How banks can charge higher loan rates despite Fed rate cuts
Here is the simplistic reasoning why banks are charging higher loan rates, despite Fed rate cuts (explained well by Jonathan Miller / Matrix)
- Investors of any kind of mortgage backed securities have vanished.
- Therefore, banks, as lenders, can no longer offload their mortgages to investors like Bear Stearns or Lehman Bros.
- Now banks are forced to hold the loans they make.
- This is why banks are recapitalizing, and still need $100 billion more (according to UBS analyst) to offset the losses from write-downs on bad loans, so they can make more loans.
- Since banks are assuming risk for the loans they make, they charge higher rates for these loans. Greater risk, greater return (in business school, this is called CAPM)
- Many lenders have disappeared, leaving little competition.
- Since banks don't have the capital to make loans (see #4 above), they make loans only to their best credit worthy customers
- With loans hard to get (#6 & #7), banks can now charge higher rates for bigger margins.
- Banks have tightened their control on lending because the competition (#6) is lighter , and many banks have closed their wholesale divisions. Loan brokers and consumers have fewer choices and are channeled to interface directly with the banks.
- Even with this control, banks have no reason to make loans now (#7, and they can't process them well anyway, they fired their processors in dramatic cost cutting measures), giving them absolute power over a desperate customer base.
- Symptom: Brian Brady tells me last week, "this is the worst funding environment I've seen"... confirming lending standards are too strict and the obscenely long time to close loans. Resorting to hard money is one way to complete transactions.
- This is why Wall Street has been calling the credit system broken. Banks prospered with the arbitrage business model associated with funding loans to consumers and selling them to investors and banking a part of that margin. Obviously arbitrage at this scale takes credit. The banks need to prove, in order, their purity (by write-downs of bad loans), their solvency (by recapitalizing) and their repentance (by sticking to "safe sex" loans) to regain the trust of the credit system. Over the last week, there has been media attention on the abatement of the credit crisis to varying degrees.
- Once credit kicks in to support the banks' higher leverage/higher return investor model, loan rates will likely drop because the banks will be motivated to underwrite more loans to sell to investors.
- Barry Ritholtz points out and interprets a shareholder report by Swiss banking giant UBS explaining the mechanics of their $37 billion write-down. The banks simply created a management compensation system that rewarded the deal, without adjustment for risk. By extension, these same systems were endemic to the industry. The banks collectively didn't know what hit them.
- Brian (#11) and I are amazed no bank steps up to the plate to attract consumer good will by simply funding loans on time! Think of what a great marketing play that would be.
- All banks' earnings are suffering, so they all feel justified to an oligopolistic position that increases their earnings by creating a loan supply bottleneck. They act like airlines; once the low cost carrier disappears, prices jump. Like any oligopoly, nobody is rocking the cart with conspicuous excellence. Just like those WAMU commercials... the bankers' club is back!
Pat. Thanks for laying this out so well. It's helped me explain the seeming paradox to clients. I like the conspiracy theory too. got me thinking and writing a bit: http://tinyurl.com/3numdl
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