How is it profitable at all to auction debt for pennies on the dollar?
In: Economics
The debt holders hope to get something even if it’s a small amount relative to what’s owed. For the buyer, it’s the hope they can eventually collect more than they paid form the debt.
Because we cannot predict stuff accurately, institutions like banks follow certain guidelines and rules. Say someone borrowed $10,000 from a bank, then they get behind in repayment. The bank, following its rules, may decide “hmm this loan might not be repaid” and write it off. Rather than expecting $10,000, it might say, maybe it is worth only $10. To the bank, this might not be worth doing anything. It expects, through experience, that some borrowers default and they build that loss into their business model.
It packages these loans off and sells it to someone else, say a debt collector, for $10 who through their own efforts might be able to recover more than that from the borrower. This makes it profitable for the debt collector. This additional profit is “foregone” by the bank because it doesn’t really want to bother with certain types of debt collection (maybe bank employee salaries are too high to afford it)
debt is promised money, they don’t have it yet and you might default on it. if they’re auctioning off your debt then you’ve already defaulted and they don’t expect to make it back, so they sell your debt to someone. bank recoups some losses.
pennies on the dollar is money now. i settled an old debt of 10k for 2k. they’d much rather have something now than the promise of something later.
So, lets say you are a company that has a customer that has a debt to you, like a hospital. Someone owes you $50,000. You’ve tried for a long time to get the money, and you just aren’t getting paid.
So you sell the debt at lets say 10 cents on the dollars. You get $5k for the $50k owed. $5k is better than nothing. And nothing is what you had before.
The company that buys the debt, tries to collect from the debtor. They offer the debtor a reduced rate, like $35k. Because even if they get $35k it’s a profit over the $5k they paid for the debt. But the debtor never pays.
So the company sells the debt again. Maybe they get 50 cents on the dollars, but hey, getting $2500 is better than zero.
That next debt company tries to collect the debt of $50k. They offer huge discounts again, maybe even going as far down as $20k to settle the debt, because they’ve only paid $2500 for it. But, no go. So they file a lawsuit and go to court. Now their costs go up, lawyers fees, court fees, etc, but in court they are likely to get better outcome. The court sides with them, but, the borrower has no unprotected income. They are on disability, so the income cannot be touched. Well, this debt company just lost $2500 plus all the fees. Maybe a total of $5k.
That’s for someone who doesn’t pay. Now consider the first debt company gets paid. Instead of losing $2500, they settle the debt at $35k. Now, they just made a $30k profit.
Or, the 2nd debt company is the one who ends up collecting on the debt. They get the court to award them the debt and garnish wages. So now, they are collecting $400 a month, but over a few years collects most of the money. They make the profit.
The profitability comes when debt company 1 or 2 actually get to collect their money. The hope for those companies is for all the debt they buy cheap, if they can ultimately collect on just a few of those debts, they will make a profit.
It isn’t. I mean, not in comparison to collecting in full on all the debt.
But of course realistically speaking nobody is going to be able to do that. A bunch of that debt isn’t going to be possible to collect on because the person who owes it simply doesn’t have the money.
However *some* of the debts might be able to be settled for some fraction of the overall sum. Figuring out which those are is quite the task and something the current owner doesn’t want to bother with. So they have a choice: Give up on all the debts, or sell it for some fraction of the overall amount to someone willing to put in the work to salvage as much as possible. No money compared to some money is an easy choice.
It isn’t. It’s an attempt to at least get back some of the lost money. It isn’t a way to profit but jus make it less expensive.
It’s not *profitable*, but it’s a judgment call to try and maximise the potential recovery of otherwise lost revenue.
Think of it as two distinct businesses. One is the lending business, another is the collection business for bad debts.
So you lend to 50 people, 48 of them pay back on time no issues. One guy let’s call him Bob is late, but is pretty sure after a month he can pay. So the company decides to hold him to it. Then there’s Sally. Sally just stopped playing and they can’t get in touch.
So lender realizes getting money out of Sally is going to be a chore. They will either need to sue, or adopt aggressive tactics. There’s legal risk: some collections tactics are illegal. There’s also a risk she’ll file for bankruptcy and extinguish the debt, they have no idea.
It’s a small percentage of their world, and lender’s people aren’t trained to deal with Sally. They’re trained to bring in more borrowers and service good borrowers. So they go to debt collector John and John says, I’ll give you 7 cents on the dollar for it. In other words, let’s say Sally was lent $100, John will pay the lender $7 and now Sally owes John the full $100.
The transaction is good for John, because he thinks he can squeeze her for more than $7 and make a profit.
It’s good for the lender because it gets *some* money. It also allows them to move on and focus on other stuff.
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