politics and competitive maneuvering unfold, effecting the outcome in ways that are predictable only in hindsight.  Such is the case with frustrated Debt Buyers who hadn't anticipated that a glut of charge-offs could actually lead to a shortage of product.  With the Banks stockpiling their charge-offs to avoid current market pricing, the demand has many Debt Buyers purchasing accounts for more than they are worth in this struggling economy.  The fact is that collections are down so low that right now, that the returns for most business models simply do not justify the pricing.

 

Understanding the Banks

 

While many people in the Collection Industry were born in the banking world, and therefore have a good handle on Bank Speak and on understanding Bank Think, as an industry we are much less sophisticated.  At this time many of us are wishing we had taken the course on "Economic Theory and Artificial Pricing" so we can at least be using the same play book as the banks are. 

 

On August 16^th, Collections and Credit Risk reported that debt pricing had reached up to 12% for fresh Charge-offs.  While it appears that this amount was indeed paid for some Pay Day Loans, our sources indicate that Fresh Credit Card debt is still holding at the 7-8 cents range.  None-the-less, talk of rising prices has smaller Debt Buyers worried.

 

With significant indications that the sputtering economic recovery may be faltering and that this may not be a typical recession, the question is, are the Banks setting the bar too high?  A few of the larger Agencies have posted strong profits, while the largest posted a loss for the fourth straight quarter, and it is rumored that several more agencies are teetering on the edge of solvency, lagging fall out from firms having purchased inventory at prices considerably higher than it subsequently was worth.  Higher pricing with poor recoveries may only make it harder for many to stay in business, an unsettling thought at a time when the entire industry should be thriving.

 

From the Banks' perspective, however there is simply no incentive to sell charged-offs in a down market and one can certainly understand their reluctance to let go of accounts at what they deem to be fire sale prices. Traditionally, in fact, they have ramped up their internal collection efforts as the market has softened, releasing accounts as the prices picked up again. This time though, the glut/recovery balancing act for the banks is potentially more explosive than in previous recessions, in that very poor recovery may not offer enough compensation for holding back charge-offs with the mother of all gluts breaking down the door.  This leaves one to wonder if the shear volume of charge-offs may just force their hand.

 

Changing Landscape

 

Further complicating matters is the fact that there are some unknown quantities right now for Debt Buyers, as the industry landscape is changing on many fronts. And, some of the things that are changing are things you couldn't have predicted a year or two ago. The reality is that debt is harder to collect than ever before, the main reasons being prolonged unemployment, and that people are simply harder to find. Skips, which have always been an issue to deal with, have now become a major part of most portfolios, with one collector confirming to us that over 90% of their accounts are skips.!!!  It appears, too, that customers are certainly more savvy about how to dodge debt collectors, the increase in cell phones contributing significantly to this little game. Many have become proficient at playing the victim card to their advantage through consumer rights activists or eager attorneys who have refined the art of securing speedy settlements from collectors.  Others have been encouraged directly not to pay their debts by a small but vocal minority offering advice to debtors.  The growing trend away from taking personal responsibility for debts incurred reflects a disturbing decline in ethical standards that has without doubt impacted recovery rates to a significant degree.  

 

This problem is exacerbated by current legislation, which in many states is poised to potentially undermine the long term value some kinds of debt, underscoring the importance of not spending more for a product than it is actually worth. In fact, if this mentality becomes more prevalent, it could ultimately become a game changer!  No one wants to get caught having paid too much for product, with the recent crisis still fresh in our minds that left so many holding the bag.  By making it harder for Collectors to do their job, by requiring full media from the beginning of time, by shortening statutes, and in many States by forgiving debt entirely when statues run out, new laws may indeed undermine the long term viability of many kinds of debt portfolios and end up forcing heavier handed collection strategies.

 

Since there is very little on the horizon to indicate that it will soon be any easier for consumers to settle their debts, in all likelihood recovery rates should continue to be on the low side for quite some time.  One thing is clear and that is that we are in uncharted, murky waters and the only thing we can count on is that things will evolve in ways we cannot predict and have yet to fully understand.  With any luck market forces will bring pricing back in line with portfolio collections.

 

You can now find all our past articles online on our website

 

www.crescentbayfinancial.com. 

 

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