back to article So why the hell do we bail banks out?

Much to my joy, I have been asked a question I can actually answer. As opposed to those difficult ones, like does my bum look big in this, do you love me and has your cocaine use ever been more than recreational? That question, coming from commentard John Smith 19, and it is, in essence, well, why do we bail out the banks? …

Anonymous Coward

Re: Maybe another reason?

Governments are generally incapable of capitalism because it doesnt buy votes

Government do not really care about votes, it's a diversion. Politicians are primarily elected by their party, NOT by the electorate, it's an aberration when someone gets in ahead of the fix. If anyone challenge the party with an opinion, they get whipped into place. The party apparatus is where the power is and actual politics is determined. The parties are not up for election - which is good for stability in the sense that we can elect a new government and get less than 2% variation in the governments priorities. Business likes that.

For the politicians themselves, the pay & bennies are the same either way, as the opposition or the government. The reason they still want to govern is that there is more graft possible on the government side, but, the really juicy bits are sucked up by the "Sir Humphrey"'s inside the central administration.

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Re: Maybe another reason?

Ideally, if the bank is small enough to fail, government (in the US, FDIC) deposit insurance will protect the depositors from loosing their money (although they may loose access to it for a period) and the bank can be either wound down or taken over by another bank. The shareholders get nothing - and with luck, the bank management gets banned from the industry. The system (as a whole) hist a speed bump, but keeps on going.

But "Too Big To Fail" banks claim that without the knowledge in the heads of the banksters and the existing relationships, the bank will collapse bringing down the national (or world) economy, and so the banksters have to be left in place because only they can understand the horrible mess they've gotten things into.

I don't pay enough attention to what's happening in the UK (and the EU) as far as "Too Big to Fail" banks, but here in the US, there doesn't seem to be any effective effort to reduce the size of these banks or the consequences when they suffer mass delusions of competency - if anything quite the reverse.

What's more, the disease of "Financial Experts" is bringing many state and local governments down as the consequences of decisions made a decade or so ago when Wall Street banksters convinced the political parties that unregulated government insurance (backing) was better than regulated government insurance (backing) when certain new financial instruments (scams) were developed.

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Anonymous Coward

Re: Maybe another reason?

> But "Too Big To Fail" banks claim that without the knowledge in the heads of the banksters and the existing relationships, the bank will collapse bringing down the national (or world) economy, and so the banksters have to be left in place because only they can understand the horrible mess they've gotten things into.

> I don't pay enough attention to what's happening in the UK (and the EU) as far as "Too Big to Fail" banks

See my comment here for how this is actually being addressed.

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Re: In fact at today's interest rates bank deposits are losing value.

Regardless of the interest rate paid to savers, deposits never kept pace with interest rates. I do recall back in the Carter days my mother signing up for the outrageously high interest rate of 13%. Of course at the time inflation was running around 17%. When it matured we were barely able to roll it over into one at 8%, with inflation running around 10%.

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Longer Term Impact

You mentioned that the central bank can and does print money to cover the liquidity issue. Fine, but if it does and the value of the overall economy doesn't go up (it can't as these loans are only to cover a technical issue) we're consequently left with more money in the system which should trigger inflation. What surprises me is that with these bailouts and QE, inflation hasn't raised its head. Is there something fundamental going on?

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Re: Longer Term Impact

That's a good question for Tim. Why hasn't QE driven inflation?

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Re: Longer Term Impact

In the provision of liquidity two things:

1) The amounts provided aren't the sort of amounts that would impact upon future inflation. Just not economically significant at that level. It's that the central bank can, theoretically, print any amount that is important (and one eurozone problem is that the central banks cannot, only the ECB can). Further, when the liquidity crisis is over, the banks hand the cash back, reclaim their security and the central bank cancels the new money. So, no permanent increase in money supply.

2) QE is a bit different. M4 is the money supply that matters for inflation reasons. This includes all bank credit created by the banks. There's usually a decent link to M1 (base money or cash) and M2 (M1 plus central bank deposits by banks) and that connection is V, the velocity of the circulation of money. Normally reasonably static is V. But it drops horribly in a recession brought on by financial panic or crash. So, QE creates vast new amounts of M1 and or M2, but it doesn't make all that much difference to M4. Or, rather, given that V has fallen, it stops M4 shrinking and us then getting deflation. And this is why to do QE rather than anything else. Because it's reversible (at least in theory). So, as V rises to more normal levels we can draw that M1 back out of the system (by selling off the bonds bought with it) and cancel it thus preventing V's rise from setting off a massive boom in M4 and inflation.

All of that's not quite right in proper technical terms but it's a reasonable trot through the logic of it all.

An awful lot of people don't like QE but has been a remarkably successful policy. UK and US would have been more like Spain and Portugal (but not as bad as Greece) without it.

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Re: Longer Term Impact

The proper answer is that it has. Without it we'd have had deflation, we haven't, it's worked. But let me come back to this as a full piece in a couple of weeks.

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Re: Longer Term Impact

The reason why we haven't had inflation is because the money did not end up in the economy - if merely filled a hole the banks had made. None of it has 'trickled down' - it never does.

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Flame

Re: Longer Term Impact

Money printing has driven inflation. Lots of it.

But not - directly at least - QE. QE was in fact driving inflation that had already happened (but was masked in silly, irrelevant price indexes by the rise of cheap Chinese goods). The real inflation was seen in house prices in the big bubble of about 2000-2005, which did the real damage, robbing the future to enrich the already-rich (house owners). The banks lending money that will never be repaid created a gaping hole, which QE then plugged.

The late, great, Terry Pratchett explained the whole system beautifully, though only in passing. He called it the Pork Futures Warehouse. And that was long before the crash!

Some of us who saw the bust coming actually took the trouble to find out about saver protection. I even forewent Icesave's market-beating interest in 2005/6 in favour of something on lower interest but protected, for which of course I was duly penalised.

As for bailouts, THEY SHOULD NOT HAVE HAPPENED. Depositor protection (including emergency measures to feed cash machines) would've cost a whole lot less. More than half a decade on, we should've seen the rise of new alternatives to traditional banks, yet they're limited to small niches by bloated zombies standing in the way of innovation. Bailouts are a negation of all that's good about capitalism! And of course they have knock-on effects:

- a long-term massive deficit placing a deadweight on the future

- interest rates detached from reality

- the rise of a zombie economy

- underwriting leverage on and income from land and housing, financially privileging rentierism over productive investment. Even (by some reports) prostituting Prime London to the global super-rich as an asset class like gold that never leaves the bank vault.

- trashing of pensions for anyone not already retired but within maybe 25 years (from the bailouts) of it. And its corollory: the zombification of of many companies with the misfortune to have been running final-salary schemes.

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Anonymous Coward

Re: Longer Term Impact

"Depositor protection (including emergency measures to feed cash machines) would've cost a whole lot less."

REALLY? How about putting up some numbers to back up this assumption, not to mention the potential economic knock-on impacts of a domino effect if a "too big to fail" bank really did fall over, taking everyone's deposits with them (including those above the protection limit as well as those of small businesses that likely wouldn't be protected).

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Boffin

Re: Longer Term Impact

REALLY? How about putting up some numbers to back up this assumption, not to mention the potential economic knock-on impacts of a domino effect if a "too big to fail" bank really did fall over, taking everyone's deposits with them (including those above the protection limit as well as those of small businesses that likely wouldn't be protected).

I can't speak for any impact in the EU or UK, but in the US the bailout total that we know about was $700B (i.e. the TARP program). If every person in the US had a bank account claim of $100K, the sum total of insurance payout by the FDIC would have been about $300B. And I think it's safe to assume that the numbers would have been far fewer than that.

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Re: Longer Term Impact

Your math's off.

A population of 300 million (3.0x10^8) drawing $100K each (1.0x10^5) would result in a debt load of 30 TRILLION (3.0x10^13). In case this doesn't sink in, that's greater than the US Sovereign debt to date and well over 1/3 of all unfunded US obligations for the forseeable future.

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Re: Longer Term Impact

"the zombification of of many companies with the misfortune to have been running final-salary schemes"

Gordon Brown had done a lot of damage to final-salary and private pension schemes way before this. I reckon the pension companies could and should have raised the profile of this: every year when they sent out projections they could have added another projection - what the pension would have been without the tax raid.

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Anonymous Coward

Re: Longer Term Impact

And before Gordon Brown did his thing, a substantial number of the CBI's finest businesses had decided to stop paying into the pension kitty for a number of years, in what was laughably called a "pension holiday". After all, that money belongs to the shareholders, not the workers.

Leading light behind those bright ideas was a bloke who at the time was called Digby Jones.

He's still around, now Baron Jones of Birmingham.

While he was Minister for Trade and Investment, the Telegraph described him as "the walking personification of the spirit of big business at its corporatist worst". And they'd certainly know, both by virtue of their readers and their owners.

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Pensions holidays

A lot of companies were required by HMRC to take pensions holidays, because the taxman thought that businesses were reducing their tax liability by overpaying into the funds.

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Re: Longer Term Impact@Gordon

Why hasn't QE driven inflation?

It has, just not supermarket price inflation. Look at asset prices, such as art or supercars. For years before QE you could buy a Ferrari 308 for around 10-15k. Now they're around 40k, and were never a sought after classic. We've got 5 year old Porsche's selling second hand for more than they cost new (GT3), with the market having reached bargepole territory. There's your QE driven inflation right there.

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Re: Your math's off.

His math's good. You didn't take into account statistics. No way in hell I'd collect on the $100K for a bank failure. Hell, I'm barely a blip on that market even now when I've actually built up a small amount of buffer. Maybe 10K tops. Statistics tell me I'm above median for my salary (US, not region), and again above median for my savings. Even my roommate/landlord who probably falls into top 5% by salary and again for savings might collect about half that $100K. His money is all in the house and retirement plans.

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Fractional reserve

I have often wondered why the fractional reserve percentage is so low. Yes, I know that by having a very low percentage it means the banks have more money available to lend out but I would think a reserve of about 50% would be a better proposition from the point of view of those of us 'lending' our hard earned to them.

Another thing, what would be the effect of removing the speculation sections from the banking sections and making them separate companies? Would this reduce the risk of the bank going bust?

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Re: Fractional reserve

50% is way too high. 6, 7% is enough. People jsut don't turn up demanding all their cash that often.

Speculation? This is the "ring fencing" that everyone is talking about. Can't use retail deposit money to finance investment banking.

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Re: Fractional reserve

Whatever fractional reserve you have above the natural level of growth (historically 2%Pa for several hundred years - its really hard to tell of late) you add a positive feedback loop which leads to instability unless you match it with inflation. If the finance sector grows faster than the economy as a whole it becomes parasitical rather than potentially beneficial.

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Re: Fractional reserve

The regulator got it wrong.

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Re: Fractional reserve

because if you ring fence 7% then your competitor ring fences 6%, makes a profit on the 1% and undercuts you. So you ring fence 5%, and they ring fence 4% ........

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Anonymous Coward

Re: Fractional reserve

"if you ring fence 7% then your competitor ring fences 6%"

To which the very obvious and initially very reasonable sounding answer is: regulate, to ensure a fair safe and level playing field, and do it properly.

Unfortunately for Joe Public:

a) regulators have a long standing tendency to be insiders whereas what's often needed is an outsider who can cut through the BS

b) the regulated community often has a tendency to misdirect the regulator. In the case of the "investment" banks and their complex financial derivatives, look at stuff like hypothecation, re-hypothecation, and so on, where the same asset can be counted several times. Imagine if you used your house as the security for five separate 100% mortgages. That's re-hypothecation (it isn't, but it's close enough).

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Re: Fractional reserve

I wouldn't go 50%, but I would go 10%. It's the minimum you should be able to pay on any item for which you want to take a loan.

There is a caveat, which is that the reserve requirement is the ultra-big, ultra-crude lever the Fed (or its EU equivalent on your side of the pond) uses to manage the money flow.

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Make directors bear losses

If a bank needs to be bailed out (insolvency not insufficient liquid cash) then the directors should be required to forfeit all their income from the bank over the previous 5 years (salary, bonuses, stock options, pension contributions etc). Making this change to the banking laws would make them far more careful about getting into the positions that could make a bank fail.

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Anonymous Coward

Re: Make directors bear losses

The directors of Megacorp are personally and individually responsible for the corporate successes of Megacorp, that's why they get their personal Megabonuses.

And exactly the same logic says that the directors of Megacorp are also personally and individually responsible for the corporate failures of Megacorp, which is why they should either accept that personal responsibility and pay the price, or not be eligible for Megabonuses. Fair's fair, right?

Applies outside banking too.

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Re: Make directors bear losses

Making this change to the banking laws would make them far more careful about getting into the positions that could make a bank fail.

You're assuming a level of competency on the part of the directors that may not exist.

However, clawbacks seem a reasonable way to share out the pain, alongside the bond and equity holders. I'd suggest going further than 5 years though - for stock options you really need to go back 10, and its those that make the senior staffers the real money.

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Re: Make directors bear losses

Meh. If the bank failed I think that's sufficient proof of such complete incompetency that the protection of the corporate veil should be pierced. Make them liable to the full extent of any assets they own whether or not connected to their stint at the bank. I'm assuming you're including corporate officers in "directors"; if not, them too.

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gosh

Interesting and informative article, non-dogmatic, even implicitly acknowledging that capitalism is not some natural state of being but a (remarkably successful) human construct that can, and should, be regulated to produce desirable outcomes. Tim, I salute you. More like this, please.

-A.

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Paris Hilton

Re: gosh

But it could have been cut down to a succinct -

"So why the hell do we bail banks out?"

"Because these banks are systematically important".

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Headmaster

Re: gosh

I think you man "systemically".

(Blame autocorrect - I always do.)

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Lehmans

Lehman Brothers was insolvent (probably, it had huge losses on some California real estate deals) as well as being illiquid

========

Wrong. On Liquidation, the value obtained exceeded the liabilities. It was illiquid

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Re: Lehmans

UK Lehmann, yes, illiquid not insolvent. But US? Not so sure.....

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Re: Lehmans

On liquidation, the "value" was based on lots of assets that should have been written down to (or near) zero but for QE. Same applies to other bank balance sheets.

Tim, an idea for another article. Debunk the orthodoxy about Lehmans being the cause of the big crash. It was of course not the cause of anything (except perhaps Barclays picking up some assets on the cheap): rather it was an effect of the credit bubble.

And more widely, how bailouts starting with Northern Rock led to precisely the outcome they were supposed to prevent.

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While of course they needed to be bailed out

the way they sat on the proceeds from government rather than trading their way out was pretty cynical. personally I would have advanced them 3 months worth of float, and then released further monies monthly depending on how much extra they had loaned out. Instead I saw shopkeepers loading their credit cards up (at interest north of 20%) because they could not get credit elsewhere.

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Re: While of course they needed to be bailed out

I like how banks were blamed for being quick to hand out the money leading to the crash. Yet expected to throw the money out of the windows once the crash had occurred. Damned if they do, damned if they dont

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Re: While of course they needed to be bailed out

OzBob,

One of the problems of banking/capitalism that Tim doesn't cover in this article is that banks are pro-cyclical.

This means that instead of countering booms and busts, they inflate the booms and worsen the busts. So during the height of the boom, when they should be saying "oh dear this is looking too bubbly, let's wind our necks in and borrow less" - they actually lend more - as that house is bound to keep going up in value for the next ten years...

Then the bust comes. And now they won't lend to anyone unless they can prove they don't actually need the money, however good their business plan or credit is. They get all cautious, having just had their fingers burnt in the preceeding boom. So they shrink their balance sheets in order to become more solvent, but this reduces the money supply, and the credit avaiable to the economy to pay for growth and investment.

Regulation often makes this worse. Because the regulators are under political pressure to rein the banks in. And so during this recession our governments were making banks expand their fractional reserves (to make them more liquid) and raise more capital (to make them more solvent). This was for good and understandable reasons. There's an argument to say that they should have told the banks that they needed to have these larger capital buffers by about 2015, but were allowed to run less safely before that. But it would be pretty politically indefensible, and took a risk - that's pretty much what the Eurozone did - they stuck their heads in the sand, then had to bail out Greece to the tune of nearly €300 billion in order to save the German and French banks who'd recklessly lent to them. They also then implemented the bailout incompetently, fucked up the Greek economy in the process, and are now blaming the Greeks for their own (and Greece's too) massive clusterfuck, such that the Greeks can't pay, the banks are off the hook and the governments have put themselves in the firing line.

Anyway an example of counter-cyclical measures would be unemployment (and some other) benefits. Because these are paid out automatically, the government will pay out more of them as joblessness increases, and pay falls, during a recession. These are called automatic stabilisers. The government now spends loads more during recessions, something that didn't happen in the 30s, and this helps to keep the economy from cratering - and makes the recessions shorter and less painful.

There's an idea to make banking regulation counter-cyclical. So that in the boom times, they'll have to maintain a higher fractional reserve or capital adequacy ratio. Thus meaning they can't lend as much, and stoke the bubbles as hard. Then when the recession comes, the pressure will be released somewhat, in the hopes they'll now be more willing to lend, having sustained smaller losses from the collapse of the boom, and having more money on hand. In a big scary recession like the recent one, that probably wouldn't work. But it might have made the 1990-91 recession a lot less steep, for example.

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Re: While of course they needed to be bailed out

@ I ain't Spartacus

I like your comments on the banks being pro-cyclical but I dont think its a bank issue, its a private sector issue. During a boom people and businesses (including banks) go nuts and buy houses/equipment/services they cant afford, and in a bust they pay back the money they borrowed or default.

I wonder if the recession would be less painful if people had some financial sense instead of the crazy over-consumer problem we do have. I start the blame with politicians and education but lack of financial planning means that it isnt just the poor that suffer and need welfare support but the self made poor also.

When I look at the desire and desperation for credit I do worry sometimes as the people using it are often the ones to add to the problem.

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If interest rates drop any lower it'll be cheaper for us to keep our savings under the mattress rather than put them in a bank. Won't that make the whole system collapse? Will we need laws to prevent people hoarding cash?

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'twas another nail in the coffin of money as a store of value.

Though to be fair, that's nothing new. Debasement of the coin was an important factor in the decline and fall of the Roman Empire, to take just one example.

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Anonymous Coward

Wrong question

Your'e asking the wrong questions.

(1) Why does banking regulation allow banks to gamble with their assets?

(2) Why are banks allowed to charge you £20 for going 1p overdrawn for one day, and pay you no interest for investing/looking after your money in a current account for an entire year?

(3) Why could banks offer a 3.5% 25-year fixed rate mortgage in the 1950s, but today, are allowed to "draw you in" to a mortgage with a lowish interest rate, and then raise the rate at their whim?

(4) Why does capitalism's "competition" not produce ONE bank which offers fixed fair rates?

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Re: Wrong question

Fixed rate loans have never been a feature of the British market. In the US, only exist because of Freddie and Fannie. 25 year fixed rate just isn't something an unadorned market will provide. Waaaay too much risk in it for the lender.

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Re: Wrong question

Fixed rate home loans are pretty much the only kind in France. The market certainly doesn't have any appetite for anything else. Any idea why that might be?

-A.

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Re: Wrong question

How do Freddie and Fannie differ from today's government mortgage support schemes in the UK?

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Re: Wrong question

(1) Why does banking regulation allow banks to gamble with their assets?

Because an economy where assets do not move is a dead economy. Banks lending those assets moves them around. ANYTHING you do with an asset is a gamble. Banks' gambles are generally less risky than other options (except when they stupidly believe some shysters who claim to have found a magical formula to remove the risk from sub-par mortgage loans, for example.)

(2) Why are banks allowed to charge you £20 for going 1p overdrawn for one day, and pay you no interest for investing/looking after your money in a current account for an entire year?

Because you've deposited into a crappy account at a crappy bank. If you're not getting any interest in your money, put it somewhere else, and that bank will have to change its policies or fail. If your account has no short-term overdraft allowances, then, again you've got a crappy account at a crappy bank. It's your responsibility as a depositor to seek out the best place for your money, and what you just described isn't it.

(3) Why could banks offer a 3.5% 25-year fixed rate mortgage in the 1950s, but today, are allowed to "draw you in" to a mortgage with a lowish interest rate, and then raise the rate at their whim?

Because the nature of the real estate market has changed. In the '50s, real estate was considered almost exclusively a long-term investment. Nowadays, there are people and industries who buy properties with the full intent of either reselling or refinancing within 5 years or less. Those adjustable rate mortgages were designed for those people and industries. But people in general don't read the fine print, so a lot of people with no intent to resell or refinance have made the mistake of getting a loan that doesn't fit their borrowing goals.

(4) Why does capitalism's "competition" not produce ONE bank which offers fixed fair rates?

Because "fair" is subjective, and your definition of "fair" doesn't match that number at which the banking market has arrived. Some of that is certainly due to inefficiencies in the market, but how much depends on your definition of "fair".

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Re: Wrong question

About a third of new French morgages are variable rate. About 0.5% (with current rates this low, that's a lot) cheaper.

I was a bit too strict above. A free market will provide fixed rate, it'll just be more expensive than variable rate. Someone, somewhere, has to take the risk of rates changing in general and if it's the bank they'll charge more.

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Anonymous Coward

Re: Wrong question

"ANYTHING you do with an asset is a gamble. Banks' gambles are generally less risky than other options."

I presume you're not aware of those banks who are prohibited from gambling? And equally you are presumably not aware of those banks who are prohibited from charging interest on loans?

I'll leave other contributors to work out what I'm talking about.

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@Tim

A commercial fixed rate mortgage has to include horrendous penalties for early repayment. Otherwise it becomes a one-way bet - if rates rise, the borrower is quids in; if rates fall, they can just refinance. I don't know how the FNMA and FHLMC manage this problem.

[I suspect you're completely aware of this, Tim - I just thought I should spell it out.]

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Re: Wrong question

@ Steve Knox

Just want to say I have no idea how you got down votes for that comment. Well said

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