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12/20/2009 8:36:48 PM - Bankers Are Idiots

The US Federal Reserve currently lets banks borrow money for 0 to 0.25%. It is a testament to their ineptitude that despite such unbelievably low borrowing rates, most banks are still managing to lose money.

Here, then, is my gift to the banking world: I shall tell you WHY you are losing money.

The answer is not that you aren't charging high enough rates. The problem is that you are lending to the wrong people because you've lost sense of what a bank should actually be. A bank should have a relationship with the customer. It should look at each customer's individual situation and decide what interest rate - if any - justifies the risk for that particular type of loan to that particular borrower.

Instead, what you get today are a bunch of banks - large and small - that have certain rate ranges for mortgage loans, certain ranges for home equity loans, etc.. They take the type of loan (which denotes the range) and plug in your credit and income history and out pops an interest rate. It's a simple - and totally inane - system. I went to Bank of America. Mind you, I don't need to borrow money. If I can obtain capital cheaply enough, though, I can pay the interest on the loan and still turn a very nice profit because my return on invested capital is well north of 30%. I was extremely doubtful that they would be able to take my specific circumstances into account and, sure enough, the loan officer just nodded her head and said that there was nothing she could do despite the fact that my particular "risk profile" should warrant paying a much lower interest rate.

In this particular case, I was willing to pledge my home as collateral. Typically such a loan would be considered a "home equity loan", and those loans are often far more risky than mortgages. The reason for this - and thus the reason why home equity loans tend to have considerably higher interest rates than mortgage loans - is because in the event that the borrower defaults, the mortgage holder has the "first lien" on the house. They must be repaid in full before the second lien holder - the entity that granted the home equity loan - gets anything. Usually, then, the first lien holder gets all or most of their loaned capital back if they have to foreclose on the house and re-sell it, whereas the second lien holder often gets nothing. The second lien holder, then, is at far more risk of losing all or much of the loaned capital, and thus it only makes sense that the interest rates charged would be much higher to compensate.

That's all perfectly logical, right? Ok, so what happens when - as in my case - there is no "first lien holder". I own the house outright and thus the "second lien holder" would be the only entity with a claim to the house if I defaulted. The "second lien holder" - the company doing the home equity loan - is therefore at FAR less risk than they would be if I had a mortgage. Since they're at far less risk, the interest rate charged - regardless of whether you call the loan a "home equity" loan or a "mortgage" loan - should be considerably less than it would be if I had a mortgage.

Bank of America pitched that their lowest rate on a home equity loan, though, was 10.39%. That's a whopping 5.515 percentage points more than their (4.875%) mortgage loans (and the mortgage loans are for 30 years - 5 more than the home equity loan.) That makes absolutely no sense and is simply indicative of the fact that rather than looking at a potential borrower's specific situation, they try to shoehorn them into a category and base their decisions upon that. If the borrower doesn't fit into any of their pre-existing categories...they just toss them into the closest one. In this case, even though a "home equity loan" with me would be no riskier than a "mortgage loan" with someone else, they expect me to pay more than twice the interest rate a person of similar means looking for a mortgage would be charged. Amazingly, trying to borrow against 1% of your home's equity is no different (other than requiring an appraisal and some minor fees) than trying to borrow against 80% (which is the maximum that most banks allow) in terms of the interest rates that they'll ask you to pay. Whether you seek to borrow 1% (in which case the bank is at almost no risk) or 80% and do or don't have a first mortgage, the rates are still the same given your credit score and income. I mean, really...with idiotic loan guidelines like this it's no wonder that most of these morons are bleeding money hand over fist despite the incredibly low rates at which they can borrow money.

Such high borrowing rates drive the good borrowers like me away. I won't pay 10.39%. I don't really need the money...even though I could use and profit from the money. After paying such an exorbitant interest rate (and of course taxes on the gains), there isn't enough left over to justify the risk that I would face from the investments that I would make. So...who would pay such a high rate? That's right...the people most likely to "pay" such high interest rates are, on average, those people less likely to be able to repay the borrowed funds. It's like a loan shark charging someone 10% a day. The only people that will take you up on such terms are the truly desperate. I guess that's the target clientele for most banks today...the truly desperate. It's no wonder, then, that they're all seeing record levels of defaults. As the current financial crisis proves, charging higher interest rates isn't always the best answer to getting a return on your loaned capital. Sometimes, you can get a better return by charging lower rates and carefully checking the specifics of each customer.

- TZ

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