The Basics of Bankruptcy Risk Management When Making Consumer Loans
 
June 22, 2004
 
James L. "Jim" Fly- Orlando

Consumers have continued to file for bankruptcy protection in record numbers.[1] Notwithstanding these increases in consumer bankruptcy filings, economists suggest that the economic climate has recently begun to improve.[2] Increased consumer spending was a contributing factor to the strengthening of the economy; however, that increased consumer spending was financed through a record level of consumer debt.[3] When interest rates rise or when the economy otherwise begins to show signs of weakening, the record level of consumer debt has the potential to wreak havoc on lenders’ consumer loan portfolios.[4] In order for lenders with portfolios of consumer loans to be prepared for the next softening of the economy, there is no better time than the present for such lenders to review their lending practices to minimize credit risk and to reevaluate their objectives with respect to consumer bankruptcies.

While lenders will always face some risk that consumers will file for bankruptcy protection, those lenders who take preventative measures during the loan application stage can reduce the risks associated with and the effects of consumer bankruptcy filings. Consumer bankruptcy filings affect unsecured creditors and secured creditors in drastically different ways. With respect to the unsecured creditors, debtors are either able to wipe out unsecured loans altogether or debtors are required to pay only a tiny fraction of the debt owed. In contrast, secured creditors having properly perfected first priority liens, should expect debtors to surrender the collateral or to make payments to retain the collateral as provided for by bankruptcy law.

The legal expenses that lenders incur enforcing their rights to the fullest extent under bankruptcy law, with respect to unsecured loans, often outweigh the value of achievable benefits. Rather than expending resources litigating unsecured loans that have, pragmatically speaking, succumbed to bankruptcy, lenders would be better served by using those valuable resources to establish and adhere to protective measures at the loan origination stage and enforce their rights in bankruptcy with respect to secured consumer loans.

Focusing on the Collateral

The appropriate time to protect against bankruptcy loss is during the loan application stage. In bankruptcy, collateral will be the key to being repaid. Nothing reduces the risk of bankruptcy loss more than perfection of liens in a timely manner and a high collateral to loan balance ratio. Since the collateral may be difficult to locate upon default, lenders should require the loan applicant to state in writing where the collateral will be kept and where it will be used. Lenders should inform the loan applicant of any restrictions related to the transfer of the collateral to third parties without the written consent of the lenders. If the loan applicant is required to maintain insurance on the collateral, then lenders should require the loan applicant to submit proof of insurance contemporaneously with the extension of credit. Documents related to the location and insurance of the collateral should be retained in the loan file and periodically updated.

Lenders should also determine the value of the collateral that will serve as the basis of the loan and ensure that the loan amount does not exceed the loan-to-value ratio based for that type of collateral. While industry resources such as the N.A.D.A. official car guide often provide lenders with a basis to determine the value of common collateral, independent appraisals should be performed as a matter of course for unique collateral such as real estate. Documents reflecting the value of the collateral at the time of the loan application and the loan-to-value ratio for the collateral should be retained in the loan file.

The law governing perfection of security interests varies by the type of collateral. For example, while state law generally governs perfection of security interests in real property and most types of personal property, federal law governs perfection of security interests in personal property such as certain aircraft and vessels.[5] Furthermore, the necessary steps to be taken to perfect a security interest may differ depending upon the nature of the loan being made and the status of the collateral. For example, when lenders provide floor plan financing to automobile dealers, perfection of the security interest generally occurs by filing a financing statement covering inventory (which is comprised of motor vehicles) with the secretary of state.[6] In contrast, when lenders finance the consumer purchase of a motor vehicle, perfection of the security interest generally occurs by recording the security interest on the certificate of title.[7] As a result of these differences in the law governing perfection, lenders should always require loan applicants to describe in writing any known liens related to the collateral, and lenders should independently assess the existence, validity and extent of any liens.

After deciding to extend credit to a loan applicant, lenders should take steps to timely and properly perfect their security interests. For example, upon granting of a security interest in a motor vehicle, lenders should take the necessary steps to properly perfect the lien. In the event that the liens are not properly perfected in a timely fashion, the liens may be void under bankruptcy law.[8] By implementing the procedures outlined above and by rigorously adhering to such procedures, lenders can reduce the credit risk associated with the filing of a bankruptcy petition.

Focusing on the Borrower

With respect to both secured and unsecured consumer loans, lenders should also take preventative measures at the loan origination stage that focus on the creditworthiness of the loan applicant. Lenders should require the loan applicant to complete and sign a loan application. A loan application should contain information such as a home address (not a post office box number), home telephone number, work telephone number, employer name, employer address, an income statement, a balance sheet and the applicant’s authorization for the lender to verify the applicant’s credit.[9] Lenders should also require the loan applicant to provide documentation supporting loan applications, including copies of pay stubs, prior years’ income tax returns, and statements of investment and retirement accounts.

Only after analyzing the loan and confirming the accuracy of that information through a credit report is the lender in a position to determine whether to extend credit to the loan applicant. All documents provided by the loan applicant should be retained in the loan file. The procedures that lenders have adopted should be strictly adhered to and uniformly implemented throughout the organization.

While these measures may slow the lending process and burden lenders with additional upfront costs, such steps should improve the total quality of the portfolio of consumer loans and translate into lower overall expenses associated with loan consumer bankruptcy filings.

For more information, e-mail James Fly at james.fly@hklaw.com, or call toll free, 1-888-688-8500.

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1. See American Bankruptcy Institute, U.S. Bankruptcy Filing Statistics, http://www.abiworld.org/stats/newstatsfront.html (visited Feb. 13, 2004) (hereinafter “ABI Statistics”).

2. See Richard Berner and Shital Patel, United States: No Slowdown in Business Conditions, Morgan Stanley Global Economic Forum, available at http://www.morganstanley.com/GEFdata/digests/latest-digest.html#anchor1 (Feb. 13, 2004).

3. See Federal Reserve Statistical Release, Consumer Credit, December 2003 (released Feb. 6, 2004), available at http://www.federalreserve.gov/releases/g19/Current/ (visited Feb. 13, 2004).

4. See William Branigin, U.S. Consumer Debt Grows at Alarming Rate, washingtonpost.com (Jan. 12, 2004), available at http://www.washingtonpost.com/ac2/wp-dyn/A10011-2004Jan12?language=printer (visited Feb. 13, 2004); see also ABI Statistics.

5. See 49 U.S.C. §§ 44101-44112; 46 U.S.C. §§ 31321-31343.

6. See, e.g., Tex. Transp. Code Ann. § 501.111 (LEXIS 2003).

7. See, e.g., Tex. Transp. Code Ann. § 501.111 (LEXIS 2003).

8. See, e.g., 11 U.S.C. § 544(a), 547(c)(3)(B).

9. See, e.g., First Card v. Leonard (In re Leonard), 158 B.R. 839, 844 (D. Colo. 1993).