One interesting lens for understanding how industries work is looking at their waste streams. Every industry will by nature have both a stock and a flow of byproducts from their core processes. This waste has to be dealt with (or it will, figuratively or literally, clog the pipes of the industry) and frequently has substantial residual value.

Most industries develop ecosystems in miniature to collect, sift through, recycle, and dispose of their waste. These are often cobbled together from lower-scale businesses than the industry themselves, involve a lot of dirty work, and are considered low status. Few people grow up wanting to specialize in e.g. sales of used manufacturing equipment.

One core waste stream of the finance industry is charged-off consumer debt. Debt collection is a fascinating (and frequently depressing) underbelly of finance. It shines a bit of light on credit card issuance itself, and richly earns the wading-through-a-river-of-effluvia metaphor.

A disclaimer: I have had substantially more at-bats with debt collectors than most people, as a result of an old hobby of writing letters on behalf of debtors to their lenders and non-affiliated debt collectors. I did this over the Internet, on my own volition, because it seemed pro-social and I was extremely underused by my actual job at the time. This experience leaves me with strong opinions on the debt collection industry; a frequent archetypical person in need of a letter was a Kansan grandmother in diminished financial circumstances who had been harassed for months. I’m going to try to keep these views to a dull roar here, in the spirit of spending more mental energy on discussing why the system presents as so broken.

The lifecycle of a defaulted debt

The majority of debt which defaults in the United States is revolving credit card debt. (Without addressing the politics of it, the impression among many informed people that most defaulted debt is medically-related is the result of successful advocacy work rather than being substantially based in reality. Trustworthy numbers are not hard to come by, due to a combination of regulatory supervision and the U.S.’s almost unique degree of population-wide debt surveillance via credit reporting agencies. We’ll return to credit reporting some other day.) Assume I’m talking about credit card debt below, though the mechanics for medical debt bear overwhelming similarity. (I’d address it specifically except that healthcare economics is a fractally complex topic once you bring e.g. insurers, public programs, and the like into the mix.)

Credit card issues bucket users into various archetypes, personas, and predicted lifecycles, because behavior is extremely heterogeneous and this is important from both a marketing and risk management perspective. Most users of credit cards, probably including readers of this column, believe they are the typical user of credit cards; no bucket is typical. If I were to make some informed guesses, relative to the population-wide distribution, you, reader, use credit cards in preference to debit cards as a payment instrument, do not routinely revolve balances, and hold some combination of student loan, auto, and mortgage debt which dwarfs your credit card debt. And so it is critical to understand that most defaulting credit card debt is not held by people who act like you.

Most credit card debt which defaults non-fraudulently was incurred in the relatively distant past. Credit cards are revolving accounts; one’s balance can increase (even as one successfully makes payments) for years as one pays off a portion of prior balances but continues purchasing with the card. This is normal and expected use of the card, planned for thoroughly, much like never carrying a balance is also normal and expected use of the card, planned for thoroughly.

A small percentage of borrowers, carefully tracked and generally oscillating between 2.5% and 5% depending on the overall health of the economy, will go delinquent on credit card debt. (Some issuers specialize in certain parts of the credit spectrum and, as a result, will have sharply lower or sharply higher delinquency rates. American Express, for example, specializes at the high end and typically has delinquency close to 1%. Capital One made its name in so-called subprime credit cards, though it has diversified since, and typically tends towards the high end among banks whose names you know. There is a largely hidden ecosystem of banks you don’t know that issue very expensive products to poor people; you can accurately predict their default rates exceed anything mentioned above.)

Default typically begins by missing (or underpaying) a scheduled payment. That in itself is a theoretical breach of contract but not very outside the ordinary for a card issuer; they will generally automatically assess a fee but take very little action. Most borrowers will recover before they are 30 days late, which is the point at which most issuers start to treat an account as being a credit risk rather than a minor operational issue.

After 30 days, issuers will typically work the account internally, using a combination of communication methods to nudge the user into payment, until one of a few things happens. The happiest is the customer gets current on their account. An outright refusal to pay is substantially less likely, and can result in an issuer moving up timelines. But the most common is that the borrower ghosts the issuer for a few months.

Consumer debt issuance is generally, by law, an exclusive privilege of regulated financial institutions. (The other big one is taking deposits.) Society wants many things from regulated financial institutions; one of those things is having accurate books, because stealth losses cause financial institutions to fail and frequently leave society holding the bag. As a result, the Federal Reserve has a Uniform Retail Credit Classification and Account Management Policy.

This tail wags the dog. Many decisions about account servicing, which a naive conception of debt might assume are between borrower and lender, are done with the goal of aligning servicing to accounting standards. In this way, the books impose their will on reality, and where the books and reality differ, reality frequently adjusts itself to accommodate the books. (As my buddy Kevin frequently muses, states are gonna see. Organizations which are tightly tied to the state, like regulated financial institutions, will develop a vocabulary and processes for seeing like the state sees, and that edifice tends to capture non-state methods of seeing that they run in parallel.)

In particular, credit classification requires that financial institutions “charge off” delinquent debt. Mechanically, they have previously accumulated an allowance for delinquency on their books as a liability; they move a bit of that allowance to a bad debt expense. In principle, nothing has to happen to the actual debt. In practice, financial regulators encourage institutions to seek certainty and finality around this.

Financial institutions achieve certainty and finality by packaging portfolios of bad debt together and selling them to non-financial institutions. This durably moves them off of the books and realizes a very, very small residual value.

The debt collection industry

There are essentially two halves of the debt collection industry. A portion of it works on an agency model: a lender can have e.g. a law firm or similar work a debt on its behalf during the several month period where the delinquent debt lingers on their books, in return for a performance fee (often 15-30% of face value) should the borrower make good on the debt.

But debts, much like people, only age in one direction. Unlike people, debts universally decline in value as they age. We’ll return to that topic in a moment. Most debt which is not being serviced successfully by the first party lenders will not long be worked by their agents. It is instead sold to debt buyers, who will then attempt to collect the contracted amount (plus fees provided for in the contract, which are legally legitimate, and not infrequently fees which were not provided in the contract, which are frequently extremely questionable). Subtract the original cost of buying the portfolio and their substantial operational costs and the remainder is profit.

Most defaults are small. This fact drives everything about debt collection; it has to be done scalably, by the cheapest labor available, with a minimum of customization or thoughtful weighing of competing interests. The average defaulted credit card debt is on the order of $2,000, the median is between $500 and $1,000. These are processed like McDonalds burgers, not like grant proposals.

Debts are sold as part of a portfolio, where (typically) thousands of relatively similarly situated debts in a cohort are sold as a packet. The value of portfolios is a huge discount to the face value of the debts; at the point where a lender has only worked it themselves and the debt is a few months delinquent, portfolios generally fetch about 5 cents on