Good News, Bad News: Credit and Collections

I had the privilege of meeting face-to-face with about 150 senior credit and collections executives recently in Washington, DC, while attending and serving as a moderator for two panel sessions at the Equipment Leasing and Finance Association (ELFA) annual Credit and Collections Management Conference. The conference was an eye opener for me, revealing current strategies and emerging best management practices that are being adopted by creditors. The three-day event provided a great opportunity for me to get a better understanding of the issues and potential concerns within the lending community.

Even in a period of unprecedented opportunity and growth for creditors, I learned, steps must be taken to prepare for a change in today's lending climate.

Beware of Complacency

One question many creditors are asking is: How do we stay ahead of the curve in credit and collections management, even with an uptick in new business volume? Is the real danger less that the current economy will slow and more that complacency today is preventing us from preparing for that slowdown?

I recall that at last year's ELFA credit management conference, everyone was talking about regulation and the uncertainties surrounding the long-pending changes to lease accounting rules. What a difference a year makes ' especially a year of very strong leasing and lending opportunities. This year, regulation was not the primary focus. Everyone, it seemed, had dealt with the regulation issues that were affecting their portfolios and resolved them. Instead, the most prominent topic seemed to be the strength of the recovery and the quality and quantity of deals being inked.

But beneath this celebration was the realization that success almost always presents its own unique risks for failure. Many I spoke with felt that the most reckless approach is not taking the time to evaluate those risks and plan for them.

If the consensus was that business seems to be booming again and increases in new businesses are at an all-time high, there was far less agreement on what this might mean. Are defaults going to pick up? Is there another recession in sight? How should creditors plan for the inevitable change from the current business climate?

Optimism remains high among lenders. No one argued that another visible recession is in sight, although many admitted they had never experienced a period like that they've seen since 2009. The sentiment seems to be that the current climate is just part of a cycle, and we are moving through it. New business is continuing to materialize, and charge-offs are at an all-time low ' under 1%, according to economist Beth Ann Bovino, the U.S. chief economist at Standard & Poor's Ratings Services, based in New York, and a presenter at the conference.

So, with charge-offs at an all-time low, why should lenders be worried?

Understanding How We Got Here

Savvy creditors know that an end to the current strong business climate is inevitable. And this means that defaults should be increasing in 2016, 2017, and going forward. The reasons for this are based on a cycle that most lenders are well familiar with. Those who have been through a downturn know and understand it fully.

To understand it, let's take a quick look at how we got to where we are today.

First, during the 2007 through 2008 downturn, lenders cleaned off their books. Faced with ever-growing numbers of defaults and increasingly futile collections efforts on their mounting delinquent accounts, many creditors ended up just charging them off. In the best of cases, it was a pragmatic approach to the then-current climate; in the worst cases, there really were no other viable options.

While there were a lot of charge-offs in 2008 and 2009, and even headed into 20010, most lenders' books were cleaned up or almost cleaned up by then. During that period when the economy was in a nose-dive, businesses were failing and certainly weren't looking for new equipment. People weren't starting new businesses, either, so there weren't startups or entrepreneurs looking for new equipment. Moreover, the companies that were surviving were just holding on, so they weren't looking to lease or buy new equipment.

Should anyone have been out and about looking for new equipment back in 2009 or 2010, they would have needed very strong credit before any finance company was going to lend to them because creditors were still reeling from what they had just experienced with so many charge-offs and so much bad debt.

When lenders weren't putting the usual quantity of new deals on their books and the deals they were booking had A+ credit, they knew that eventually there weren't going to be charge-offs on the portion of them that would end up as bad debts. Again, savvy creditors understand that you need a steady flow of new business to see the inevitable fall-off on the back side. So that's what happened: Charge-offs plummeted simply because so few new leases and loans had been written during the downturn and the ones written were solid.

At my company, which is focused specifically on buying charged-off leases and loans, we saw first-hand that the writing was on the wall and knew that this was a cyclical phenomenon. With the default rate dropping, we started to buy all the charge-offs we could because we knew we needed to expand our business right then, at that optimal point in the cycle. We knew charge-off rates were destined to plummet with the low volume of new equipment lease business being conducted.

I'm glad we acted while there was still an opportunity. Defaults and their subsequent charge-off rates have been under 1% since about 2010. That's five years of an all-time low rate for charge-offs.

Which Way Out?

The path out of the last downturn has been relatively easy to see for those lenders who have been down it before. Many at the conference who have experienced previous recession cycles recognized a familiar pattern reappearing ' once the bottom had been hit.

Over the past several years, once lenders got comfortable again and felt they needed to add new deals and the economy started to improve, businesses saw opportunities and became entrepreneurial again. It's a simple truth that growing businesses need equipment, and they're willing to invest in it in order to continue to grow their business and generate revenue. In meeting this demand, it didn't take long for leasing companies to start getting business back on their books again.

And with this new influx of business came the foundation for the predictable uptick in defaults that we are just now starting to see.

Yes, it has taken a while, but today, lenders and lessors have gotten back on their books the quantity of business they had before the downturn. If they've got a five-year lease, when would an obligation that old necessarily go into default? Not quickly, in most instances. Consequently, it's been taking time to churn through all the new business that's been booked since 2009 to where it's soon going to be seen in the rate of charge-offs. Will it be a year or two before the uptick in defaults really becomes apparent? As far as projections, no one really knows, but Beth-Ann Bovino did show conference attendees data indicating there's an increase underway already.

Now, some people will say, “Uh oh, there's an increase in charge-offs. That's bad, right?” But overall, the feeling is it's not necessarily bad; it's just the natural result of a certain percentage of the unusually large volume of new business falling into default.

Gaining Perspective

When creditors sign the large volume of new lease or loan business they've seen since 2009, they're surely going to generate a certain volume of delinquent accounts that end up being charged off. Even though it might look scary to have any rate of charge-off, even under 1%, an average charge-off rate back in the day was 2% to 3%. Think about it: That's a 200% to 300% increase over what it is now.

The truth is, if leasing companies have a 3% charge-off rate, this means 97% of their overall portfolio is performing well. That's a tremendous success rate when you look at the big picture. Remember, 3% is a very small percentage to have charged off, but it's still a substantial portion of business that needs to be dealt with by the work-out department or, eventually, for some companies, sold to companies like mine that buy charged-off paper. The bottom line is that leasing companies can still be thriving tremendously with a 3% charge-off rate because 97% of their portfolio is still performing successfully.

For the most part over the years, it has been the die-hard, hangers-on businesses, the ones that applied for and obtained credit, that kept funders active because their lease or loan approval rate has been exceptionally high as well. Does that mean that lenders are loaning to pretty much anyone who applies? Or is it that the stronger companies are the ones that have survived and are still around to merit and receive funding?

It appears to be that the stronger companies are the ones that are applying for equipment leases, and now, as the economy continues to get better and down-trodden companies re-establish their footing, find their niche, and get entrepreneurial again, lenders are going to have more new businesses to fund. In addition, maybe companies that are not as strong but suddenly are feeling more confident in their businesses and their need for new equipment will be applying, as well. This scenario may bring down the overall loan or lease approval rate a little bit, but it will get things back to normal ' or at least to where it was when times were good and everyone was happy.

While the prospect of rising charge-off rates should not necessarily be a cause for alarm among lenders, being unprepared for it could be.

Bolstering Collections Capability

Conference attendees learned about the results of a proprietary survey TBF Financial conducted on behalf of the ELFA regarding collections departments within leasing companies. TBF surveyed them starting in 2009 and was able to track developments in their collections efforts as the recession receded. Given the overall decline in the number of charge-offs, many leasing companies were finding their in-house collections departments underutilized and unprofitable. In many instances, personnel and resources in these departments were being reallocated ' if not cut altogether. The ELFA wanted to know what percentage of leasing companies were maintaining their in-house collections capabilities. Were they adding staff? Were they having a hard time collecting? Were they using their collections department to generate additional income?

TBF's survey covered a wide array of leasing companies with collections capabilities. Not surprisingly, most of the respondents were banks, primarily focused on small-ticket leases. Participants were split approximately 50/50 between captives and independents.

Respondents were asked to list the default rate of their portfolios. They were then asked to provide their collections success rate, which proved to still be very low. Some 20% of survey respondents said they had a 1% to 5% increase in core collections over the past year. But one of the more interesting observations from the survey was that many respondents admitted having a difficult time hiring new people, and they were often unimpressed by the candidates they did find for their collections positions. A common sentiment was that collections departments are not perceived as “sexy,” and the overall impression of the collections field is not a good one. Apparently, candidates for collections work do not perceive it as a stepping stone or a great place to start in finance.

But the most surprising discovery TBF made is that, despite the recognition that defaults are expected to increase, a majority of companies were not committed to adding more personnel or resources to their collections department. Instead, they apparently plan to do more with less staff. Survey respondents admitted they were concerned that their collections capabilities will not be prepared to deal with a rise in defaults that will end up as charge-offs. Many have resigned themselves to the notion they'll be scrambling and will just have to deal with it.

The survey also revealed that recoveries are at an all-time high. In the 30-to-60-day timeframe, ELFA data show the default rate is up, but leasing companies end up collecting on most of those accounts because companies are increasingly allowing their accounts to go into default. While it used to be standard practice that accounts that were past due by 15 days were immediately contacted so they didn't hit the 30-day mark, leasing companies now are letting their lessees hit that 30-day mark, calling them on day 31, and telling them they're late and must pay a late fee. This strategy has been successful for many companies in generating late-fee revenue via collections. Even though the 30-day default rate is up, almost all accounts are getting collected within 90 days, keeping the overall charge-off rate under 1%.

Certainly, no one at the conference could predict when our current period of unprecedented opportunity and growth for creditors might slow, end, or change direction altogether. But the savviest lenders seem to recognize this uncertainty and are taking steps to minimize the risk associated with the inevitable change in today's lending climate.

Brett Boehm is a principal of TBF Financial, LLC, which serves the equipment leasing and finance industry by purchasing portfolios of charged-off small-ticket leases and loans to help individual companies recover cash quickly and improve their account balances. The Deerfield, IL-based firm is an active member of the ELFA, and Boehm has served on its Credit and Collections Planning Committee since 2012.

The robust economy's low default rate has many creditors rethinking their collections practices and capabilities. But what should be their strategy for when the good times end?

Since emerging from the recession in 2009, lenders have enjoyed a nearly unprecedented opportunity to add new deals to their portfolios of loans and leases. Meeting the recovering and expanding demands for equipment has meant financing opportunities have been abundant.

While at face value, an expanding economy is almost always a cause for celebration, lenders today are finding today's strong growth can present its own unique challenges. Many are finding trends developing that must be recognized and planned for now ' before the inevitable change in the business climate occurs.

I had the privilege of meeting face-to-face with about 150 senior credit and collections executives recently in Washington, DC, while attending and serving as a moderator for two panel sessions at the Equipment Leasing and Finance Association (ELFA) annual Credit and Collections Management Conference. The conference was an eye opener for me, revealing current strategies and emerging best management practices that are being adopted by creditors. The three-day event provided a great opportunity for me to get a better understanding of the issues and potential concerns within the lending community.

Even in a period of unprecedented opportunity and growth for creditors, I learned, steps must be taken to prepare for a change in today's lending climate.

Beware of Complacency

One question many creditors are asking is: How do we stay ahead of the curve in credit and collections management, even with an uptick in new business volume? Is the real danger less that the current economy will slow and more that complacency today is preventing us from preparing for that slowdown?

I recall that at last year's ELFA credit management conference, everyone was talking about regulation and the uncertainties surrounding the long-pending changes to lease accounting rules. What a difference a year makes ' especially a year of very strong leasing and lending opportunities. This year, regulation was not the primary focus. Everyone, it seemed, had dealt with the regulation issues that were affecting their portfolios and resolved them. Instead, the most prominent topic seemed to be the strength of the recovery and the quality and quantity of deals being inked.

But beneath this celebration was the realization that success almost always presents its own unique risks for failure. Many I spoke with felt that the most reckless approach is not taking the time to evaluate those risks and plan for them.

If the consensus was that business seems to be booming again and increases in new businesses are at an all-time high, there was far less agreement on what this might mean. Are defaults going to pick up? Is there another recession in sight? How should creditors plan for the inevitable change from the current business climate?

Optimism remains high among lenders. No one argued that another visible recession is in sight, although many admitted they had never experienced a period like that they've seen since 2009. The sentiment seems to be that the current climate is just part of a cycle, and we are moving through it. New business is continuing to materialize, and charge-offs are at an all-time low ' under 1%, according to economist Beth Ann Bovino, the U.S. chief economist at Standard & Poor's Ratings Services, based in New York, and a presenter at the conference.

So, with charge-offs at an all-time low, why should lenders be worried?

Understanding How We Got Here

Savvy creditors know that an end to the current strong business climate is inevitable. And this means that defaults should be increasing in 2016, 2017, and going forward. The reasons for this are based on a cycle that most lenders are well familiar with. Those who have been through a downturn know and understand it fully.

To understand it, let's take a quick look at how we got to where we are today.

First, during the 2007 through 2008 downturn, lenders cleaned off their books. Faced with ever-growing numbers of defaults and increasingly futile collections efforts on their mounting delinquent accounts, many creditors ended up just charging them off. In the best of cases, it was a pragmatic approach to the then-current climate; in the worst cases, there really were no other viable options.

While there were a lot of charge-offs in 2008 and 2009, and even headed into 20010, most lenders' books were cleaned up or almost cleaned up by then. During that period when the economy was in a nose-dive, businesses were failing and certainly weren't looking for new equipment. People weren't starting new businesses, either, so there weren't startups or entrepreneurs looking for new equipment. Moreover, the companies that were surviving were just holding on, so they weren't looking to lease or buy new equipment.

Should anyone have been out and about looking for new equipment back in 2009 or 2010, they would have needed very strong credit before any finance company was going to lend to them because creditors were still reeling from what they had just experienced with so many charge-offs and so much bad debt.

When lenders weren't putting the usual quantity of new deals on their books and the deals they were booking had A+ credit, they knew that eventually there weren't going to be charge-offs on the portion of them that would end up as bad debts. Again, savvy creditors understand that you need a steady flow of new business to see the inevitable fall-off on the back side. So that's what happened: Charge-offs plummeted simply because so few new leases and loans had been written during the downturn and the ones written were solid.

At my company, which is focused specifically on buying charged-off leases and loans, we saw first-hand that the writing was on the wall and knew that this was a cyclical phenomenon. With the default rate dropping, we started to buy all the charge-offs we could because we knew we needed to expand our business right then, at that optimal point in the cycle. We knew charge-off rates were destined to plummet with the low volume of new equipment lease business being conducted.

I'm glad we acted while there was still an opportunity. Defaults and their subsequent charge-off rates have been under 1% since about 2010. That's five years of an all-time low rate for charge-offs.

Which Way Out?

The path out of the last downturn has been relatively easy to see for those lenders who have been down it before. Many at the conference who have experienced previous recession cycles recognized a familiar pattern reappearing ' once the bottom had been hit.

Over the past several years, once lenders got comfortable again and felt they needed to add new deals and the economy started to improve, businesses saw opportunities and became entrepreneurial again. It's a simple truth that growing businesses need equipment, and they're willing to invest in it in order to continue to grow their business and generate revenue. In meeting this demand, it didn't take long for leasing companies to start getting business back on their books again.

And with this new influx of business came the foundation for the predictable uptick in defaults that we are just now starting to see.

Yes, it has taken a while, but today, lenders and lessors have gotten back on their books the quantity of business they had before the downturn. If they've got a five-year lease, when would an obligation that old necessarily go into default? Not quickly, in most instances. Consequently, it's been taking time to churn through all the new business that's been booked since 2009 to where it's soon going to be seen in the rate of charge-offs. Will it be a year or two before the uptick in defaults really becomes apparent? As far as projections, no one really knows, but Beth-Ann Bovino did show conference attendees data indicating there's an increase underway already.

Now, some people will say, “Uh oh, there's an increase in charge-offs. That's bad, right?” But overall, the feeling is it's not necessarily bad; it's just the natural result of a certain percentage of the unusually large volume of new business falling into default.

Gaining Perspective

When creditors sign the large volume of new lease or loan business they've seen since 2009, they're surely going to generate a certain volume of delinquent accounts that end up being charged off. Even though it might look scary to have any rate of charge-off, even under 1%, an average charge-off rate back in the day was 2% to 3%. Think about it: That's a 200% to 300% increase over what it is now.

The truth is, if leasing companies have a 3% charge-off rate, this means 97% of their overall portfolio is performing well. That's a tremendous success rate when you look at the big picture. Remember, 3% is a very small percentage to have charged off, but it's still a substantial portion of business that needs to be dealt with by the work-out department or, eventually, for some companies, sold to companies like mine that buy charged-off paper. The bottom line is that leasing companies can still be thriving tremendously with a 3% charge-off rate because 97% of their portfolio is still performing successfully.

For the most part over the years, it has been the die-hard, hangers-on businesses, the ones that applied for and obtained credit, that kept funders active because their lease or loan approval rate has been exceptionally high as well. Does that mean that lenders are loaning to pretty much anyone who applies? Or is it that the stronger companies are the ones that have survived and are still around to merit and receive funding?

It appears to be that the stronger companies are the ones that are applying for equipment leases, and now, as the economy continues to get better and down-trodden companies re-establish their footing, find their niche, and get entrepreneurial again, lenders are going to have more new businesses to fund. In addition, maybe companies that are not as strong but suddenly are feeling more confident in their businesses and their need for new equipment will be applying, as well. This scenario may bring down the overall loan or lease approval rate a little bit, but it will get things back to normal ' or at least to where it was when times were good and everyone was happy.

While the prospect of rising charge-off rates should not necessarily be a cause for alarm among lenders, being unprepared for it could be.

Bolstering Collections Capability

Conference attendees learned about the results of a proprietary survey TBF Financial conducted on behalf of the ELFA regarding collections departments within leasing companies. TBF surveyed them starting in 2009 and was able to track developments in their collections efforts as the recession receded. Given the overall decline in the number of charge-offs, many leasing companies were finding their in-house collections departments underutilized and unprofitable. In many instances, personnel and resources in these departments were being reallocated ' if not cut altogether. The ELFA wanted to know what percentage of leasing companies were maintaining their in-house collections capabilities. Were they adding staff? Were they having a hard time collecting? Were they using their collections department to generate additional income?

TBF's survey covered a wide array of leasing companies with collections capabilities. Not surprisingly, most of the respondents were banks, primarily focused on small-ticket leases. Participants were split approximately 50/50 between captives and independents.

Respondents were asked to list the default rate of their portfolios. They were then asked to provide their collections success rate, which proved to still be very low. Some 20% of survey respondents said they had a 1% to 5% increase in core collections over the past year. But one of the more interesting observations from the survey was that many respondents admitted having a difficult time hiring new people, and they were often unimpressed by the candidates they did find for their collections positions. A common sentiment was that collections departments are not perceived as “sexy,” and the overall impression of the collections field is not a good one. Apparently, candidates for collections work do not perceive it as a stepping stone or a great place to start in finance.

But the most surprising discovery TBF made is that, despite the recognition that defaults are expected to increase, a majority of companies were not committed to adding more personnel or resources to their collections department. Instead, they apparently plan to do more with less staff. Survey respondents admitted they were concerned that their collections capabilities will not be prepared to deal with a rise in defaults that will end up as charge-offs. Many have resigned themselves to the notion they'll be scrambling and will just have to deal with it.

The survey also revealed that recoveries are at an all-time high. In the 30-to-60-day timeframe, ELFA data show the default rate is up, but leasing companies end up collecting on most of those accounts because companies are increasingly allowing their accounts to go into default. While it used to be standard practice that accounts that were past due by 15 days were immediately contacted so they didn't hit the 30-day mark, leasing companies now are letting their lessees hit that 30-day mark, calling them on day 31, and telling them they're late and must pay a late fee. This strategy has been successful for many companies in generating late-fee revenue via collections. Even though the 30-day default rate is up, almost all accounts are getting collected within 90 days, keeping the overall charge-off rate under 1%.

Certainly, no one at the conference could predict when our current period of unprecedented opportunity and growth for creditors might slow, end, or change direction altogether. But the savviest lenders seem to recognize this uncertainty and are taking steps to minimize the risk associated with the inevitable change in today's lending climate.

Brett Boehm is a principal of TBF Financial, LLC, which serves the equipment leasing and finance industry by purchasing portfolios of charged-off small-ticket leases and loans to help individual companies recover cash quickly and improve their account balances. The Deerfield, IL-based firm is an active member of the ELFA, and Boehm has served on its Credit and Collections Planning Committee since 2012.