[Editor’s Note: This is a guest post from Brian W. Tuite. Brian is Chief Business Development Officer for SquareTwo Financial, a leader in the $100 billion asset recovery and management industry.]
Anyone who runs a business runs the risk of not being paid for the products or services the company provides. In the FinTech space, this comes in the form of delinquency and, ultimately, charge-offs.
Delinquency begins when customers miss their first payment. Most companies have an in-house collection operation designed to help customers become current again, but some customers are unable or unwilling to make the necessary payments to become current. After a period of time (usually 120 days for personal loans, 180 days for credit card loans) the company is required to move the account from delinquency to charge-off status. This article focuses on management options for charged-off accounts.
Although charge-offs are relatively low in the FinTech space today, defaulted accounts are always a top concern, and as the industry continues to grow, so too will the number of defaults.
There are several things for companies that find themselves with charged-off accounts to consider. First, they need a solid understanding of charge-offs. Second, they need to put in place a strategy for handling them.
Understanding Charged-Off Accounts
First, what does the term charge-off mean? Let’s get technical for a minute. Most FinTechs, whether consumer or small business, charge-off an account immediately after it becomes 120 days delinquent. When an account is “charged-off,” the balance is removed from the balance sheet as a receivable and is recorded on the profit and loss statement as an expense under the “Gross Charge-off” line item.
However, the account still holds intrinsic value post charge-off, as the customer is still liable for the debt. The post charge-off value realized on the account – either through continued collections or through a debt sale – is recorded as a contra expense against the “Gross Charge-off” line item, resulting in a “Net Charge-off” expense that is lower than the “Gross Charge-off” expense on the P&L.
Charge-offs are a natural outcome of lending. The more loans a company books, the more charge-off dollars it will incur, regardless of credit criteria. During good times for a consumer loan portfolio, charge-off rates will average 5-6 percent on a vintage basis (a specific tranche of loans measured over time), depending on underwriting criteria. It is important to note that looking at charge-off rates on a total portfolio rather than a vintage portfolio can be misleading, as new assets generated from a fast-growing portfolio (new and existing assets being the denominator in the charge-off rate calculation) can significantly outpace charge-off dollars generated from previously issued loans (charge-off dollars being the numerator in the charge-off rate calculation).
During an economic downturn, delinquencies and resulting charge-offs will spike on a vintage basis. During the last recession, unsecured personal and small business charge-offs increased at a higher rate than most other loan types. This is a function of a stressed consumer or small business having to prioritize which bills to pay and prioritizing loans such as their car, mortgage, and credit or business card ahead of their unsecured personal or small business loan.
Managing Charged-Off Accounts – What are your Options?
The first thing to understand when it comes to managing charged-off accounts is that it is important to have a strategy in place, ideally before you need to use it. This strategy should center on three main options:
1. In-house collection
An in-house collection strategy for charged-off accounts involves hiring internal staff to manage the accounts throughout the entire recovery lifecycle. Staff is required to manage the accounts through the non-legal collection channel via an in-house call center and through the legal channel via local counsel law firms.
Pros:
- Maintain ownership of the account, assuming ownership for life is important to you.
- Internal control over how the account is managed post charge-off.
Cons
- Requires operating and overhead investment in call center and support staff, technology, operations, compliance and control.
- Investment in recovery operations is often a lower priority than marketing and underwriting investments, which typically results in suboptimized performance and returns relative to other options.
- Recovery dollars are recognized over time as they are collected through the various collection phases.
2. Outsource collection
A collection agency, often referred to as a third-party agency, is an outside company used to collect on charged-off accounts. Collection agencies usually work on commission, receiving a percentage of the total amount they collect. Individual collectors are typically paid a base wage plus commission based on performance.
To maximize performance, multiple agencies will be required to manage the various categories of charged-off accounts including bankruptcy, deceased, cease and desist, prime accounts (within six months of charge-off), post-prime accounts (after six months from charge-off), and out of statute accounts.
An outsourcing strategy also involves suing a percentage of accounts where a customer has the ability but not the willingness to pay. For these accounts, an outsourcing strategy requires hiring local counsel law firms to pursue collections through lawsuits. For national lenders, the number of local counsel law firms required for 50-state coverage is in the dozens.
Pros
- Maintaining ownership of the account, assuming ownership for life is important to you.
- The institution has vendor oversight control over how the accounts are managed post charge-off, and can recall the accounts at any time.
Cons
- Requires investment in staff and technology to manage the accounts on a daily basis.
- Requires compliance and performance oversight of multiple collection agencies and dozens of local counsel law firms. Depending on your size, it can be difficult to gain priority with your collection agencies and local counsel law firms relative to their other clients.
- Recovery dollars are recognized over time as they are collected through the various collection phases.
3. Sell
A third option for managing charge-offs is to sell to a debt purchaser. Debt purchasers are companies that purchase charged-off accounts from a creditor at a discount to the face value depending on the anticipated collectability of the accounts. Typically, the earlier the accounts are sold after charge-off, the higher the price. The debt purchaser’s core business is to analyze the value of a debt portfolio, purchase the debt, and manage the accounts through their entire recovery life cycle.
Pros
- Requires little staff and minimal operating and overhead expense.
- Recovery dollars are realized upfront to return to the shareholder or to reinvest in the business. Typically, the return of holding versus selling accounts is Net Present Value (NPV) neutral – the primary motivation is money up front and minimal internal operating and overhead cost.
Cons
- Foregoing ownership of the account, assuming ownership for life is important to you.
- Control over how the accounts are worked. Following are ways to mitigate risk associated with selling:
1. Choose a debt purchaser who has been examined by the Consumer Financial Protection Bureau (CFPB). The CFPB is a federal agency created by the Dodd-Frank Act that regulates banks and debt purchasers.
2. Choose a debt purchaser who has a self-contained operation with little to no outsourcing.
3. Conduct a thorough on-site audit of the debt purchaser.
4. Incorporate protections in the Purchase Sale Agreement (PSA) such as no resale, complaint and dispute reporting, and more.
Selecting Partners – Managing Compliance and Brand Risk
There are pros and cons to every option for handling charge-offs, and compliance and brand risk exists regardless of which option you choose. Your process for selecting partners is a key element to mitigating compliance and brand risk.
What is the best method for choosing a collection agency, law firm, or a debt purchaser? With creditors concerned about compliance and brand risk, it is important to complete comprehensive due diligence, ensuring the entities you choose have the scale to absorb high compliance costs, have a well established customer-centric culture, and have a robust compliance management system in place to mitigate risk. In particular, a creditor can limit compliance and brand risk by preventing the agency, firm or debt buyer from further outsourcing the accounts to additional entities.
Finally, as with choosing any business partner, it is critical to verify credibility, reputation, and experience in the space via reputable testimonials.
If you are interested in reaching out to Brian, you can contact him at (303) 713-2200 or btuite@squaretwofinancial.com.
This column is not written on behalf of the author’s employer. It is provided for informational purposes only. It is not intended to be financial, regulatory or legal advice, nor is its intended audience anyone other than business professionals in the FinTech industry. Always seek professional advice before making financial and or legal decisions.
