Wednesday, August 31, 2011

Appropriate Compensation #11: Keep it Simple(r)

Here in post-Irene New Jersey many of us still have some recovery to attend to but, as the month ends, I want to quickly clarify the idea put forward in our last post.

This is what I mean by a Seller-based approach to an allowance for credit losses:

1. Let’s say that all active Sellers on TRE represent the same share of total auction activity. (Clearly, that’s unrealistic, but it’s just for illustration.) And let’s say that our analysis suggests that 3% of active Sellers will default in any given year. If we assume that every default results in a total loss, we might say that overall TRE pricing has to provide for an annual loss of 3% of capital (before recovery expenses).

That 3% loss provision is not based on the gross income of auctions purchased. It’s not a top-down calculation. It is an absolute loss provision that has to be included in auction pricing to compensate for perceived Seller-default risk.

That’s an extremely simplified example of a platform-level approach but, hopefully, it conveys the idea.

It’s not possible at this point, for a Buyer to “buy the Exchange” i.e. there is no single transaction that will expose the Buyer to a pro-rata position in the entire TRE portfolio. So an Exchange-level analysis, even if it were really possible in a statistically meaningful way, wouldn’t go far enough for the individual Buyer.

The individual Buyer will have to account for his own strategic portfolio and auction purchase decisions in creating an allowance.

2. Let’s say that a given Buyer has a portfolio diversification rule that limits his exposure to any one Seller to an amount equal to 10% of the Buyer’s capital. And let’s say that the Buyer believes that his Seller-qualification criteria allow an annual probability of default of 1 in 20. If a total loss on default were assumed, and the Buyer’s investment at the time of default were at its 10% maximum, the simplistic loss allowance should be about 5% of capital per year.

3. Let’s take the same situation as in #2 and assume that the Buyer actually expects a net loss recovery of 50% of defaulted amounts. In that case a net loss allowance of 2.5% of capital per year would be indicated.

Obviously, a Buyer projecting a loss of 2.5% of capital per year will think and act differently than one projecting a 5% loss. (And those making no conscious allowance for loss will be unpleasantly surprised sooner or later!)

There is not yet enough history of TRE operations to reasonably estimate the probability of a “typical” Seller defaulting. Nor is the information about actual default experience publicly available.

What we ARE able to say is that the experience of TRE to-date has caused it to make a number of meaningful changes to procedures, staffing and operations that affect both risk of default and likelihood of recovery post-default. And that those changes have been constructive.

However, it remains true that:

• There is a wide range of (reported) financial capacity among TRE Sellers.

• There is a wide range of financial capacity among TRE Account Debtors.

• There is a wide range of past experience among TRE Seller/Debtor pairings.

• There is a wide range of documentation strength provided in TRE transactions.

• There is a wide range of actual pricing in TRE transactions.

Because each Buyer’s actual and perceived risk/return profile is dependent on many individual portfolio construction and auction purchase decisions; and many assessments of risk are still largely subjective in the context of limited TRE history; the question of an appropriate loss reserve will also necessarily be both individual and largely subjective.

I might think, based on my own portfolio construction and auction purchase criteria, that an annual Seller default probability of 1 in 20 is reasonable. Another Buyer might find some other number to be more reasonable.

I might think that a net recovery expectation of 25% is reasonable. Another Buyer might think differently.

I’ll develop this idea further in subsequent posts but I hope this clarifies the distinction between a Seller-based analytical process and one that is Debtor-based.

I should note that I’m not ignoring the differential strength of Account Debtors. Regardless of Debtor capacity, it is the Seller that is ultimately responsible to make good on invoices sold. And, in the context of TRE notification/verification procedures, I think that the quality of the Debtor is best considered as one element in the assessment of Seller risk.

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