Market for old debt fuels payday for rich
Thursday, September 8th, 2011
This story is being co-published with New America Media
Kristi thought her old Target credit card was ancient history. She had fallen behind on payments after a long bout of unemployment and hadn’t heard a peep about the account for about five years. She figured the debt was old enough to be uncollectible, and was surprised when she got a letter from Midland Funding LLC in 2010 explaining that it had purchased her account. A few months later, someone showed up at her door and served her with a lawsuit. She says she had a little more than a month to come up with $1,504 to settle the suit, or the court would slap her with a default judgment.
“I got really freaked out,” she said. “My biggest fear was a judgment.”
Kristi, who asked that her last name not be used, is in her early 40s and works as a finance manager in the Maryland suburbs of Washington, D.C. She had spent much of the previous two years cleaning up her credit, with hopes of soon buying a house and starting a family. A judgment would’ve derailed her chances of qualifying for a mortgage.
She didn’t have the money to pay Midland Funding and didn’t want to take on new credit-card debt to do it. So she swallowed her pride and borrowed $1,200 from friends and family to settle the case.
“In the end, I was just happy to not have to go to court and have a judgment against me,” she said.
Kristi is part of a large swath of Americans who have been blindsided in recent years by old debts that were purchased and resurrected by a relatively new breed of collector: debt buyers.
These companies buy debt that’s been charged-off as uncollectible for pennies on the dollar, then hound consumers to pay the debt through calls, letters and millions of collection lawsuits filed each year. The huge profit potential has attracted the attention of some of Wall Street’s best-known moneymen, whose private equity firms and hedge funds back many of the largest debt buyers. When Americans like Kristi, who are struggling to get back on their feet, borrow from friends and family to satisfy old debts, the money often trickles into the pockets of the über rich, whose fortunes are invested in the elite asset management firms that have gained control of many debt buyers and fueled a boom in the industry.
Here’s how it works. When a consumer stops paying his or her debt, most companies will use in-house efforts to collect from customers for about six months before charging off the debt as uncollectible. At that point, the company may either hire a third party agency to try to collect the debt or sell the account to a debt buyer, who then tries to collect the debt itself, either through traditional means or lawsuits.
Using the courts
Debt-buyer lawsuits have come fast and furious in recent years. Midland Funding is a subsidiary of San Diego-based Encore Capital Group Inc., one of the largest debt buyers, having purchased $55 billion in face-value consumer debt to date for an average of 3 cents on the dollar.
Encore filed 517,000 lawsuits in 2010. The vast majority of these cases go uncontested, resulting in automatic judgments for the debt buyers, giving them the right to garnish wages and property to collect the debt. Kristi’s was one of 541 lawsuits Midland filed in Maryland state courts during August 2010. Of those, 64 percent resulted in judgments for Midland, while 15 percent were dismissed — often because the debtors settled. The other 21 percent of cases were still outstanding a year later, mostly because of paperwork technicalities or because Midland couldn’t track down the debtors to serve them with the court papers.
Many debt buyers, including Encore, have taken flak for their lawsuits. The Maryland Commissioner of Financial Regulation hit Encore subsidiaries with $998,000 in fines in 2009. A judge also approved a class-action settlement in March of this year, in which the company agreed to drop 10,168 potentially illegal lawsuits against Maryland residents. In August, a federal judge in Ohio ruled that Encore could pay $5.7 million to settle other class action claims across the nation related to the paperwork used in its lawsuits, even though the Federal Trade Commission, attorneys general in 38 states and consumer protection advocates opposed the settlement, arguing it would give consumers too little and would allow Encore and other debt collectors to evade further legal action and regulation.
The company didn’t admit wrongdoing in any of these cases, and it was generally not in dispute that consumers owed the debt Encore was suing over.
For its part, Encore says it uses litigation as a “last resort,” but that “80 percent of customers don't respond to our phone calls and 95 percent ignore our letters,” said CEO Brandon Black in an emailed response to questions. “When Encore acquires a portfolio, it fully expects that 80 percent of consumers will not pay us anything and that the 20 percent who are able to pay will only settle their obligations at about 65 cents on the dollar.”
Debt buying happens in a mostly informal market, where the same portfolios of debt can be bought and sold multiple times over several years, with the most picked-over accounts selling for a fraction of a penny on the dollar of the debt’s face value. There’s not a lot of data on the size of the industry, though more than $100 billion in face-value debt was purchased in 2006, according to collections consulting firm Kaulkin Ginsberg, which publishes research on debt buying and advises on mergers and acquisitions within the industry.
About three-quarters of that is credit-card debt, while the rest includes retail installment loans, car loans, utility bills, telecommunications debt, health care debt, home mortgages and delinquent taxes.
Abuses are common in the industry. In 2010, there were 140,036 complaints filed with the Federal Trade Commission against debt collectors (which includes debt buyers) — more than against any other industry. These accounted for 27 percent of all complaints filed with the FTC, up from 22.8 percent a year earlier. The most common gripes were excessive calling, misrepresenting the debt (including trying to collect debt that wasn’t actually owed) and skirting the rules on notifying consumers about their rights.
Despite the flood of complaints, the FTC initiated just 24 enforcement actions between 1998 and 2008 for violations of the Fair Debt Collection Practices Act, according to a 2009 Government Accountability Office report. That’s because the law, which governs collectors, was designed to be enforced primarily through suits by private citizens, rather than through government action, said Tom Pahl, assistant director of financial practices at the FTC, adding that there were about 11,000 cases brought last year by consumers against debt collectors.
Beginning July 21, the Consumer Financial Protection Bureau, created as part of the Wall Street reform law passed last year, also stepped in and began regulating debt collectors. The agency has been given more authority than the FTC to create and enforce new rules on the industry, and has vowed to rein in abusive practices, though it’s not yet clear just how it will go about it.
The FTC plans to release a large study on the economics of the debt-buying industry later this year, and the consumer protection bureau will likely take the study’s findings into consideration as it determines how to regulate the industry, Pahl said.
The credit-card revolution
Outstanding consumer debt in this country, excluding home mortgages, ballooned from $958 per person in 1975 to $8,523 at its peak in 2008. The main culprit for this was the exploding use of high-interest credit cards, which began in earnest in the 1980s. As the credit-card defaults rolled in, it didn’t take long for the markets to find new ways to make money off the mountain of uncollectible accounts.
Encore Capital, for example, was a third-party collection agency for more than 30 years before it started buying debt in 1992. The potential for profit caught the eye of billionaire Nelson Peltz, who made his fortune as a corporate raider in the 1980s. He and his longtime business partners, Peter May and Kerry Packer, bought control of Encore and took it public in 1999.
After the dot-com bubble popped in 2000, interest rates fell and housing prices soared, expanding access to wealth dramatically. This sent credit-card companies into overdrive, filling mailboxes everywhere with applications for easy money, said Mark Russell, a debt-buying consultant with Kaulkin Ginsberg. “That became the next boom in the debt-buying space. All this credit was being issued, and the lending standards were dropping. … Students were walking around with $30,000 or $40,000 in credit card debt and $70,000 or $80,000 in student loan debt — and they didn’t even have a job yet. It was crazy.”
As people defaulted on that easy credit in droves, banks began selling it by the billions to debt buyers. As it turns out, many of the banks selling debt were also making money by giving big revolving lines of credit to debt buyers, which the debt buyers then used to finance the debt they bought from the banks. So essentially, banks were making money on both the sell and the buy sides of the deal. Also, banks would use debt sales to help them manage their earnings, according to Kaulkin Ginsberg research. If banks were in danger of not meeting their quarterly numbers, they would often sell a large portfolio of debt to give them a boost of cash that made them appear better to investors.
With credit card defaults soaring, private equity firms and hedge funds — elite asset management firms that generate oversized returns for wealthy investors — jumped in with both feet, snatching up big investments in many large debt buyers and fueling the boom. In the early 2000s, debt buyers were often making 300 percent to 500 percent returns over five to seven years, Russell says.
Encore, for example, grew from $28.2 million in revenue in 1999 to $117.5 million four years later. Peltz and his partners sold off their majority stake in Encore between 2003 and 2007, reporting gains of $162.1 million, according to Securities and Exchange Commission documents. They left Encore in the hands of billionaire and former Goldman Sachs partner J. Christopher Flowers, who runs private equity firm J.C. Flowers & Co. He partnered with his former Goldman Sachs colleague Willem Mesdag and his hedge fund Red Mountain Capital Partners LLC to buy a 40 percent stake in Encore.
Flowers made a name for himself investing in distressed companies, and he saw an opportunity amid the Great Recession's tsunami of defaults. While sitting on a panel in New York in February 2009 about Wall Street’s prospects through the financial crisis, he said: "Lowlife grave dancers like me will make a fortune."
Indeed, Encore is coming off its two best years ever, thanks in part to the money it has saved by moving much of its operations to India, where two-thirds of its 1,891 employees sat as of the end of 2010. Two years earlier, 57 percent of its staff were in the U.S. The moves helped boost the company’s stock, which allowed Flowers and Mesdag to net a profit in March of this year when they sold off a chunk of their holdings in Encore for $71.6 million — more than two-and-a-half times what they paid for it four years earlier. Flowers and Mesdag remain by far Encore’s largest shareholders.