Q: Ilyce, I have been confused over the last six months by how the major banks are reaping major profits while the number of homes in foreclosure continues to rise.

Don’t the bad home loans have an impact on the banks’ bottom lines? If so many of these home loans are bad and yet they have still been able to rake in large profits then why did we bail them out?

A: Thanks for your thoughtful question.

The country’s biggest banks have profited in 2009 in a variety of ways. For Bank of America, Merrill Lynch has brought extraordinary profits. Goldman Sachs profited by hedging against its real estate investments and not getting in as deeply as other big banks.

Also, when banks help consumers by originating mortgages, they’re pocketing profits from those loan originations as well. This year, many people have refinanced to take advantage of mortgage interest rates that touched 50-year lows twice.

And, more consumers have been saving money rather than spending it. A lot of people have put their money into savings accounts that are insured by the FDIC. Banks are using that cash (and paying less than 1 percent on it) and lending it out at 6, 7, 10 or even 14 percent to small business owners (or up to 30 percent for credit card customers) and other types of borrowers. The spread is extremely profitable.

Let’s talk about how mortgages get done. When you go to a lender and apply for a loan, the initial capital to fund the loan might come out of the bank’s own pocket. But more likely, it’s “presold” to Fannie Mae, Freddie Mac or FHA, which buys the loan from the lender almost instantaneously. That puts cash back into the bank’s pockets. So, mortgage lending is, or was, essentially a risk-free proposition for most lenders.

However, many banks bought mortgage-backed securities or other kinds of exotic instruments that relied on the interest generated by home loans as the base against which the security was constructed.

When so many Americans started defaulting on their mortgages, these securities essentially became worthless. The banks had to write down the value of the securities, which caused their capitalization rates to fall. (That’s the amount of cash and cash-like securities the bank has to have on hand.)

In addition, since so many people defaulted, and banks began to go under, everyone decided all of the other players couldn’t be trusted. That’s partly how we got to the credit crisis, when banks around the world became too nervous to lend to other banks, and lending essentially froze.

We bailed out the banks because the government believes that without a strong financial system, American capitalism would be toast. I have to agree. But we should have placed requirements on the cash we lent to the banks, so they would aid in the recovery (which they’re not really doing).

The short answer is that banks will always find a way to profit, but Americans are entitled to some financial relief as well.

I hope this answers your question.

Read More:
Mortgage Loan Applicants Need More Documents