Banks and profits...summarized

[Wagner]

NEW YORK (Money) -- Question: Do you think it's morally fair for a bank or mortgage company to make profits from the interest on a home mortgage when all people are trying do is provide a home for themselves and their family? --Herbert K., Anchorage, Alaska

Answer: Essentially, you're asking whether the economic and financial system we have in the United States is equitable. It's a fair question, excuse the pun, and one that many people are asking today.

Given what's happened over the past year or so, there's a widespread perception among many people, justified or not, that the system is rigged or at least inherently flawed. How else, they say, could so many members of the financial community exploit the financial markets for their own gain by peddling toxic mortgage securities and derivatives that ultimately damaged the economy while leaving taxpayers (most of whom never bought derivatives or defaulted on their home loans) with the tab for the bailouts?

There are enough experts barking back and forth at each other on these matters, each claiming the moral high ground. I don't want to simply add to the cacophony.

Rather, I'd like to suggest a few ways you might think about our financial system and how it works, so that you can come to your own conclusion about how fair or unfair it is, recognizing at the same time that no system is perfect.

Let's start with your question. You ask whether it's moral for a bank to profit from mortgage interest when all someone is trying to do is put a roof over his or her family's head.

Well, let me put a question to you: Would it be fair for a bank not to pay its employees?

I think you'd agree the answer is no. We expect to be paid for our work. But if a bank doesn't charge interest on the loans it makes, then how can it generate the revenue it needs to pay the people who work there? At the most fundamental level, that's what banks do. They lend money to make money.

I guess you could say, okay, banks should be able to pay their expenses and even make a profit. But couldn't they also be more empathetic when evaluating borrowers and setting loan rates, and perhaps cut some slack for people who need loans but can't afford to pay the going rate? In other words, why can't they lower the rate in cases where people deserve some help?

But would that be fair? Who would decide who deserves lower rates? What criteria would be used? If a bank charges some customers less, it will have less money to pay to the people who earn their living working at the bank (which, by the way, isn't just hot-shot executives, but tellers, administrative people and lots of others who aren't pulling down huge bucks).

And there's another party to consider in this decision: savers. To get money to lend, banks must attract it from depositors. If you're a retiree living off interest from CDs, would you be okay with earning less on your CDs because the bank wants to give a break to more deserving borrowers, whoever they may be? Or would you be more inclined to get your CDs from a less compassionate bank that can afford to pay you more interest because it insists on getting the highest rate it can on its loans?

Obviously I'm skipping over lots of details here. But the point is that interest rates, whether those paid to depositors or charged on loans, are not figures that banks dream up or set arbitrarily. Interest rates represent an interaction between savers and borrowers, with savers wanting the highest rate they can get and borrowers the lowest. While it may seem from the outside that the bank sets the rate, it's really the pull and tug between borrowers and savers -- as well as other forces in the economy -- that do so.

Interest rates are the price people pay for the use of money -- i.e., what banks pay depositors and borrowers pay banks. And it's that price that ultimately determines where savings or capital goes -- i.e., which banks attract it and which borrowers get it -- just as the price of cars or electronic gadgets determines who buys them and how many are produced each year.

That, in a grossly oversimplified way, is how our system, a market-based system, works.
Fixing flaws in the system

Is it perfect? Hardly. We've seen the effect of some of its weaknesses over the past year. One problem was that many lenders apparently felt free to make dubious mortgages because they knew the loans would be bundled into securities and sold to other people. The lenders didn't have to worry whether the loans would default.

But there are ways to address these weaknesses. Tighter and more comprehensive regulation is certainly one prescription that the Obama administration is already considering.

Higher capital standards for financial institutions might also help. We've got to remember, though, that regulation and capital requirements also have costs. Regulate too heavily or impose onerous capital requirements and you may raise the cost of borrowing, making it even harder for people to get loans they can afford. I'd note that other forms of government intervention that are popular in some circles today, like setting compensation levels for executives, also have at least as much potential to do harm as good.

Clearly, there are lots of other issues -- job creation, health care, tax burdens, etc. -- to consider in determining the fairness of our economic system. But my feeling is that, when you tote up its plusses and minuses, our system is pretty fair, although there's plenty of room for improvement. I can understand, though, that others may feel a lot differently.

So when you're considering whether our system is equitable, don't restrict your gaze to a single group of people. You've got to consider the ripple effects actions may have on other groups. An attempt to give an advantage to one party (in your case, deserving homeowners) could very well disadvantage another (retirees living on interest payments) that would then feel aggrieved.

Do this often enough and the system devolves into myriad splinter groups clamoring for special treatment and feeling aggrieved and resentful if they don't get it.

All these issues, both in the financial arena and beyond, have huge implications for our economy and our society overall. They deserve a public airing and spirited debate as we work through the detritus of this recession. I, for one, look forward to it.

[amacman]

they give cheap loans to employees and friends then rob anyone who gives them the opportunity . truth .sure they need to attract savers and investors but the interest charged on loans varies widely depending on the gullibilty of the borrower .

[cbirk]

Originally Posted by amacman

they give cheap loans to employees and friends then rob anyone who gives them the opportunity . truth .sure they need to attract savers and investors but the interest charged on loans varies widely depending on the gullibilty of the borrower .

Do we need additional legislation and regulation to protect the stupid from their own stupidity (understanding that each of these increases the cost for the more savvy consumer)? Where does it end? Today it's banking, tomorrow Ebay? Shouldn't Uncle Barack also protect people on Ebay from paying too much (I see variable pricing there as well preying on the gullibility of the purchaser)? Maybe the gov't should establish appropriate pricing for all goods and services?

[JCL]

Originally Posted by cbirk

Do we need additional legislation and regulation to protect the stupid from their own stupidity (understanding that each of these increases the cost for the more savvy consumer)?

If you are referring to the stupid consumers, then no, as long as they are personally bearing the costs of their own stupidity.

If you are referring to the stupid bankers, then yes, as the costs of their stupidity (and greed) are passed on to society at large. Transparency would be improved with a reasonable regulatory environment, thus lowering the costs to society.

[cbirk]

Originally Posted by JCL

If you are referring to the stupid bankers, then yes, as the costs of their stupidity (and greed) are passed on to society at large. Transparency would be improved with a reasonable regulatory environment, thus lowering the costs to society.

Interesting point.
I would argue that excessive government involvement is a greater issue than banker stupidity. With Fannie and Freddie (and consequently Uncle Sam) backing bad loans, why wouldn't bankers take more risk if that risk isn't going to be retained?

[amacman]

Originally Posted by cbirk

Interesting point.
I would argue that excessive government involvement is a greater issue than banker stupidity. With Fannie and Freddie (and consequently Uncle Sam) backing bad loans, why wouldn't bankers take more risk if that risk isn't going to be retained?

that is the problem , the finance sector were deregulated to the point that they could do what they saw fit , unfortunately some of them were blinkered by their own greed and not fit to be in such a job .
they do not care that the government and thus society picks up the tab for their greed.
if they were faced mano a mano with the victims of their actions , do you think they would accept a punch in the face as a bonus .

[cbirk]

Originally Posted by amacman

that is the problem , the finance sector were deregulated to the point that they could do what they saw fit , unfortunately some of them were blinkered by their own greed and not fit to be in such a job .
they do not care that the government and thus society picks up the tab for their greed.
if they were faced mano a mano with the victims of their actions , do you think they would accept a punch in the face as a bonus .

Isn't it the government involvement (and not deregulation) that has Fannie and Freddie buying bad notes?

[Wagner]

Originally Posted by cbirk

Isn't it the government involvement (and not deregulation) that has Fannie and Freddie buying bad notes?

Yep. Also has car lenders being told to allow credit under 620 scores to be considered for loans.

[JCL]

Originally Posted by cbirk

Isn't it the government involvement (and not deregulation) that has Fannie and Freddie buying bad notes?

Yes, in the form of intervention, as opposed to regulation.

It wasn't the only factor, though. The two were publicly traded, and they reportedly saw big stock price gains following their move into risky notes in 2000, with corresponding bonuses paid to their executives. Sounds like a lot of other companies. As MacLeans reported, perhaps they were driven "largely, though not wholly, by the same distorted incentives as the rest of the subprime circus"

So, there was pressure from Congress, Wall Street, and shareholders. All contributed to management making bad decisions, short term gains that were far too risky.

What might have helped is a regulatory environment that set certain standards around leverage and capital ratios. More transparency would allow investors to realize what they were investing in.

Another interesting debate is whether the nature of state regulation of banks in the US is a contributor. Being regulated by a number of agencies is not as effective as having a single regulator.

There is a lot of discussion about the amount of regulation, but not so much about the quality of that regulation. Not all regulation is created equal. Regulation that is rules-based tends to promote rule-skirting. Regulation that is principles-based tends to promote more of an approach focused on risk evaluation and better management decisions, IMO.