Sunday, September 27, 2009

Speculation on Banking Behavior

I recently spoke with a very astute and insightful friend of mine who has successfully invested in real estate for over 20 years. The topic of discussion was the seemingly strange behavior of banks. In particular, the questions were explored were:

1. Why are so many banks (that are financially sound) so reserved about loaning money to credit worthy, collateral rich individuals? We even know of landlords with 750 credit and solid income who cannot get a moderate line of credit.

2. Why are so many banks so reserved about negotiating with property owners who are on the verge of foreclosure. In particular, an associate of mine merely required a 3 month suspension of his mortgage to repair and rent his property, thus making his investment portfolio cash flow positive. This would have allowed him to catch up with mortgage and avoid foreclosure. Rather than undertake this strategic act of goodwill, the bank foreclosed on his severely depreciated property. The end result was that the bank had foregone a $600,000 loan and gained no more that $250,000 of property, a loss of $350,000 for the bank.

My friend pointed out that in the last 5 months the Federal Reserve more than doubled the money supply, which will inevitably lead to a spike in inflation. Inflation decreases the value of money, so it's hazards are felt heaviest by those who saved money and those who issued loans. Think of it like this: a landlord takes out a line of credit for $10,000 in 2009 dollars. And let's say by 2012 inflation lowers the real value of the dollar by 50%, which the landlord uses to pay back the bank. In effect inflation has wiped out half of the debt, initially to the bank's disadvantage.

So, perhaps one of the reasons why banks are so reserved about issuing new loans is that they anticipate a spike in inflation. In regards to the foreclosures, perhaps they anticipate that the value of repossessed property will increase while the value of the loan will decrease via inflation. Of course this is purely speculative, but it is worth considering. But what is clear and indisputable is the economic, political and social hazards of inflation.

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