Sunday, March 4, 2012

How Banks Turn Small Problems Into Big Ones

If you get into a little financial trouble, your bank may turn it into big financial trouble.  Your finances may not be as rock-steady as you think.

During the last financial crises - 1989, not 2009, the banking industry was facing difficulties.  The Savings and Loan crises took down a number of S&Ls - leaving Uncle Sam to clean up the mess.  Nervous regulators started demanding that banks have more capital to balance their loan portfolios.

So, for companies that survived the downturn and had profitable businesses, it seemed that things were going well.  That is, until the bank called.  "I'm sorry, but we're going to have to call in your notes and cancel your line of credit," the banker says.

"Why?" asks the mystified businessman, "I am current on all my payments, my business is profitable, I have a healthy balance sheet, my credit rating is good, and my Dun & Bradstreet report is clean!  Why me?"

And the banker replies, "It is nothing personal, but the regulators say we need more cash on hand, so we have to start calling in loans."

And since business loans are "callable notes" they can do this.  And suddenly, a businessman who thought he was solvent one day, finds himself bankrupt the next.   He scrambles to find alternative financing, but other banks are facing the same problem, and no one wants to lend.  And in some cases, this ends up "taking down" a business that otherwise seemed healthy and profitable, but perhaps was a little too hollowed out.

And of course, it goes without saying, if you bounce a check or are late on a loan payment, similar things can occur.  For example, for a businessman, if they are late on a loan, the payment may be "accelerated" and the entire balance is now due - it becomes a balloon payment, with the entire thing due NOW, at a time when the business is faltering slightly.

It seems remarkably unfair.  A businessman hits a rough patch and can't make a loan payment.  The next month, he can, but in the interim, the bank has pulled the trigger on a handgun aimed at the businessman's head, and he is now insolvent and bankrupt - overnight.

And it seems like a stupid deal for everyone involved.  The bank rarely comes out ahead in these deals - getting only pennies on the dollar in bankruptcy court.  And the businessman of course, loses his business.

In your personal life, similar things can happen.   You are late with a credit card payment, and at a time when you need help the most, they jack your rate to 25% or 30%, which insures you never can pay it off and makes bankruptcy inevitable.  And late fees and the like are folded in and add to the amount due.  A little problem snowballs into a large problem, very quickly.

Similarly, our mortgage crises is based on the same scenario.   You over-pay for a house, sign a bad loan agreement, and then lose your job.  The bank jacks the rate and then throws you out of the house, and then sells it at foreclosure for less than the balance on the loan.   You lose, the bank loses.  And your credit rating is destroyed.

Wouldn't it make more sense to work out a deal with the bank?  If you have a job and can pay something close to a reasonable mortgage payment, wouldn't it be a win-win situation for everyone?

You would think that, and many are calling for that, and as part of some laws and court settlements, banks are trying that - in a small minority of cases.

But historically, it has been shown that whenever a bank offers a "workout" to a home owner, in 3/4 of all cases, the homeowner ends up losing the house anyway.  Usually, there is more at stake than merely being upside down - the homeowner cannot afford to pay, period.  And the sooner the bank can sell the home, the more they collect, of the amount owed.  The longer the process drags on - in most cases - the harder it is for the bank to recover.

That is the thinking, anyway, behind these acceleration devices in loans, credit cards, and mortgages.  A businessman, facing difficulty, will try to "hang on" for months or years, accumulating more debt and hollowing out his business further.  Better to wipe him out now, while there is still something to liquidate.

If you are late on a loan, you have a bad credit rating, making it harder to refinance the loan and raising your available interest rates.  At a time when you need help the most, you get hammered.  Meanwhile, the fellow with money in the bank who doesn't need the loan is offered the lowest rates and the best terms.

It is unfair?  Probably.  Well, that was the way I felt, having four callable notes and a line of credit on my business - and being "slammed" to a higher interest rate, once, on a credit card.  Is it going to change anytime soon?  No, alas not.  The OWS protesters can rob and rape all they want, it ain't gonna change much.

But - and this is the big but - you do have control over your own behavior and that is one reason I gave up on leveraging myself this way.   It can all go horribly wrong, in an instant, even if you are solvent, even if you are paying your loans as agreed, even if you have a healthy balance sheet.  There is a reason they call it leveraging - you are at the end of a lever, and things can swing wildly out of control in response to small inputs on the other end.

Having debt makes you vulnerable.  It leverages you, it hollows you out.  And while such scenarios may remain stable for months, years, or even a lifetime, they are susceptible to the slightest wind of change.  And it goes without saying, such leveraged scenarios require your constant attention and a steady income stream.  One slip up and it all goes south in a hurry.

It is like loading up your rowboat with 10 people - far in excess of its capacity.  You figure this way, you can make more money rowing people across the river.   But since you only have a half-inch of free-board, the slightest gust, the slightest wave, the slightest movement by one of your passengers will swamp the boat in short order.  And all of these things are beyond your control.  Perhaps 5 people in the boat isn't as profitable, but you have 6 inches of free board and can survive a category 1 whitewater rapid.

Life ain't fair, yea.  And these banking mechanisms seem unduly harsh.  But you don't have to play.  The ultimate decision - the ultimate control over the situation - lies with you.