When B of A spokesman Lawrence DiRita turned up on the evening news not long ago to assure listeners that his employer was willing to work on a case-by-case basis with troubled customers, we decided to call his bluff. Would DiRita, formerly a high-ranking official in the Defense Department, go to bat for the borrower whose “teaser” loan from the bank was about to shoot up overnight from 0% to 12.24%? Everyone with a credit card has been offered such a loan at one time or another, and it was once possible to initiate one at rates varying from 0% to 4%, with no additional fee for the balance transfer. Not any longer, though. Anyone unfortunate enough to have gotten caught with a large balance when the music stopped is now paying rates of 12 percent or more to service it. And while there are still promotional rates available as low as 5.99%, a balance transfer fee of 3% to 4% effectively kicks that up above 13% annualized, since the loans are typically for 6-8 months.
If you’re in this situation and hoping the bank will work with you, don’t hold your breath. We were told that the lowest non-promotional rate available from B of A at the moment is 12.24%. The man we spoke with, who reports directly to B of A’s top brass, implied that only credit card customers with spotless records could borrow at that rate. We shudder to imagine the rate that would apply to those with spotty credit histories.
Funds Cost Nothing
Now, we don’t doubt B of A’s sincerity when they say that 12.24% is a pretty good rate for unsecured borrowing. The man we spoke with said that’s what the bank must charge in order to make a profit. We did point out to him that B of A and a few other biggies can borrow effectively limitless quantities of money from the federal government at rates approaching zero (a fact of which he seemed unaware). However, we had to concede that soaring default rates and delinquencies were probably behind the relentless rise in teaser rates. With so many borrowers skipping out on creditors, it’s possible banks really do have to charge at least 12%-15% on revolving-charge loans just to break even.
But has anyone really thought this through? With the income and net worth of most Americans shrinking at the fastest pace since the 1930s, borrowing at nominal rates of 10%-15% equates to borrowing at real rates of 20% or more. This is more obvious in the mortgage world, where, just as we predicted here years ago, a 30-year fixed-rate loan at 5% would in deflationary times become a crushing burden. Although a 5% mortgage is easy to pay off when one’s home is increasing in value every year, if the price of the home slips by, say, 3%, one’s inflation-adjusted burden would shoot up to 8%. In fact, home prices in the U.S. have fallen by 30% on average, subjecting scores of millions of homeowners to effective real-rate burdens so high that, unless inflation returns to the real estate sector with a vengeance, the loans are destined to become virtually unpayable.
Best Game in Town
Meanwhile, banks continue to offer extortionate rates to credit card borrowers because, even with default rates so high, it is still the best game in town for the lenders. However, we think they are seriously mistaken if they expect default rates to decline from this point forward. We see defaults at least quadrupling before deflation has run its course. At that rate, perhaps the banks should be charging 50% on unsecured loans?
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Two belated responses, which no one will prob. see, but anyway:
Universlman writes:
“Few items hold their value more than homes, in spite of a proportion of value being based on style, condition, effective age or inflation or deflation. I suspect that this is because like cars, homes do serve needs just by their happy existence, unlike say a bar of gold.”
This is such a common perception in this country yet is not correct per se. It obviously is not correct for any “home” bulit back when in now ghost-towns across the west, or for that matter for over half the homes in Detroit. They have held NO value at all, and at some point in the future, this will apply to many tracts in the desert surrounding Las Vegas.
But it shows a larger error of perception:
Homes do NOT maintain value, they are, just like any other capital good, depreciating assets, which is why buildings are allowed to be depreciated in many tax structures, in many European countries, to spur more development, 15-yera write-offs are commone for residental construction. Rather one must continually expend resources to maintain the present state of a home/building. Invest nothing for a long enough time-frame, and your home holds as much value as the ruins all over Detroit’s neighborhoods (btw, just look at pitcures of abandonded properties in CA, and you will see that this time-frame isn’t even that long).
What really underlies the value of homes is the land under the building, if it rises, that is as function of demand.
We have lost or been “educated” away from this kind of conception in the US, elsewhere though people still understand this. There, for two identical properties in like location, the one with the newer structure would be priced/valued higher.
Instead, most Americans have come to believe, that they can get a return greater than the investment by “improving” a home through additions, or a new kitchen, etc, even though realtor’s statistics demonstrate, that for virtually all projects, the return is <100%. Why should it be otherwise? Who pays more for a used car than for a new one?
Ben:
By way of example I mean:
Assume this situation:
The owner of a business with a stable revenue stream for himself acquires a home, with a mortage requireing $6000 per month, for both principal and interest, financed at 6%, 30 year fixed.
If he is in a market with rising prices, his real-rate burden declines, but if his business burns down, causing his cash-flow to disappear, he will default on his loan and lose the house. ( He may try to sell ahead of that, and even have a capital gain, but that is not the point here.)
If on the other hand, his business is stable in a way where the cash-flow can be maintained, then he can still pay that $6000/month, even if he is underwater, and having a real burden of 8% or more.
In the former case, the declining real burden does not prevent loss of home, in the latter it the rising real rate does not force it.
By persuade to ditch vs. force I mean that in the former case the homeowner may decide to no longer throw good money after bad, by no longer voluntarily paying his $6000/month, to keep current a loan, which may be a few hundred-thousand greater than the assets current value (people have done this, and lived rent-free until foreclosed upon 10-12 months later. The jingle-mailers were the suckers here, they left too early).
Thus it is not the same, the "persuade to ditch" is the result of a cold and rational evaluation of the present state by the homeowner with subsequent voluntary consequences by the same, the "force" is a cold and (somewhat) rational evaluation by the lender, with subsequent involuntary consequences for the homeowner.
If his wife or kids complain, because ot the attachment they have formed to the house, neighborhood, friends, etc, they often will veto the cold and rational evaluation to stop making those $6000 payments, and to keep throwing good money after bad.