By Michael R. Flock
As the pool of available credit portfolios has shrunk, many debt buyers have failed to diversify into other types of credit. Michael Flock notes that specialty lenders need to develop new solutions for a wider variety of portfolio asset classes amid increasing regulatory challenges that are changing the playing field.
The shrinking number of portfolios is not the only challenge facing the industry. Debt buyers are coming under more government regulation as the Consumer Financial Protection Bureau (CFPB) begins to enforce existing laws and review new regulations. In early November, the agency announced it is looking to write rules that may set new restrictions on originating creditors; require accuracy of documents shared between all collection parties, such as buyers and settlement firms; and update rules on how collectors communicate to consumers, including through text messages.The reduced availability of consumer credit during the past several years has created a domino effect for investors that purchase delinquent debt portfolios from lenders. As the pool of available credit portfolios has shrunk, many debt buyers and collectors lost revenues as they failed to diversify into other types of credit. For specialized asset-based lenders, these changes have narrowed the market to only a handful of investors that understand the risks of a tighter lending environment.
All of these changes mean that our industry is at a pivotal point — and one where specialty finance companies can be a catalyst to drive new growth. In the old business environment, specialty finance companies provided the capital and moved on. But to meet the changes in the industry, specialty lenders need to develop new solutions for a wide variety of portfolio asset classes in multiple sectors: credit card, auto, healthcare and student loans. They must understand how market conditions and increased regulation are changing the playing field, forcing debt buyers to develop a strong infrastructure to comply with regulations while also serving their clients. These funding solutions must meet those needs and enhance performance.
Recession Effects
Prior to the Great Recession, debt buyers bought portfolios from credit card companies for a small percentage of the original value, and assigned them to collectors. Dozens of hedge funds and commercial banks provided portfolio financing to medium and large debt buyers. Pricing and returns were at an all-time high. Debt buyers spent up to 13 cents for “fresh paper,” sold by the originating credit grantor. Gross collections were projected to average 2.5 to 3 times the investment over five years.
All that changed overnight. The implosion in the employment and housing markets had a devastating effect on portfolio liquidation rates and debt buyers’ returns. Many debt buyers who stayed in business were forced to take impairments on their inventory and restructure their loan facilities.
The 2008 crash radically changed the structure of asset-based funding; consequently, the financial markets for debt buyers have tightened dramatically. Only a handful of funds now finance debt buyers, and they no longer provide “blank checks” or blank lines of credit. Funds lending money in this space typically require their own level of underwriting and approval for individual portfolio acquisitions. Due diligence is deep and rigorous on each transaction.
To make matters worse, the steady decline of new credit card originations since 2008 has made the supply of debt portfolios extremely tight. With little paper to buy and financing hard to find, what’s a debt buyer to do?
Unfortunately, while new sources of financing emerged to fill this void, none appear to be a long-range solution. Some large industry buyers have created their own funds, but their due diligence and underwriting standards and processes can be onerous. Friends and families remain a trusted source, but can be fickle and usually can’t be sustained. Commercial banks have exited the market entirely, except for a few very large banks that supply very large debt buyers, and almost always with guarantees.
Regulatory Changes
As the U.S. economy rebounds, financial institutions once again are beginning to extend credit to a wider swath of Americans. Consumer borrowing increased nearly $19 billion in December 2013 — the best month in almost a year. We expect that with the return of credit availability, the need to collect from the bottom few percent of those portfolios will grow, providing new opportunities for debt buyers and collectors.
But this time around, the market for debt buyers will reach far beyond the traditional credit card portfolios. Other businesses, including automotive dealers, healthcare providers and even municipalities are embracing the benefits of selling delinquent portfolios to help increase liquidity.
Every year, more than $12 trillion in consumer loans are made, generating $317 billion in charge-offs for five asset classes: credit ($21 billion), auto ($8.5 billion), healthcare ($11.6 billion), mortgage ($30 billion) and student loans ($143 billion). And each year, there is between $150 billion to $200 billion in delinquent debt sent to collectors that recover between 20% and 25%.
But even as the economy expands and credit gradually increases, the debt buying industry will receive more government regulation and supervision. Up until 2011, the Federal Trade Commission enforced the Fair Debt Collections Practices Act (FDCPA), which is designed to eliminate abusive collection practices by debt collectors. But in 2011, the Dodd-Frank Wall Street Reform and Consumer Protection Act granted the CFPB the authority to issue regulations and guidance related to the law.
It didn’t take long for the CFPB to make changes. Once a consumer complaint is filed with the CFPB, the agency passes it on either to the concerned company or to another government agency. Companies have 15 days to respond to the consumer and the agency, and must address most complaints within 60 days. This means that most debt collectors will spend more time and energy addressing complaints.
Now that the CFPB has aggressively established itself as a major force with creditors, collections agencies and debt buyers, everyone is waiting for the CFPB’s new rules on debt collection.
In the meantime, when we look at the changes taking place in the market, what are the key implications for debt buyers? Here is what I see:
Originator Risk: Debt buyers will have to demonstrate that they can help reduce the debt issuer’s risk. Presently, the banks have made the strategic choice that the cost of government intervention is greater than the profits from selling debt. The debt buyer will have to provide the capital and expertise for strategic, infrastructure and controls needed to reduce the originator’s risk of outsourcing/selling. Being able to demonstrate compliance has the greatest value.
Process Alignment: Debt buyers will have to demonstrate that the culture, capabilities and systems are not only aligned with the issuer, but are transparent. Process alignment reduces the risk of non-compliance. This alignment allows the issuer to outsource their work. Key aligned processes have to be supported by systems and technology, which moves industry data and information from the issuer to the debt buyer.
Industry Consolidation: Debt buying companies of all sizes will have to scale and diversify asset classes. The industry is moving from being highly fragmented with low levels of entry to consolidating with higher levels of entry. The large debt buyers are consolidating and carving out market segments and products that are scalable. Middle market debt buyers will have to become nimble and find emerging markets and products.
The Economy: The cost of collections will continuously have to be reduced. The economy has put pressure on the industry’s margins. Debt buyers will need to use training and consumer analytics to increase productivity. An example is that Encore’s cost structure was lower than Asset Acceptance, which made Asset Acceptance’s portfolios more valuable to Encore. Debt buyers will have to use emerging technology, off-shoring and increased capacity to reduce their cost structure.
Social Trends: Consumer-centric collection strategies will have to be developed. These strategies will also include holding accounts longer to consider “positive life changes” for those debt buyers who have the willingness but not the ability. The industry leadership will have to continually demonstrate to Congress, the news media and consumers that the industry is not run by “bad guys,” and processes should include Six Sigma qualities.
Capital Structure: Debt buyers need to have a strong equity foundation for their new funding needs. Developing and aligning CFPB compliance will have to be balanced with the scaled purchase of diverse asset classes. A review of public-debt-buying companies demonstrates an increased investment in infrastructure changes. Building equity and balancing funding requirements will require a different set of financial competencies, especially for the middle market.
And, finally, what is the impact on financing? Here are key ingredients that any debt buyer should seek from his finance company:
• Cash-flow and returns that create sustainable growth, but also meet compliance regulations and the standardization of industry business practices
• The ability to scale the company to meet the needs of a consolidating industry and CFPB needs of sellers
• A long-term working partnership
• Long-term asset appreciation of the client’s portfolios. To achieve this performance level, the funding partner has to provide the debt buyer with added expertise for portfolio purchases, on-going performance and eventual exit
The changing marketplace will require a specialty finance company that has the capital and the business expertise to deliver value for investors and the debt buyer. Debt buyers will always need capital for portfolio acquisitions, but a strong financing arm will also offer the skills and information to guide buyers to generate long-term growth.
Michael R. Flock is chairman and chief executive officer of Flock Specialty Finance.