[Collections & Credit Risk—Table of Contents] June 2002

Portfolio Grooming:
Portfolio Grooming's Shaping Up

The growing sophistication of portfolio grooming tools helps determine more accurately the return on investment of working charged-off accounts, as well as their value on the open market.

By Peter Lucas

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The decision to work a charged-off account or sell it used to be based largely on gut instinct. Sure, collections managers had scoring applications available to indicate the likelihood they might recover some dollars on the account, but not to measure the amount of recoverable dollars versus the cost to recover them.

As a result, the decision about whether to work bad debt in house, farm it out to a third-party agency, or sell it was often made without understanding the true economics of the portfolio. The situation was exacerbated when collections managers faced increasing pressure from management to lower operating costs, a situation that can lead to hasty decisions about which accounts to sell. Under such circumstances, savvy debt buyers enjoyed an advantage: They were more likely to obtain accounts capable of yielding a return considerably below their normal cost of recovery.

That's no longer the case. Advances in portfolio grooming for charged-off accounts and an expanded roster of vendors offering grooming applications have combined to enable creditors to manage their bad debt more precisely and clear their profit hurdles.

"Grooming doesn't necessarily allow us to recover more dollars, but rather enables us to spend less to recover those dollars," declares Matt Melius, an executive vice president with Minnetonka, Minn.-based Metris Companies Inc. "In the recovery game, getting cash in the door is key. Grooming lets us recover cash more efficiently."

So efficiently that Metris typically collects about 80% of recoverable dollars while expending about 45% of available resources to work a charged-off account, Melius adds. That's an exceptional rate of return. "Grooming is an investment decision based on the net benefit of dollars recovered," he says. "In grooming, the big question is whether I can make money working this account."

Metris, which ranked as the 12th largest credit card issuer based on receivables in 2001, according to Card Industry Directory, has used internal scoring models for the past three years to measure such criteria as credit quality and account behavior prior to chargeoff. Once the account is scored, Metris uses the information to determine which accounts to work in house, farm out to a collections agency, or sell.

Other data that can be applied to groom portfolios include macroeconomic and demographic data. Most portfolio grooming applications incorporate behavior scoring to help determine recovery rates on individual accounts. "The strategy behind grooming is to go after the accounts with large balances owed that have a higher probability of return while putting the least amount of dollars into those recoverable assets," explains Dennis Ash, director of consulting and analytics, Decision Solutions Group for Orange, Calif.-based Experian Inc. "Less dollars may go into working accounts with fewer recoverable dollars, but those accounts have a lower threshold to recoup collections expenses."

Custom vs. Template
Experian offers modules for grooming bad debt as part of its suite of account management software. The modules can be fully customized or offered as a template with minor customization. The latter helps lower the cost of entry for small and mid-size lenders. Creditors can purchase a portfolio grooming application for as little as $70,000 or upwards of $1 million for more sophisticated models. "Fully customized models are an expensive proposition," says Ash. "Models built as templates still provide a higher level of sophistication, allowing lenders to segment accounts by risk type and run champion/challenger models on strategies and matrixes."

The ability to recover dollars more efficiently has begun to grab the attention of a broader range of lenders. In addition to bank card and retail issuers - still the biggest users of behavior scoring for portfolio grooming - mortgage, auto, subprime, and personal lenders are embracing the technology.

"In many markets outside the credit card industry, bad debt has traditionally sat on the books for extended periods," says Vernon E. Gerety, a senior vice president for PBDS Inc., a Tinton Falls, N.J.-based provider of behavior scoring models. "The slowness of the economy and drive to increase profit is pushing more lenders to look at new ways to determine what they can get from working or liquidating their bad debt. As the return on investment becomes clearer, more lenders are seeing the value of using these applications."

Indeed, creditors are finely grooming their accounts to determine which in-house collector or third-party agency might be best suited to work an account with a particular set of characteristics. Golden, Colo.-based Narex Inc., for example, offers models that simulate collection strategies employed by agencies to determine which one will work the account to produce the highest return. "A creditor may still want to farm out 30% of the accounts, but this allows them to determine which accounts go where," explains Bernhard Nann, Narex president and chief executive. "The idea is to optimize placements."

Creditors using this strategy have increased their recovery rates by an average of 10%, says Nann. Such data is crucial to lenders looking to improve recovery rates while containing costs. "When you pay a 10% to 30% commission to an agency, you want to know what they can recover before making the placement," says David R. Kelly, principal for Atlanta-based Sigma Analytics and Consulting. "Creditors want to make sure agencies are employing the best strategy to get the most out of their dollars spent."

Much of the sophistication in grooming portfolios to optimize recovery is based on the ability of models to help make better decisions, rather than simply provide a score that predicts a behavior pattern. San Rafael, Calif.-based Fair, Isaac & Co. Inc.'s Strategy Science application measures a debtor's potential reactions to various collections strategies to make a recommendation about how to handle the account. "It's not that there has been a lack of data in the decision-making process, but more a lack of discipline to drill down on the economics of working or selling an individual account," explains Lori A. Sherer, vice president, Strategy Science for Fair, Isaac. "The goal is to make more efficient tradeoffs between business conflicts, such as applying more resources to work an account and managing profitability." Strategy Science, which was launched more than a year ago for risk managers, is now being offered to collections managers and debt buyers. The cost starts at about $500,000.

The improved decision-making process creditors enjoy as a result of grooming charged-off accounts is also being applied to delinquent accounts. The aim is to gain efficiencies at the front end of the collections cycle by accelerating chargeoffs. A Narex client is using its scoring model to evaluate delinquent accounts before reaching 120 days past due. "When an account reaches that stage, the chance of collecting anything is small, so why not evaluate the potential for recovery sooner and sell the accounts that don't meet the desired rate of return before chargeoff?" Nann asks.

In addition to removing much of the uncertainty for creditors related to the decision to work or sell an account, behavior scoring has significantly reduced the risk of creditors' accidentally selling off potentially high-yield accounts. As a result, debt buyers have begun embracing behavior scoring to gain a better understanding of the accounts they are buying and their value.

Smarter Moves
"In the old days, debt buyers found a lot of gold on the ground, but as creditors get more sophisticated in grooming techniques, they have had to follow suit," says PBDS' Gerety. "Grooming at either end provides more intelligence to the decision more consistently."

Most debt buyers have developed scoring models to evaluate the quality of an available portfolio, experts report. Although buyers often have more sources available to them than a creditor to locate a debtor, the surge in creditors' use of portfolio grooming applications has increased the risk of overpaying for an account if they don't do their homework. "Grooming applications let buyers and sellers more easily settle on a price," says Experian's Ash. "But it's important to have both parties agree to run the same application on the portfolio so they're making the same comparisons."

For creditors and debt buyers seeking to reduce operating costs and maximize profits, portfolio grooming tools can shape their holdings, giving them a sleeker, better-groomed look - and a more profitable one, too.

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