Hello!
I just watched “Buffaloed”- a movie on Hulu… which goes into great detail about debt collectors in America. How they buy debt from banks for pennies on the dollar, and then come after debtors for the full debt making immense profit when the “debt” is repaid.
My question is, why does the bank need to sell the debt?
To whom does the bank owe money too?
I know banks give loans, but where do they get that money?
I know they can make profits off interest, but would that not take YEARSS to do before seeing profits large enough to dish out real cash to borrowers in a newly established bank?
I see how it all just cycles basically but my brain still doesn’t fully comprehend.
Maybe I’m asking for too much, and if I am and nobody has the time to explain- maybe someone could point me into the direction of educational material online because I’m not finding much on Google that doesn’t give me a headache because there is oftentimes a lot of financial jargon.
And before I get roasted, I went to a sh-t public school system deep in the rural south and I am still young, so please excuse me for my very very shallow understanding of all of this.
In: 5
>, why does the bank need to sell the debt
For a debt that has gone extensively unpaid, the bank may decide that it just sent worth their time and effort to get anything back for it, and selling it to someone willing to take the risk involved for a fraction of face value may make sense.
>know banks give loans, but where do they get that money?
Customer deposits and borrowing from larger banks (or the federal reserve)
1. Banks loan money to people who sometimes don’t pay it back. It’s too much hassle for the bank to try and get these small debts back but they can sell them on to someone who can be bothered at a large discount. The banks get something and get rid of the debt on their books and a middleman has an opportunity to make money chasing it down perhaps not having to keep as good a reputation as the bank.
2. Theoretically the banks take in deposits and loan that money out. In fact they may lend out more than the actual assets they hold or have taken. But its all electronic book keeping really. They only have to be able to cover a proportion of deposits in case of trouble which is why there is a problem if everyone suddenly asks for their money back. This is backed and regulated by their central bank. Though they may not get much interest from on loan ,they make money from the fact that they loan so much. Its not the interest that they take in that they loan out as such.
Hope , if I’m accurate, that helps.
If you default on your debts the person who loaned you the money can sell your debt to another person/entity who will attempt to collect on that debt by ruining your credit (making it hard/impossible to get another loan until you pay it back) They are the legal owners of your debt.
Good answers so far so I won’t be repetitive. However, I want to address the last part of your post. This is ELI5, so if anyone roasts you, they’re being a dick. This is usually a safe place to ask questions.
Thank you for your question!
Banks get the money from people who deposit it in their bank.
We use something called “fractional reserve banking” which means that a bank only needs to maintain a fraction of the total money its customers deposit in their “vault.” So say I deposit $100 dollars in my bank, my bank may loan out $70 of that, and keep $30 on hand to keep up with requests for withdrawals.
Banks don’t really provide a high return to depositors, only like half a percent on interest, the main service the bank provides is keeping your money safe, and easily accessible. They do loan out your money, but the risk of loss is very low, so the returns are also low. But the banks do make money on the interest. Which is paid monthly. It would take a long time for a new bank to start turning a profit, but they receive a lot of money from deposits, so they can keep it going until they see that return.
When a bank or other organization “sells debt” it is not the bank that owes money, but rather someone who owes money to bank. What they are selling is the title to that debt. Say you borrowed $100 from me. You aren’t paying me back and I don’t want to deal with it, so I sell that debt to my friend john for $70. Now you are obligated to pay john back instead of me, as he now owns the title to that debt.
Banks or other organizations sell their claim to debt when they think the cost of collecting it is greater than the actual value of the debt. Say you have someone who isn’t paying you back, you can either hunt them down, and pay for a lengthy legal battle to get repayment, or, you can sell the debt for less than its face value, and let someone else deal with it. Which is often times what companies prefer to do. And the debt collectors take their chances on the business model that they are going to be able to get the debt paid, for less than they paid for the ownership of that debt.
Banks sell debt when they’re no longer interested in collecting on that debt. Sometimes collecting debt is easy. For example, a bank may loan out $15,000 to Becky and Becky is responsible and she pays her monthly statement without any fuss so the bank doesn’t have to spend any money to collect. Sometimes collecting debt is hard. For example, Johnny may have decided he no longer wants to pay back his credit card so now the bank has to spend money on collectors to call Johnny, letters asking him to pay, and if this goes on long enough lawyers to take him to court. Sometimes a bank says enough is enough and they’ll sell the debt. The debt they’re selling is the money that’s still owed by the customer and they’re selling it for a price less than that. The companies that buy debt are gambling. If they pay a little bit of money for the right to collect the debt they’re hoping they can convince, or legally force the debtor to pay up. Sometimes banks also sell debt that’s not delinquent if they think it’s high risk. Someone poor living in an expensive house may be paying now but what if the economy goes down and they lose their job? The bank would rather sell for less than the total they could collect than risk not getting paid at all later.
The bank owes money to 3 main groups. First, it owes money to its customers. Customers who open checking and savings accounts are essentially giving away their money for the bank to loan out to others. The bank pinky swears the money will be there when the customer wants to withdraw but the reality is if all the customers wanted cash at once the bank wouldn’t be able to pay them all back. Second, the bank owes other private banks. Banks are just like any other business and when they need money to expand they can ask another private bank for money. Third, the bank has it’s own bank. In the US it’s called the Federal Reserve (each country except Cuba & North Korea has its own national bank you can look up which is for which country). The Feds are responsible for printing money. The way they distribute the printed money is by loaning it out to banks so that the banks can loan it out to businesses and people. The Feds are responsible for a lot of the money that’s loaned out. I can’t explain how the Federal Reserve works in a simple way but basically they use fancy math to try and keep the economy from collapsing (they’re not very good at it imo).
Banks don’t solely profit off loans! They have other products too! Their two big sources of revenue are fees and investing. We’ve all dealt with fees, banks charge what they feel is fair to use their products and they charge fees if you do something they don’t like. Second, they invest money. The economy is always growing so investing is always going to make money. They use both their own money, and the money from investment accounts, to buy and sell stocks and bonds which generate profit. I’m assuming you’re asking about how new banks get their money. The reality is it takes a LOT of money to open up a new bank. “Small” banks have a lot more money than you think and there’s laws and standards practices in place that dictate how much money banks have on hand to operate. Opening a bank is nothing like opening a regular business. You can’t just start with no money.
Hope this answers your questions. If something is unclear or this made you think of more questions don’t be afraid to ask! I’d be more than happy to explain further the mind boggling banking system.
Banks operate because the government gives them special permission to operate. One of the conditions of that permission is that they operate in a safe and sound manner (the government’s interest is that depositors **always** get their money from the bank).
As a result, the government prefers that they not sit on old loans that aren’t paying (the government doesn’t trust the bank’s management to accurately asses the value of these old bad loans) so the government pressures the bank management to sell non-paying loans so the bank can stay in the business of making loans and paying depositors, and also to force the bank to recognize the cost of their bad loans as a cost of operating their business.
As for how banks make money, they are loaning $1 of the bank’s capital and $9 of depositors money (these are loans to the bank), and they earn the spread between the lending and deposit rate. That’s normally enough to account for a nice return on the $1 they had to put up for the loan.
Banks can lend like 9 or 10 times their deposits.
So if they have $1,000,000 in deposits they can lend out $9,000,000. Depending on the loan type they can get anywhere from 3% per year ($270K; from real estate loans) to 22% per year ($1,980,000; for unsecured credit cards). Now most banks have hundreds of millions if not billions of dollars in deposits, and now you can see how they make so much money.
Banks take in money in the form of checking, savings accounts, Certificates of Deposit, etc. and then lend out that money for car loans, mortgages, business loans, credit cards, etc. The spread between interest they pay on deposits and the interest they charge to borrowers is their primary source of revenue. It’s a matter of scale — lending billions of dollars, even a couple percent spread ads up.
But sometimes banks/lenders cannot collect money they’ve loaned out. They eventually want to get those loans off their books and move on… there are tax benefits to writing them off, carrying un-collectible debt makes their books messy, etc. So they’ll sell the debt for a fraction of what’s owed to debt collectors.
The collectors then make money by trying to collect more than they paid for the debt. Say somebody has a $3000 credit card balance the bank wrote off and sold for $500. The debt collector is hoping they’ll be able to extract something more than $500 from the debtor. Sometimes they’ll strike out and get $0. Sometimes they’ll eventually collect the entire amount.
Banks sell the debt to make *something* back from a bad loan.
I loan you $100, you run off and I can’t find you.
I contact a debt collector and sell the right to collect the loan for $5. I’m still out $95 but hey its something.
They track you down and say hey if you pay them $10 they’ll leave you alone. You give it to them because you can swing that.
Even if they can’t find you they can buy 20 debts to collect on for cheap and if just a couple pay back anything then they’re doing well. It’s a volume business.
That’s how selling a debt works.
How banks get their money to make loans in the first place is a separate issue. That comes from fractional reserve banking. Essentially everyone’s checking accounts is a pool of money that the bank can loan out because most people are just leaving their money in there. Even in an age before electronic banking if you deposited $100 in the bank and later took it out it wouldn’t literally be the same money.
That did lead to problems when everyone tried to withdraw their money all at once and was called a ‘bank run’ but nowadays we have an organization called the FDIC that insures most of our checking accounts from this even if the bank fails.
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