Sunday, November 28, 2010

A Comment on Risk

The downward pressure on auction pricing that began in late August has continued and intensified through November. I’ve suggested before that this might have more to do with excess liquidity than with either improved quality of Sellers or Debtors or with decreased transaction risk.

While auction volume has continued to increase it appears that liquidity has increased at a more rapid rate. One indicator of that is the percentage of auctions sold at their specified “buy-out” prices.

On one recent day, there was only one auction that DID NOT sell at its buy-out price.

I suspect that there is a substantial Buyer out there who has given instructions to a trader that he is not to BID on auctions; but rather only to BUY them.

So, no matter that an auction might be had on better terms, this Buyer pays the “ask” price. And that, of course, provides a powerful incentive for Sellers to drop their “buy-out” or “ask” pricing.

Now, I might very well be wrong about this and I have no knowledge of any other Buyer’s actual trading dynamics. I’m just speculating based on the activity as I see it.

Viewed from the perspective of both the Exchange and the Seller community, of course, the current dynamic is very attractive.

For the Exchange, it makes the job of attracting potential Sellers, and of retaining current ones, easier. Lower cost of funds and rapid auction closings provide the sales force with a strong "story" when marketing TRE to prospects.

For the Sellers, obviously, lower pricing is always desirable.

And Buyers could ultimately benefit as well to the extent that more Sellers might be attracted to the Exchange, although this benefit is a lagging function and is obviously offset by the lower yields available at least in the near term.

In the long run, the Exchange cannot thrive on the basis of a pricing level that does not, on average, compensate Buyers for: a) cost of funds, b) cost of operations, and c) risk assumed.

The TRE Buyer community is very diverse, not only in terms of the primary businesses they represent but also in terms of their motivation for participating in the Exchange. A Buyer that is not primarily in the receivables finance business; whose interest in TRE might principally be as a place to “park” cash balances in the short term; will have a very different view of acceptable pricing than will a Buyer whose principal business is buying accounts receivable.

It’s really impossible for anyone except the managers of the Exchange – who will know all of the Buyers and their reasons for participation -- to comment on the likely range of Buyers’ cost of funds, cost of operations or motives for participation.

But the risk involved in an Exchange transaction is the same regardless of the identity or motivation of the Buyer.

I’ve commented in previous posts about the differences between the typical business model of a company whose principal activity is the purchase of receivables and the model on which TRE is based.

In several respects the risks of buying invoices on TRE have to be acknowledged to be higher than is typically the case in the receivables finance business. Here I’m thinking of issues like the lack of personal guarantees and of blanket first liens on Sellers’ receivables.

On the other hand, there are offsetting advantages to the TRE model that are not inconsequential. The lock-box arrangement not typically available to a spot-factor, the advantageous nature of the Louisiana law and a generally higher-quality Debtor community, are examples.

Each Buyer, or potential Buyer, will make his own assessment of the balance between those advantages and disadvantages.

But today I want to revisit a risk-related topic that I’ve commented on before that has become a larger issue in the current pricing environment. It does not arise from the TRE operating model but is significantly affected by its pricing model: specifically the impact of its fee structure on auctions of very short duration.

Given the relatively brief history of TRE it’s very hard to devise a risk analysis that would result in a conclusion regarding the probability of loss in transactions with certain given characteristics.

We really can’t say, for example: “the probability of loss in a transaction in which Seller A is owed money by Debtor B for the provision of goods or services with characteristic C, under the terms of an agreement with characteristic D ---is in the range of X% to Y%”

We’re just not there yet.

But there is a way to make a STATEMENT regarding risk even without actually suggesting an actual evaluation of risk. The statement I’m referring to is grounded in the traditional payback-period calculation from Financial Analysis 101.

Applied to a TRE auction it would take the form of:

“It would take X successful transactions (with given characteristics) to offset 1 such transaction in which a total loss was suffered.”

That says nothing about the actual risk of loss, of course, but it can provide a useful means of:

a) conceptualizing the consequences of a default, and

b) providing a relative measure of loss consequence between and among transactions.

Looking to the actual auction activity from a recent day I can pull an example of a transaction made at the low end of the typical range of expected duration and discount rate; one at the high end; and one in the middle.

The analysis has two steps:

1) using the likely duration and actual transaction parameters, calculate the expected net dollars returned to the Buyer upon full payment of the invoices purchased, and

2) divide the total funds advanced, including transaction fees and costs, by the expected net dollars returned.

The low-return transaction example, because of its short duration and low discount rate, produces a small dollar-amount of expected return. If a Buyer were to suffer a total loss on an auction with these exact characteristics, it would take 489 successful transactions with the same characteristics to recapture the loss.

The high-return transaction example has a very long expected duration and an unusually high discount rate. It would take only 7 successful transactions with these characteristics to offset a total loss on one.

The mid-range example, which is more characteristic of the typical transaction, has a moderate expected duration and a discount rate somewhat higher than the current average (but closer to the historical average) than either of our “extreme” examples. In that case it would take 45 successful transactions to recapture one total loss.

To my knowledge there has been no default on auctions involving the Seller/Debtor pairings whose auctions I’ve used in these examples.

It SEEMS clear that the Buyer community assesses the relative risks among them quite differently. But I wonder…..

Let’s take the case of the low-end example above. I don’t know who is buying those auctions or others with similar characteristics. But I wonder if they actually consider the relative risk to be roughly 1/11 that of the mid-range example?

I don’t know.

But I do know that it’s wise to remember two things:

1) The typical receivables transaction is of very short duration when compared to most other fixed-income investments; meaning that the ratio of dollars earned to dollars risked in a single transaction is low, and,

2) The direction of errors in projecting (percentage)returns on an invoice-purchase transaction is almost always negative. Other than earning a slightly higher return than expected if durations extend, you can’t really get surprised on the upside.

As time passes and experience is accumulated we’ll be better able to quantify relative risk using appropriate statistical means. Until then we’ll have to do the best we can with what we’ve got.

But I think it pays to at least acknowledge the implicit judgments being made until we get to the point where explicit ones can be supported.

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