U.S. debt purchasers face earnings headwinds over the near term from weakening collections, higher interest costs as new portfolio purchases are debt-funded at higher rates and the risk of portfolio write-downs, Fitch Ratings says.
Debt collections were down an average of 16.5% in 2022 for the three Fitch-rated debt collectors, and have continued to fall toward pre-pandemic levels as benefits from government stimulus fade and consumer financial health weakens. Collections that were already reduced by lower portfolio purchases in 2021 and 1H22 have been further pressured recently by lower-than-anticipated tax returns, with PRA Group (PRA) most negatively affected.
Debt collectors’ purchases are mainly comprised of delinquent credit card receivables and thus their business model is inherently linked to consumer health. U.S. credit card balances at US commercial banks have accelerated to a record high of $999 billion in 2Q23, non-seasonally adjusted, per the Federal Reserve Board.
Delinquencies have been rising after troughing during 2H21 as higher rates on variable-rate credit card debt has weighed on consumers. Total consumer delinquencies of 30 days or more for 1Q23 are up 18bps QoQ and 88bps YoY and to 3.0%, driven by credit card and mortgage loans. Late-stage credit card delinquencies (90-day +) have also risen this year, up 57bps QoQ during 1Q23 to 8.2% per the NY Fed, and are approaching pre-pandemic levels.
These trends should bode well for purchasing opportunities, with both PRA and Encore Capital having cited a more constructive supply market as financial institutions take a larger volume of non-performing loans (NPLs) to market. The full benefit, however, will flow through to earnings generation with some delay and remains subject to sustaining pricing disciplines.
The weakening economic backdrop and consumer balance sheet have increased the near-term risk of portfolio impairments. The recent vintages are more challenged in the current environment as they were purchased at high prices when NPL supply was constrained, while declining collection rates have led to underperformance against management expectations. Consequently, U.S. debt purchasers have indicated that they recently experienced negative marks on their estimated changes in recoveries.
Leverage is expected to increase as debt purchasers utilize borrowings to purchase portfolios. The pace of future deleveraging remains subject to an improvement in collections from portfolio purchases made in recent quarters. Leverage for PRA has been above Fitch’s negative sensitivity trigger in 1Q23, while Encore’s leverage has ticked up to 2.8x and is approaching Fitch’s negative rating threshold of 3x.
Rated issuers have proactively managed funding and liquidity by extending durations, reducing near-term refinancing pressure. On average, approximately half of outstanding debt at rated issuers is fixed rate (or roughly two-thirds with hedges), and the lack of debt maturities until 2025 protects issuers against near-term refinancing risks. Funding costs have risen in recent quarters given increased utilization of revolving credit lines for portfolio purchases, which are variable rate. Interest coverage has declined but should remain adequate against the assigned rating category.
Regulatory risk and scrutiny of the debt purchaser business model continues as the CFPB increases its focus on debt collection practices and consumer reporting violations. Persistent regulatory headwinds and ambiguity could continue to pressure earnings, but could also lead to portfolio buying opportunities from smaller players lacking scale.
Ratings constraints for debt collectors include the monoline nature of business models and limited revenue diversification, with leverage and funding diversity also important considerations. Failure to maintain leverage within targeted ranges could result in negative rating actions. Profitability metrics should remain within ratings sensitivities as issuers are focused on cost-cutting measures, with Encore and PRA recently reducing headcounts to right-size businesses. However, operating losses leading to covenant breaches, as recently seen with PRA, are negative for credit, and could constrain funding flexibility.
Source: Fitch Ratings
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