Today’s topic focuses on what in the industry is called “Recoveries”. A recovery is the amount of money that you can extract from a debtor once a loan has been charged off and the value of the asset has been written down to zero. Although effective collections on charged off loans can reduce the impact of credit losses, keep in mind that recoveries can be significantly less important to a lender’s success than loan selection, pricing for risk, and diversification.
Given the regulatory structure under which Prosper was launched, there were certain practices that Prosper could not use without the consent of a majority of lenders. Our terms of service stated that at day 31 past due we place the account with a collection agency engaged to “cure” the account. If they were not successful, when accounts reached 121 days past due, they were held in a pool (with the agency continuing collection activity) until that pool was of sufficient size to sell the accounts to an unaffiliated debt-buyer.
The debt sale portion of this process worked reasonably well through year-end 2007. Prosper had four debt sales and lenders received recoveries ranging from 2.4% (cents on the dollar of outstanding principal) to 30%. There was a different buyer for each of the four debts sales and each buyer used different criteria to segment their pricing. Factors included: credit grade at origination, home-ownership and state of resident.
Looking below the surface of these sales, there were signs of weakness in the demand for Prosper’s loans. In the cases of the early sales, although a number of debt buyers were interested in viewing the file, there were few bidders. No previous bidder ever bid on a subsequent sale. There was a downward trend in sale price from the first to the last sale. In general the feedback we received from debt buyers was that the file was too small and the collections performance of the loans was unknown.
In April 2008, we sent out a bid file for what would have been our fifth debt sale. At the time we sent out the file, we knew that the market was saturated and prices were falling rapidly. When the bidding closed, we had what it appeared to be a bid of 3%. However, as we went into contract discussions, the buyer added a number of provisions and other conditions that made the deal unworkable. The best unencumbered bid that we had was only 1.5 cents on the dollar – with no differentiation by account attributes. We concluded that taking this offer was not the best economic decision, and not in the best interest of lenders.
So what’s happened in the past 15 months? Were we right or wrong not to take the bid?
The inventory of debt for sale continues to grow. Michael Ginsberg of Kaulkin Ginberg estimates that prices have fallen by 35% or more in the past year. Moreover, in a market saturated with credit card debt, there is no appetite for a new asset class such as Prosper loans.
If you look at the population of loans that were slated to be sold plus all the loans that would have become eligible to be sold by November 30th, 2008 – this represents the universe of loans that would have been sold during Calendar Year 2008. It totals 2,697 loans with total principal balance as of DPD 121 of $30,561,042. Going from the cut-off date of the sale file – or from the date when a loan reached 121 day past due, whichever is later, and looking at the payments received net any agency commissions, we have collected $695,244.22 in “recovery payments” on these loans or 2.27% of the principal balance [note: I use quotes around "recovery payments" because we did not identify payments as such until we implemented the "Charge Off" status on 10/28].
This shows a value higher than what the loans can command in current marketplace. So that should be a good thing – still there is an issue. The $695K in payments came from only 385 loans (14.3% of the 2,697 loans that could have been sold). Those 2,697 loans were funded by 26,401 lenders. Of these lenders, 40% (10,588) received at least one payment and 24% received more than 1.5% of principal. If you look at lenders with at least 10 loans in the population, 85% received at least one payment and 41% made more than 1.5%. This is a clear example of why diversification across many loans is important.
Why do we think not selling was the right decision? The overall dollars received are more. The average of the individual lender recoveries was 1.94% — again better than what was possible from a debt sale. We understand that at the end of the day many lenders will fare worse than they would have with a debt sale price of 1.5 cents; however, lenders were compensated based on the payment behavior of the loans they chose to fund. Had we taken the debt sale price of 1.5%, not only would lenders as a whole be worse off, but the lenders with paying loans could argue that they were being forced to subsidize lenders who chose loans that didn’t pay.
Perhaps most importantly, the new legal structure that Prosper adopted as part of the registration process gives us the flexibility to pursue a wider range of collections. Starting now, our plans relative to charged off accounts are as follows:
1. We continue to monitor the distressed debt market and to see if a sale is a possibility.
2. Until such time that the expected sale price exceeds the projected net recoveries for the first 12 months after charge-off, we are not going to sell.
3. We are going to place the accounts with a collection agency that specializes in charged-off accounts (the first agency has been identified and the contract is in the works).
4. The agency is going to employ a settlement strategy with settlement authority based on age, charge-off balance and current credit score. For post charge-off accounts, this is the best strategy to maximize total dollars recovered.
In order to maximize dollars to lenders, Prosper is going to waive any Failed Payment Fees, Bank Draft Fees or Servicing Fees that would come to Prosper in our normal payment hierarchy.
In general, the downside of employing a settlement strategy has been that it reduces the sale value of accounts that do not pay, but were offered a settlement. The lack of a market for Prosper loans means that this strategy really has no downside for lenders.
Although these steps are a departure from our original approach to severe delinquency, I am confident that they will result in both a larger amount of recovery dollars and a better per lender result for diversified lenders.