The new year has started like a chatty breakfast after a good night out. For those involved in the consumer receivables industry - be it lender, purchaser, collector, or otherwise - the past several years have been euphoric times, like a good night out.
Rising house prices, abundant capital, high employment and low interest rates have made the last several years an exciting time to originate, acquire or service consumer receivables.
Other than the rise in personal insolvencies through individual voluntary arrangements and bankruptcies, it has been close to a 'Goldilocks' period.
Now 2008 feels different. It has started much more like the morning after and less like a continuation of the party and, like at most breakfasts after a big binge, there is much to talk about.
For the debt purchase industry, giving a prognosis for 2008 and beyond requires a clinical assessment of the fundamentals of the industry.
Debt purchasers use capital to acquire receivables that deliver a future cashflow stream. The good news thus far is that collections have remained solid. For the debt purchase market to remain stable, collections levels need to remain stable.
Stability of the market
Over the course of 2008, the stability of collections will depend on three factors: employment, house prices, and re-financing liquidity. So far, employment has been strong, house prices have been flat, and re-financing liquidity has contracted significantly. This contraction is important because many customers use re-financing liquidity to pay off their more expensive borrowings and their distressed borrowings.
A contraction of the debt consolidation market, which is currently occurring at pace, will cause a reduction in collections over time for purchasers of delinquent receivables as the liquidity required to make large repayments evaporates.
The next most important issue is financing. Debt purchasers need large amounts of capital to support their balance sheets. Historically, the large purchasers have been able to borrow up to 85% or 90% of that capital in the form of low-cost bank borrowings.
This has radically changed in the past six months. The global credit crunch has made obtaining low-cost bank debt financing for acquiring collateralised debt obligations extremely difficult. When raising debt financing was easy, debt purchasers could drive their total cost of funds into single digits. In today's market, debt purchasers will be lucky to maintain total cost of funds in the teens.
Worse still, some debt purchasers will not get funded at all. This is because the global financial system is very stressed currently. Large global banks are requiring equity injections. They are guarding liquidity carefully. As the securitisation market and other secondary markets for collateralised debt obligations are restricted, banks will be very hesitant to extend balance sheet lending to debt purchasers.
This is because defaulted consumer loans are not perceived to be strong collateral and banks, assuming they want to make any further balance sheet credit advances, can get good returns lending to borrowers who can provide prime and super prime assets as collateral. The rise in core LIBOR rates is a demonstration of this stress, and a shortage of debt financing for debt purchasers will be one result of these stressed conditions.
This higher cost of capital really dents the prices that debt purchasers can pay for charged-off consumer receivables. Even if collections remain relatively stable, which is a risky issue, the price that debt purchasers can afford to pay for these future cashflow streams is probably around 40% below 2007 levels, if debt purchasers are forced to make a bulk replacement of low-cost debt with expensive equity capital on their balance sheets. The good news is that equity capital is currently plentiful - it is just expensive and selective.
The other major risk to the debt purchase industry is from regulatory issues. In January, the government outlined possible changes to personal insolvency laws.
Also, in 2008, the review over banking charges - including overdraft fees and payment protection insurance - will continue and may create some concerns and confusion for customers and debt purchasers who inherit these accounts from the banks.
Hopefully, these regulatory issues do not create uncertainty or instability in the marketplace, but few of the regulatory issues being discussed have positive implications for debt purchasers.
Outlook for 2008
This assessment of the fundamentals leads to the following outlook for 2008:
Customers will focus on repaying secured loans (including mortgages), car loans, and credit cards where the customer needs to protect the collateral they have pledged (the car or the house) or where the customer will get future utility, like a credit card which requires repayment for the customer to maintain their right to borrow.
Unsecured personal loans lack both the collateral pledge and the future utility (in most cases) and so will likely rank at the bottom of the customer's waterfall of where they focus on repayment. This will create some noise in 2008 for banks and debt purchasers.
Selling debt will still remain a key strategy for the banks due to their desire to have liquidity and to release capital. However, the banks will spend more time in 2008 picking what assets to sell and managing those sale processes carefully to ensure they are getting good prices for their asset sales in more difficult conditions.
In summary, 2008 should be a year for everyone in the consumer receivables market to return to fundamentals. Assuming collections stay robust, house prices stay stable, and liquidity returns, 2008 could be an attractive year for all market participants.
If these fundamentals deteriorate, then 2008 will likely feel more like the morning after than a continuation of the party. As these things usually take longer than expected to become clear, it may be well into 2008 before the outlook and direction become apparent.
Hopefully, the fundamentals remain strong and all market participants enjoy another successful year in the market. Those are the fundamental conditions necessary for everyone to enjoy the chatty breakfast! CCR