The Worst Case Scenario for Third Party Collections

Laws are changing, the economic outlook for consumer credit has never been worse, and a tidal wave of public sentiment is turning reliable collection agency clients against them. Could uncontrollable forces be conspiring to end the contingency debt collection industry as we know it?

While it’s highly unlikely, there are shining, neon red flags waving in the faces of decision makers in the third party collection space.

The Cash Cow is Sick

Credit card debt is the lifeline of the debt collection, and broader ARM, industry. With near-universal adoption spanning practically every socioeconomic classification, credit card debt has been commoditized by banks, investors, and the ARM industry. Declining card volumes could be a new normal for ARM companies in the very near future. Banks simply will not have the inventory of charged-off debt that currently burdens them, and upon which the ARM industry relies.

For starters, banks have been burning the candle at both ends in the last two years in their attempt to shed bad credit card debt from their balance sheets. By some accounts, more than $150 billion in credit card debt has been charged off since the summer of 2008. And it’s still growing: by every account, credit card charge-off rates topped 10 percent in the first half of 2010. The Federal Reserve posted their highest charge-off rate ever for credit card debt in the second quarter of this year.

Once banks work their way through all of the old bad debt, it would be natural to assume that fresh bad debt will take its place. After all, a certain percentage of all loans go bad. But a troubling trend has developed in the ratio of charge-offs to delinquencies:

From the beginning of 2007 through the first quarter of 2009, charge-off and delinquency rates were roughly aligned. This is logical, as delinquencies drive charge-offs. But in the second quarter of 2009, the situation changed.  Consumers seemed to get a handle on their finances and card delinquencies flattened. Meanwhile, banks ramped up their charge-off exercise in earnest. Ever since then, the two measures have diverged, culminating in a 10.66 percent charge-off rate and a 5.01 percent delinquency rate in the second quarter of this year. And the gulf widened before beginning to close in the third quarter. Put more simply, banks are running out of bad accounts to charge-off.

Newly-enacted provisions in the CARD Act will further pressure charge-off inventory. Card issuers are using stricter underwriting procedures for all loans, credit card included. With a new set of mandates intended to standardize credit card lending activity, only the most creditworthy consumers will see expanded credit limits similar to the mid-2000s. The result will be fewer purchases charged on cards.

Banks will still look to save money by outsourcing or selling their charged-off card inventory. But the volumes after 2012 will be a far cry from the halcyon days the ARM industry is currently enjoying.

Some Markets May Simply Disappear

In her address to a crowd at ACA International’s Annual Convention, new FTC commissioner Julie Brill explicitly stated that in her view, all debt collection activities on time-barred – or out of statute – debt should be banned. While current law protects consumers from lawsuits on time-barred debt, there is a sector of the industry that pursues this paper through traditional means.

The FTC also recently announced that it was clarifying its position on deceased debt collection. While the policy statement does not contain sweeping changes, and is generally accepted by those in the ARM industry that focus on the market, it is another sector that is being placed under the microscope.

Health care reform dominated the news in late 2009 and early 2010. Finally signed into law in March 2010, health care reform in the United States could have a dramatic impact on the ARM industry over the next decade. With every American required to carry some form of medical insurance, the portion of medical costs covered out of pocket will likely dramatically decline. These are the deficiency balances that collectors call on.

Speaking of health care reform, the American student loan industry was turned upside down by a provision embedded within the landmark legislation. The Student Aid and Fiscal Responsibility Act ended the practice of federally subsidized private loans. Now, all federal student loan funding will be devoted to direct loans from the government. While the overall volume of delinquent debt will not change at all as a result, there will now be only one client for student loan collection agencies to sell to: Uncle Sam.

How to Remain a Going Concern as a Contingency Collection Agency

The debt collection industry is a fragmented industry. The success of each firm is often predicated on the strategies put in place by management. Good firms can survive bad times while bad firms can fail in good times.

If a seismic crunch is coming, agencies will need to evaluate everything about their businesses, from the processes they use to collect, to the technology they deploy, to the industries they service.

If federal regulators succeed in passing amendments to the FDCPA in the next two years, once of the changes sure to be included will be requirements surrounding the use of courts to collect debt. Many of the requirements will involve proper files validating the debt as owed by the targeted debtor. The collection agencies and debt buyers that already require this documentation will have a jump on their competitors as they scramble to catch up. Also, in an environment where cost-cutting measures will see mass layoffs of frontline collectors, ARM firms that already leverage automated collection techniques will have a leg up.

In most industries, companies can count on growth by targeting different markets. But if markets are eroding in the ARM industry, this could be difficult. There are some markets, however, that will expand – like telecommunications.

As mobile phones become more ubiquitous and feature-rich, the price points for service have steadily climbed. Consumers no longer balk at paying $80 per month for a device that serves as their primary phone, email reader, and Internet browser. Likewise, cable companies have expanded their services to include HD premiums and an emphasis on On-Demand entertainment. This has resulted in soaring cable bills, which consumers also seem happy to pay. The telecommunications sector is already a very robust market in the ARM industry, but it will do nothing but grow over the next decade.

Regardless of the five-year outlook for contingency collections, the most successful companies will be those that act first and act boldly.

This article originally appeared in the free quarterly newsletter Know Your Debtor, a collaboration between insideARM.com and LexisNexis® Risk Solutions. To subscribe, please visit your My Account page.