As I was on the road to an appointment this morning, I happened to flip on the local talk radio station in my car.  The show that was on at the time was doing some sort of a call-in segment which included what at first sounded like a rather confused sounding businessman arguing with the radio show host.  As the argument went, the businessman was saying that the bank had foreclosed on his business mortgage even though he was making all of his payments, with the radio show host insisting that banks just don’t do that.  Since banks really don’t just do that, I figured that the guy had something else going on that he wasn’t telling anyone, and it wasn’t too disappointing when the host hung up on the guy.  When a second guy called in saying the same thing happened to him, the radio show host sat there confused, and I got to wondering what might make this make sense.  I think the answer lies in the time value of money.

To begin with, there was certainly nothing incorrect about the radio show host insisting that banks don’t foreclose mortgages against people who are making their payments even if they have the right to.  The way lending programs work, banks give you a lot of money right now, and profit when you pay it back with interest later.  To a bank, foreclosure is generally an outcome best avoided and most will go to considerable lengths to avoid foreclosing on a property.  The reason, quite simply, is that banks have very little desire to own real estate; it’s expensive to maintain, not easy to convert into another type of asset, laden with taxes, and bothersome to sell.  As a result, banks sell them for prices well below market rate in order to get them off the books quickly.  In the end, the owner is out the property and the bank suffers a substantial loss on the loan.  Since everyone loses in foreclosure, it seems as though it would be most irrational for banks to foreclose on companies which are making their payments.

However, what might make the move make sense is the time value of money.  A central axiom of finance is that a dollar today is worth more than a dollar tomorrow.  From the bank’s point of view, a mortgage is a series of promises that they will receive a dollar today, a dollar tomorrow, a dollar the day after that, and so on until the mortgage is paid off.  This is normally good for steady cash flow, but not so good for getting money right now.  With the economy still in crisis mode, banks have a strong desire to have cash available to them immediately, and one way to do that and to reduce their liabilities at the same time is to demand final payment on mortgages, foreclosing where necessary.

To understand why a bank would close out mortgages of well paying borrowers, it is only necessary to consider where else the banks might get money from.  Borrowers who aren’t making payments are probably in a financial position where they can’t afford to make payments, which means they certainly aren’t in a position to repay the mortgage in full.  Borrowers who are making payments and who have enough capital will likely find a way to repay or refinance the mortgage rather than suffer major damage to their credit rating, so the bank will get their money.  Borrowers who are making payments but do not have enough capital to cover the mortgage, borrowers like the call-in businessmen, get caught in foreclosure.  Banks could be gambling for money between the second and third class of borrower.

While I have no particular insight to know if my conclusion is correct, it does at least seem plausible that banks are making a money play to get some cash on hand today rather than waiting for it to trickle in on schedule later.  Banks do have a need for immediate cash and there is a class of borrower which can supply money after sufficient arm twisting.  It certainly appears to be a horrible business practice, but at least it might make sense.

Tags: economics