The “BK” Man Returns

Brett Christensen
August 6, 2008 | COMMENTS

I hate to be the one to tell you, but it looks like your old nemesis (loan losses due to bankruptcy) is making a return. The bankruptcy law changed in October of 2005 and you had a nice break from losses in 2006, but on January 3, 2008, Sam Gerdano, director of the American Bankruptcy Institute, made this statement: “The number of Americans filing for consumer bankruptcy increased by nearly 40 percent in 2007 over 2006. The spike in 2007 presages an even higher number of filings this year as the heavy consumer debt load is made worse by the home mortgage crisis.”

I also read online that February 2008 bankruptcy filings were 15% higher than January 2008. Ouch! It definitely appears that Sam's prediction for an increase in 2008 filings is coming true.

I bet some of you lenders are thinking right here, “this sounds like the collector's problem.” No, I disagree. A very important point for a lender to realize is that members who are in a financial bind will come to a lender for more money before they go under. There are many times that your collector does not even know your member is in a financial mess and the bankruptcy filing notice will show up at the credit union from the District court.

Therefore, a good interviewer and a good underwriter are on the lookout for members that are heading down bankruptcy's road. Before I write about how to recognize members that are heading down this path, I would like to share a survey that I found in USA Today a number of years ago when filing for bankruptcy was all the rage.

Why Do People File Bankruptcy?

Here are the top reasons why people file for bankruptcy:

1. Credit card bills (63%)
2. Job loss or pay cut in the family (50%)
3. Mismanagement of personal finances (37%)
4. Medical bills (28%)
5. Difficulties with a business they own (15%)
6. Divorce or breakup of a marriage (13%)
7. Lawsuit or legal bills (12%)
8. Taxes (10%)
9. College expenses (8%)
10. Death in the family (7%)
11. Gambling debts (2%)

Please understand that there are five things on this list you cannot predict as an underwriter (because you do not have a crystal ball that can see the future):

• Job loss
• Divorce
• Medical
• Lawsuit
• Death

But doesn't Reason 3 in the survey sound a little bit like Reason 1?

I will bet that if your members cannot manage their personal finances they have a credit card or unsecured debt problem. In other words, the No. 1 and No. 3 reasons for people going to bankruptcy court had to do with unsecured debt. Hmmmm....

A number of years ago, I learned the three statistically validated early indicators of bankruptcy and this knowledge saved our credit union hundreds of thousands of dollars in potential loan losses (and it can do the same for you).

The following information was written in Credit Union Manager's Newsletter, Volume 23, Number 8, April 1997. After reviewing credit bureau profiles for two million consumers, CCN identified these early indicators of bankruptcy:

1. Escalating debt.
2. The amount of unsecured debt.
3. Maxed-out revolving lines-of-credit.

Escalating Debt

Simply put, this is how much debt a member is bringing on and how fast he/she is bringing it on. Consumers often load up on new loans before they file for bankruptcy.

In order to measure escalating debt, you need to look at three things:

1. The number of inquiries members have on their credit bureau report. If members are applying for new loans, their debt load is about to escalate. Look carefully at the list of inquiries. If a member has twelve inquiries at auto finance companies over two weekends, that is just really one inquiry (because they are out trying to buy a car). But if they have 30 or 40 inquiries at every type of lender over a two-year period, bells should be going off in your head. This behavior is not a little unusual—it is real unusual. Did you know that according to www.myfico.com the average American has only one inquiry per year?

An important point to remember regarding the number of inquiries a member has is that he/she doesn't have to make payments on inquiries. In other words, inquiries alone are not going to send your member to bankruptcy court. But what do inquiries lead to? The second thing you need to be looking for.

2. The number of new loans with balances. I recommend that lenders go back 18 months and count the number of new loans with balances. How many is too many? It is difficult to say without having all of the member's loan application information in front of me. It certainly ties in to a member's income. Somebody making $90,000 a year can handle more new loans then someone that makes $30,000 a year.

I know what the wrong answer looks like. If the member in front of you makes $30,000 a year and they have five, six or seven new loans in the last 18 months, that is way too many. They are not used to those new loans and the payments will bury them.

3. The number of total loans with balances. I don't care if the loan is new or old—how many loans with balances does the member have? How many is too many? Again, that depends on income. A member or members that make $120,000 a year can handle a lot of debt. They could handle a first and second mortgage loan payment, two car payments, a boat and motorcycle payment, and four credit card payments (10 loans with balances).

Again, I know what the wrong number looks like here. Your member(s) makes $40,000 a year and they have ten loans with balances. It is just too many, it will kill them financially.

Please be careful of three situations where escalating debt can easily occur:

1. Members buying a house . They call buying a house the “American Dream,” but I would prefer to call it “The American Financial Nightmare!” I have purchase four in my lifetime and I will never buy another (because I take four steps backwards financially). You circle the day a member gets a new mortgage loan and then just watch all the other loans that pop up on their credit.

I am not saying that everyone who buys a house is going bankrupt, but I am saying that this is a life event when escalating debt can easily occur and you need to be on the lookout for the problem. You know in this great country, the member doesn't have to turn back in the plasma TVs and the dining room table when they file for bankruptcy.

2. Members new to the workforce . These are the youngsters, kids 18- to 24-years-old that get out of high school or college and land a good-paying job. They know that they need credit and they plan to be good with that credit; but when it becomes escalating it can bury them.

3. Members new to the country . These are the immigrants that come to America and land a good-paying job. Again, they know that they need credit and they plan to be good with their credit; but if it becomes escalating it can bury them.

Excessive Unsecured Debt

Once you understand the financial destruction a high-interest rate credit card can cause, it becomes no surprise that excessive unsecured debt is a bankruptcy predictor. Consider the following example:

Credit Card Balance: $8000

Interest Rate: 18%

Minimum Payment Required: 2% of Balance

Members find themselves in this situation and decides to never charge again. How long will it take them to pay off the balance, just making a 2% of balance payment? Just 47 years!!

If it takes this long to payoff an $8,000 balance, how long does it take to pay off $30,000 or $40,000 in credit card debt making minimum payments? And what happens if they go late one month or a credit score drops and suddenly their rate jumps to 24% or 29%?

Excessive unsecured debt is measured by looking at a debt ratio, but it is not your total debt ratio or debt-to-income ratio which measures total monthly payments divided by monthly gross income.

The unsecured debt ratio (UDR) is calculated by dividing total unsecured balances by a member's annual gross income. For example:

UDR = $20,000 (unsecured balances)

$60,000 (annual gross income)

UDR = .33 or 33%

I include the following loan balances in the unsecured balance figure (the numerator) above:

1. Credit card balances.
2. Signature loan and unsecured line-of-credit loan balances.
3. The mystery installment loans (the finance company loans that jump to 24% if they are not paid off during the introductory period).
4. The new unsecured money I give the member today (signature loan or the advance on a credit card or line-of-credit loan, not the credit limit that I don't know if they will use).

I do not including the following loans in the unsecured balance total:

1. Any secured loans.
2. Student loans (there is no specific bankruptcy threat associated with student loans because the government-backed student loans cannot be included in a bankruptcy filing).

Once you have calculated this unsecured debt ratio, you can observe the following guidelines:

• An UDR < 20%: Generally speaking, you are OK (i.e., they should be able to handle this amount of unsecured debt),
• An UDR between 20% and 30%: “Slow Down and Be Careful.” This doesn't mean you can't do a loan, but your preference would be secured or maybe you give them less unsecured money then what they are asking for.
• An UDR > 30%: “Danger, Danger, Will Robinson!” Again, I'm not saying that all of these loans have to be denied, but this is a lot of unsecured debt. If you are going to approve a loan here, it should probably be a secured loan.

Maxed-Out Revolving Lines

Interestingly, we learn that maxed-out revolving loans are a bankruptcy predictor from the FICO credit score. As you remember, 30% of the FICO score is a component called “capacity” and the primary weighting of capacity is how much of the revolving loan limits are being utilized. In other words, as the limits of the revolving loans are used up, the credit score goes down (which signifies greater risk to the lender).

All of this is very logical. If members find themselves in a financial bind and they do not have a significant savings account, what becomes their savings account? Their credit cards. If their credit cards are then maxed out, their financial future may be bleak (and FICO is trying to predict their financial future).

As you go down the list of loans on a member's credit report, pay attention to what the revolving loan balance is compared to its limit. If several or most of the revolving loans are maxed-out, it is a very big red flag.

One flaw that you need to understand about the measure of a member being maxed-out (the percentage of revolving limits that are available) is that it looks at percentages, not balances. In other words, one member that has only 10% of their revolving loan limits available can be in financial trouble (because they have $36,000 in credit card balances and $40,000 in limits); but the other member that has 10% revolving available is not in financial trouble (because they have $900 in balances and $1,000 in limits).

Frequently I am asked in my travels for my opinion of the credit bureau's bankruptcy score. I would say that about one-third of credit unions pay to have the credit bureau include this score on the credit report. Here are my thoughts regarding this score:

• I am fine with you looking at this score. My experience of looking at loans that end up in bankruptcy tells me that the score does a pretty good job of predicting members that are heading down this road.
• But I would not use the bankruptcy score in your loan pricing matrix. For pricing you need to stick with the FICO score so that you don't have to try to explain the bankruptcy score to members.
• The one knock I have on the bankruptcy score is that your credit bureau rep will probably not come and teach you how it is calculated. And I do have a problem putting faith in a number that nobody will explain to me.

In conclusion, I will say that you should not feel obligated to purchase the credit bureau's bankruptcy score. Personally, I would rather have well-trained underwriters who know the three statistically validated predictors of bankruptcy and they are looking for them on every member's loan application.

BK Predictors—What Do You Do Now?

Once you have been trained to look for bankruptcy predictors, they will jump off the page at you as you review member credit reports. One of the things that is most interesting about the three predictors is that often they exist with A-, B-, and C-paper members that have had years of perfect credit.

The bankruptcy laws have changed, but the issue of bankruptcy is not going away. At many credit unions, up to half of all credit union charge-offs are caused by members that file bankruptcy.

Let us clarify one fallacy right up front: You can never completely avoid bankruptcy—you can make a great loan today and bad things happen down the road to good loans and good people. But you do need to learn how to spot the obvious cases of members heading down bankruptcy's road.

Let's clarify another fallacy: A member's total debt-to-income ratio does little to forecast BK!

A study was done a few years ago by Purdue University for the Filene Research Institute and one of the findings was that 65% of all bankrupts had debt-to-income ratios of less than 40%. Wow. The three statistically proven indicators of bankruptcy are:

1. Escalating debt.
2. An excessive amount of unsecured debt.
3. Revolving loans that are maxed out.

When a member is applying for a loan and the three bankruptcy predictors exist, would you want to approve that person for an unsecured loan? Probably not, although it does depend on the severity of the predictors.

You are probably going to deny a loan unless:

1. The member is applying for a secured loan and you will be well protected in the event they file (a 20% to 30% positive equity position). With a significant equity position in a secured loan, you will come out OK if the collateral is turned back to you by the member when they file.
2. The member has an equity position in his/her house. The overwhelming percentage of members that file bankruptcy do not move, so your chance of a re-affirmation of a loan that is against their house is very good. This makes a strong argument for the credit union offering equity loans up to 100% of the home's value, especially if you can move your unsecured loans over to the house before they file for bankruptcy.

Learn the three statistically proven indicators of bankruptcy to improve the quality of your underwriting decisions.

Brett Christensen is owner CU Lending Advice, LLC. Contact him at brett@culendingadvice.com or 800-219-9733.