Amongst the headlines of various financial publications this morning I found an article
talking about Citibank offering to refinance home loans. That they need to
is perhaps part of their own doing.
In the USA, the interest paid on a loan is indexed against your credit score. An example of this can be seen in this table http://www.myfico.com/myfico/creditcentral/LoanRates.asp where a low credit score results in twice the interest to be paid.
This represents the risk to the bank - a low credit score means you're not very good
at paying all of your bills (credit cards, utilities, etc.) So a person with a high
risk has to pay more because the chance of them defaulting is considered to be greater.
While this model can make it very profitable to be a bank, it can all come unstuck
if there are too many people defaulting because they cannot afford the interest
repayments. And that's where we are now. Too many empty homes for people that cannot
afford the loans sitting on bank balance sheets, losing value and the bank money.
One wonders if banks should have been doing this 12 months ago, but perhaps they
thought there were enough people with good credit that could soak up the excess
property that has come onto the market. Although it can be hard to believe that the
banks didn't know this was coming, maybe they had a different view of reality.
I would really like to have seen what internal spreadsheets were predicting for
loans in the sub-prime category.
While I haven't read any details about what Citigroup and Wells Fargo are doing
with respect to refinancing, one hopes that they realise that a home with people
giving them some money every month is better than an empty, foreclosed, home that
they can't sell.
What I'd like to see is a complete abandonment of the credit-score linked to
interest rate model. It disadvantages those who would benefit from low interest
the most. In essence, the credit score penalises the poor for being poor and making
bad money decisions and benefits the wealthy. What we should be doing is preventing
the poor from being able to make mistakes with money by restricting the amount of
credit they can have or reducing the amount they can obtain via a loan. Index the
maxmimum amount of debt they're allowed to have via the credit score rather than
how much that debt costs them.