The Anatomy Of A Consumer Loan Default

What Is Behind The Recovery Of A P2P Loan?



P2P investors are attracted to the higher returns banks have enjoyed for decades but are often not sure if there is even a process around or protections against a default. We often hear investors ask what happens when a borrower defaults or what prevents a borrower from walking away from a loan when there is no collateral. Does a credit score pose a strong enough deterrent for a defaulting borrower? Could it really be that simple? It turns out the answer is yes, and we explore the motivations and options facing both the lender and borrower in the US following delinquency in this article. This article covers the recovery dynamics for personal unsecured loans, as they directly apply to loans underlying Lending Club and Prosper notes. In future posts, we will cover other loan sectors such as SME and international loans.


Social Rejection & P2P Loans

The belief that someone will pay their debt is based on the social norm known as reciprocity, which in turn is driven by an evolutionary fear of being ostracized. This pain deterrent is a root driver of not only our fear of rejection, but our need to be trusted. Trust is our only true protection against ostracism, and is the main ingredient captured in feedback mechanisms like product reviews (for example: Yelp, Amazon, Ebay), bond ratings, and credit scores. Matthew Lieberman’s seminal book, Social, details how the human brain registers the pain of social rejection in the same place as physical pain. This hypothesis was first tested in a 1978 Jaak Panksepp study performed on socially isolated puppies. Subsequent studies including those by Nathan DeWall and Naomi Eisenberger also showed this pain anatomy applied to humans as well.

Delinquent borrowers can be classified as unable (good actor) or unwilling (bad actor). Mechanisms in the US like bond ratings and FICO credit scores are the reason the vast majority of delinquencies are made by the former. Credit scores are only as effective as the extent they are adopted by the public. The US has one of the most advanced financial systems in the world due to the level of credibility afforded by its rating and credit agencies. These entities cover borrower trustworthiness on an institutional and individual level. They are also a primary reason the market mechanisms behind non-performing loans follows an orderly process with multiple players and a functional secondary market. Their widespread acceptance poses a legitimate threat to delinquent borrowers of being completely ostracized from the entire US economy.


Lender Side: Recovery & The Delinquency Cycle

Loans that are 3-6 months past due enter a first-party collection process where the collection is handled by the lender’s internal credit team. During this phase, the loan stays on the lender’s balance sheet, which means the full recovery amount goes back to the bank. After delinquency passes 90 days or what the Fed deems as “seriously delinquent,” the bank enlists a third-party collection agency. This agency takes a small cut of what is collected, but the loan remains on the bank’s balance sheet.

If third-party collection efforts fail, the loans are charged-off by the bank and typically sold off the bank’s balance sheet for pennies on the dollar into the secondary market. This is when the loan makes its entrance into the massive debt collection industry that earns an estimated $13 billion in annual revenues. Given the low cost of acquisition, collectors that succeed in even settling 10% of their debts at 50% of par are still profitable. These agencies can use any method to collect the debt within the boundaries of the Fair Debt Collections Practices Act (FDCPA), which is regulated by the Federal Trade Commission. Nonetheless, many borrowers unaware of their rights still find themselves subject to daily harassment and threats from highly motivated collection agencies.

The ultimate outcome for the lender depends on whether the borrower is a good actor or bad actor. The former will work closely with either the lender or collections agency to repair and maintain their credit standing. Bad actors require more aggressive action, which brings us to the range of options facing a delinquent borrower.


Borrower Side: Options and Repercussions

Damage to a credit score is a function of the length of time past due, the amount delinquent, and how recent the default was. Loans that are less than 90-days overdue may be hit with a fee from the lender, but they do not stay on a credit report beyond two years. After 90 days, the smear on the credit score lasts far longer and as mentioned earlier, an entire debt collection industry exists for this borrower. Ultimately, it is the borrower’s tolerance for economic ostracism that dictates the best option.

Debt Consolidation is the practice of combining a borrower’s outstanding debt into one loan, typically at a lower interest rate. Consolidating debt is the least disruptive to one’s credit since the principal amount is still paid by the borrower. This option is good for borrowers who are current or within the 90-day past-due window, and is one reason why the speed of platforms like Lending Club and Prosper attracts many borrowers. Consolidation is also a good fit for borrowers with good credit scores and have income to make the consolidated debt payments. Loans classified under debt consolidation also happen to be among the most favored loans by our machine learning models across most US-based P2P platforms.

Debt Settlement/Arbitration is a more disruptive solution that typically involves a third-party arbiter negotiating with the lender to bring down both the principal and interest of the borrowers’ loans and consolidating under one loan. Settlement discounts normally range from 10-50% of original principal. In addition, negotiators are often able to lump interest payments into this number making the discount even larger. Debt settlement is a good option when a borrower who already has significantly impaired credit, does not mind the additional credit hit involved in arbitration, and does not have a short-term need for credit. After the settlement amounts are paid, the negotiator requests the creditor to report a “paid in full” or “paid as agreed” status to the credit bureaus. These statuses are more favorable than the “charged-off” or “in collections” statuses already on the credit report, and they start the process of credit repair. This makes arbitration a more attractive option than a flat-out bankruptcy.

This may sound too good to be true to the borrower, but this option is not without risk. First, the degree of discount is predicated on the arbiter’s ability to convince the creditor the likelihood of recovering any money from the borrower is near zero. This means it is better for the borrower to stretch out the delinquency period, all the while being harassed and threatened by the debt collector. While there are borrower protections under the FDCPA, they are not nearly as definitive as under bankruptcy law. If the negotiator and borrower are strong, the debt can be reduced to near the debt collector’s original cost. As mentioned earlier this could be pennies on the dollar. Second, any discounted amount is considered taxable income, hence increasing the discount needed to breakeven. Third, there is the risk of the negotiator, who may fail to obtain a discount below the upfront fee (normally 20% of the original principal) paid by the borrower. The negotiator may even fail to persuade the creditor to report the “paid in full” status to the credit bureau.

Declaring Bankruptcy is a good fit for creditors wanting a complete reset of their credit. This typically applies to debts that will take longer than five years to pay off. The two options available to individuals are Chapter 7 (liquidation) and Chapter 13 (re-organization). Creditor petition courts tend to be borrower friendly, with a nearly 95% success rate for individual Chapter 7 cases in 2016. Despite the success rate and protection afforded by a bankruptcy filing, the cost is still substantial. Bankruptcies stay on the credit report a long time: 7 years for Chapter 13 and 10 years for Chapter 7. The social stigma resulting from a bankruptcy makes it extremely difficult to obtain credit during this time. The costs are also non-trivial. In addition to legal fees, all of the borrower’s personal assets beyond bare essentials like primary residence and vehicle are subject to liquidation by a court-appointed bankruptcy trustee. In addition, the approval process may last up to six months, during which time the borrower is still subject to harassment from debt collection agencies.


Conclusion: Summary and the Underbanked

Credit scoring mechanisms in the US provide a highly effective deterrent against rampant defaults due to their widespread adoption. As chronicled above, the menu of options facing both the lender and borrower in the US is robust and can cater to the tolerance any borrower may have for lower credit. Beyond the US and for sectors with less developed mechanisms such as those serving the underbanked or many emerging market economies, lenders can still leverage this human desire to avoid social ostracism. This may come in the form of the affinity group model showcased by the veteran-focused lending platform, Streetshares. This model is akin to the Kye and Hui systems in Korea and China respectively where money is collected within a community to lend to one party. Similarly, negative enforcement in emerging markets provide effective non-violent methods, particularly for SME loans.