Why banks still profit with so many bad mortgages out there

By Ilyce R. Glink
Saturday, January 9, 2010

Q: I have been confused over the past 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 loans are bad, and yet the banks have been able to rake in large profits, 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 (which the bank acquired in late 2008) 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 twice touched 50-year lows.

And more consumers have been saving money rather than spending it. A lot of people have put their money into savings accounts 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 pockets. But more likely, the loan is "presold" to Fannie Mae, Freddie Mac or the Federal Housing Administration, which buys it 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 a sharp decline in their capitalization rates. (That's the level of cash and cash-like securities the bank has to have on hand.)

In addition, because so many people defaulted and banks began to go under, everyone decided that all the other players couldn't be trusted, either. 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 that 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.

Q: I'm interested in refinancing my 7.9 percent home loan from 1993. My balance is $35,000. I have a HUD Nehemiah grant of $15,000 attached, and it shows up as a second mortgage.

The rider states that the HUD grant is due in full if I refinance except for a purpose other than "sale, equity or property transfer." Is it possible to refinance only the balance on the original home loan?

A: First, it will be extremely difficult for you to finance a home loan balance of only $35,000. Mortgage lenders don't make enough money on loans of less than $100,000 (or $50,000, depending on where you live), so they generally turn away these loans.

You are about 17 years into your 30-year loan. That means that most of your monthly payment to your lender is going to pay down the debt you owe. If you were to refinance now, you could get into a 15-year loan, but you're not likely to see a substantial drop in your monthly payment. But you might have to pay considerable fees in trying to refinance the loan.

You generally can't get a home-equity loan; lenders really aren't doing those at the moment. The government is requiring home equity lenders to carry 50 percent of the balance of the loan in cash in case of defaults. So banks aren't doing many of these.

Your HUD Nehemiah grant is probably an interest-free loan, and my guess is that the lender won't subordinate that loan to your new primary lender. If that's the case, you'll be out of luck and will not be able to refinance unless you repaid the grant.

But if you add that $15,000 loan to the $35,000 balance, you may be able to get a new loan for $50,000 and enjoy some of the lowest interest rates in decades.

But remember, your current monthly payment is mostly principal. That means most of your payment is not going toward paying down your debt, and in 13 years your home will be fully paid for. If you refinance, you need to make sure the costs of refinancing are low. Some lenders may add those costs to your loan, but you'll just pay that increased debt over time with interest.

If you decide to refinance, make sure you understand the costs involved in refinancing, how long it will take you to pay off your loan and what your monthly payments will be.

Please talk to a number of lenders (including a credit union, if you belong to one or can join one) about your loan and your options.

Ilyce R. Glink is an author and nationally syndicated columnist. If you have questions, write to Real Estate Matters Syndicate, P.O. Box 366, Glencoe, Ill. 60022, or contact her at her Web site, http://www.thinkglink.com.

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