Few in the credit card industry would dispute that debt sales have become a bona fide recovery method. Everyone also agrees debt prices are at historically high levels.
But that is about where the agreement ends in the debate about where the market for debt sales is headed. The quick rise of debt prices has some players feeling anxious that the industry could experience a blowup similar to the one seen in the late 1990s, when the then-biggest company, Commercial Financial Services Inc., went out of business. After all, history has shown that buyers who overpay for debt put their operations at risk.
Others say the industry has learned its lesson over the last decade and debt-buying companies have matured. Recovery models are more sophisticated. Today's investors are deep-pocketed and patient, and they are more than able to ride out any troubles that could arise.
"There's some nervousness in the market," says William F. Herberger, executive vice president at the Wilmington, Del.-based card services division of J.P. Morgan Chase & Co. Herberger, though, does not share that nervousness. He believes issuers are being more choosy about whom they sell debt to, and they also are being careful not to rely solely on debt sales for recoveries.
Over the last decade, the sale of chargeoffs has become a standard practice among credit card issuers. Debt sales routinely are used as part of a recovery strategy that also includes collections by in-house staff and collections by outside agencies, paid on a contingency basis.
The run-up of debt prices generally has been good for credit card issuers. But it also recently has become a cause for concern. Issuers worry that buyers who pay too much for chargeoffs might be desperate to speed recoveries. This could lead to violations of collections law, which could tarnish the issuer's reputation or potentially lead to lawsuits.
As a result, some issuers are being choosy about to whom they sell their debt. Meanwhile, debt buyers say high prices have made it hard for them to make money. They worry high prices could put them out of business and possibly lead to an industry meltdown.
For-Sale Debt Grows
Wherever debt sales are headed, there is no doubt that the bad-debt market has grown. Bad-debt sales reached $80 billion in 2004, according to Garnet Capital Advisors LLC, a debt broker based in New York. The company estimates that debt worth about $72 billion was sold in 2003. About two-thirds of the debt sold is credit card chargeoffs.
The flow of new investment money into the debt-purchase market has increased as well. About $500 million, both public and private equity, has entered the market over the last two years, according to recent research by Stephens Inc., a Little Rock, Ark.-based investment banking firm.
Eager investors view bad-debt purchases and collections as a highly viable business model that generates healthy profits. Stephens estimates the publicly traded debt buyers average earnings before interest, taxes, depreciation and amortization, or EBITDA, margins and return on equity of 41% and 24%, respectively.
Three big debt buyers have issued public shares in the last two years. Private equity, though hard to track, has continued to flow into the industry. New money comes from an expanding pool of investors, including even hedge funds.
Chumbler attributes the recent run-up in credit card debt prices to the large amount of capital chasing deals-a view shared by others. "The influx of capital has driven up debt prices," he says.
Over the last two years, credit card debt prices are up about 25% across the board, multiple industry sources say. Research by Garnet Capital shows the price of fresh credit card chargeoffs at the end of 2004 had risen to 10.5 cents (on the dollar) from 7 cents at the start of 2003.
Even less desirable older paper-accounts that already have been through a collections process-has shown a dramatic increase in price, says Lewis DiPalma, Garnet's managing partner. For instance, so-called tertiary debt at the end of 2004 rose to 5.5 cents from 3.5 cents at the end of 2003.
The market experienced similar price spikes in 1993 and 1996, DiPalma says. But he draws a distinction between those periods, after which prices declined sharply, and today's situation. "Back then there were a few big players distorting the market," notes DiPalma. "Today there is a broad base of buyers."
Many observers agree that a large and diverse pool of buyers has reduced the risk of an industry blowup. Financial trouble at one or two buyers will not necessarily lead to a widespread price collapse, they argue. If troubles do arise among buyers, the more likely result will be consolidation.
Another factor that might prevent huge price declines is the maturation of the debt-buying industry, now a decade old. Industry conventions, makeshift affairs only several years ago, now draw well over 1,000 attendees. Also, debt buyers are broadening their own portfolios, purchasing other types of debt, from healthcare receivables to past-due cell phone bills.
Today's debt buyers are more sophisticated than buyers of the past, says Gregory M. Beer, group director in Las Vegas at HSCB Card Services, the nation's seventh-largest issuer of MasterCard and Visa credit cards with managed receivables of $18.4 billion. In particular, buyers have refined collections strategies, often retrading certain types of debt to partners, such as attorneys, that specialize in a particular debt category.
Beer also says many new buyers have a low cost of funds from their investor partners. Buyers are able to pay more for debt and yet remain profitable.
Buyers also have adjusted their recovery models. "Buyers can increase prices because they are looking at a longer liquidation curve," Beer says.
The industry norm for portfolio recovery is 60 to 72 months. Buyers generally expect to recover portfolio-acquisition costs in 18 to 24 months. But projected recovery periods are growing longer. Some argue the recovery model is supported by the growth of retrades, where debt is resold for a quick profit.
But stretching recovery periods could be dangerous, according to Greggory S. Haugen, senior managing director at Cargill Value Investment, a large investor in non-performing consumer assets based in Minnetonka, Minn. "If buyers are paying double what they did 18 months ago, that calls into question whether they will get their investment returned," he says.
Haugen believes these buyers are not pricing for risk, while overestimating cash flows. "That's where they'll get surprised," he adds.
Like other buyers and investors, Cargill's margins have grown thin. Haugen would not say exactly how thin, but he notes that Cargill has walked away from certain deals, or more aggressive buyers have outbid it. "We've lost some portfolios at (price) levels where our (collections) partners could not make them work, and we believe our partners are top quartile," he says.
Last year, Cargill invested about $360 million in consumer debt portfolios, of which 80% to 90% were credit card receivables. The previous year, Cargill invested about $450 million. Haugen expects the company to invest about $400 million this year, only because of some unique purchases.
Thin times for buyers have meant fat deals for sellers, the card issuers. Profits from the sale of chargeoffs drop right to the bottom line.
"The stars are aligned," says Brian Collins, senior vice president of bank card services at Memphis, Tenn.-based First Horizon National Corp.
Debt broker David B. Ludwig characterizes the mood among credit card issuers as a "happy" one. "We see a lot of recovery managers hitting their budget numbers by the fourth month of the year," says Ludwig, president at National Loan Exchange in Edwardsville, Ill.
But can there be too much of a good thing?
Maybe so. Credit card issuers are growing wary, carefully screening buyers and methodically employing multiple recovery methods to hedge the risk of a pricing collapse.
Several card issuers now sell debt on a private Web site operated by Ludwig's company. Buyers, who access the Web site with a special password, are pre-approved in advance of auctions.
HSBC Card Services recently marketed a portfolio of chargeoffs and conducted due diligence on 10 potential buyers. HSBC examined how well the buyers were capitalized, sources of funding, reputation and tenure in the debt-purchase market.
"We knew we would be comfortable selling to these buyers no matter who bought the debt," says HSBC's Beer.
Beer prefers to cultivate long-term relationships with certain buyers. "Some issuers sell in a fire action to a different buyer every time," he notes. "We are not comfortable with that approach."
Chase Card Services also has a stringent buyer-certification process. It includes an examination of the buyer's financial statements.
"This is not an open market," Herberger says. "We want to make sure we are selling to good credible organizations and that there are no legal ramifications."
Issuers worry that buyers eager to speed recoveries might violate collections law, or engage in practices that reflect poorly on the issuer.
"Yesterday's chargeoffs (represent) tomorrow's customers," notes First Horizon's Collins. "Legalities aside, you never want to sell to a group that treats people badly. That can stain your reputation."
Some issuers prohibit retrades so their chargeoffs do not get into the hands of a disreputable buyer. Such restrictions lower chargeoff prices though, industry sources say.
Not everyone believes sellers are cautious nowadays. "We are surprised when sales are made to buyers with little experience," says Cargill's Haugen. But high bids often win out, he adds, because the seller looks like a superstar, at least for the moment.
Meanwhile, issuers are regularly reexamining the role of sales in their overall recovery models. Issuers rely on a mix of internal collections, outside agencies and sales.
But how delinquent accounts are collected depends on the market. "We are constantly reevaluating and testing our methodologies," says Chase's Herberger. "As we see opportunities, we move from one channel to the next. It's an ongoing process."
At HSBC Card Services, sales are also part of a balanced recovery strategy. Fresh chargeoffs are sold on an ongoing basis, but the risk is reevaluated regularly.
"We are trying to mitigate the risk of a downturn," says HSBC's Beer. "If it got to the point where, from a net-present value standpoint, it would no longer make sense to sell chargeoffs, we would use other collection techniques."
So how long will high debt prices last? Guesses range from several months to several years.
'Top of the Cycle'
Pricing already has peaked, according to Andrew Zaro, chief executive at Cavalry Portfolio Services LLC, a debt buyer in Hawthorne, N. Y. "We are at the top of the cycle," he says.
Zaro predicts a fall in prices as buyers who paid too much for debt fall short of projections. He also believes the supply of credit card debt for sale could increase as banks look for ways to maximize profits amid rising interest rates and declining mortgage business. An abundance of debt for sale could lower prices in a business that is a slave to supply and demand.
"We wouldn't expect these high prices to last, as they are just not economically sustainable," Cargill's Haugen states. He expects some buyers will have problems, which will result in consolidation among buyers and prices returning to normalized levels.
"Although it is difficult to predict whether it will be in six months or 36 months, that's probably the end point," Haugen adds.
Others foresee price stabilization, or a nice gradual rise-at least that is what they hope for. Nobody really wants price jolts, either up or down, to upset the market.
For now, prices have yet to show signs of weakening, says industry analyst David Scharf, managing director at JMP Securities LLC, San Francisco.
Authoritative analysis and perspective for every segment of the payments industry
Authoritative analysis and perspective for every segment of the industry
Have an account? Sign In