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More Evidence Banks May Be Starting Another Race to the Bottom

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Less than a month ago, your Foolish servant reported on easing lending standards at banks. Now the American Bankers Association says some banks are making loans to people who recently defaulted on a mortgage. Yikes!

Almost 40% of these borrowers got an auto loan or a personal line of credit. The majority got credit cards. Repossessing an auto is costly but doable. Personal lines of credit and credit cards are tougher to recover assets against. Still, some banks seem to think that if a borrower didn't default on anything but a mortgage they're a reasonable credit risk.

If a borrower didn't default on anything but a mortgage in the last few years there is an argument to be made that they're a reasonable credit risk. Many borrowers lost their jobs and depleted their savings during the worst recession in decades. There is reason to believe many mortgage borrowers were misled by mortgage brokers and/or banks and didn't understand their mortgages. Other borrowers, seeking a mortgage modification, were allegedly advised by their banks to miss at least one payment. 

On the bright side
Wells Fargo
(NYSE: WFC  ) says it won't extend credit to such a borrower unless it believes he or she is willing and able to repay. (Gee, that's what banks were supposed to do all along ... before abandoning prudent lending practices and leading us into the greatest financial crisis in almost a century.) The bank says it also considers the depth of its relationship with the prospective borrower and whether a default was an isolated incident. At least Wells Fargo appears to have learned something from its mistakes.

Bank of America (NYSE: BAC  ) , HSBC (NYSE: HBC  ) , and SunTrust (NYSE: STI  ) also acknowledge lending to such borrowers, but were less specific about their criteria, noting that they evaluate several factors and don't focus on just one risk. It's at least a step in the right direction.

Banks that admit to lending to these borrowers -- most don't -- are showing another measure of prudence by charging them higher interest rates. For example, a borrower who defaulted on a mortgage is likely to pay a whopping 20% to 25% interest rate on a credit card, compared to the average rate of 15%. For a loan on a new automobile, he or she could pay as much as 19% - -almost four times the typical 4.7% charged of borrowers with top credit ratings. It's nice to know that responsible borrowers get some benefit from repaying their loans.

Foolish takeaway
Tepid loan demand is a threat to banks' earnings outlook and could encourage more risky lending. Time will tell if extending new loans to people who recently defaulted on a mortgage is a reckless act of desperation or a well-managed return to prudent lending standards.

What do you think: Are banks starting another race to the bottom even as Congress argues about how to pay for the last one? Keep an eye on the situation with The Motley Fool's recently introduced, free My Watchlist feature. You can get up-to-date news and analysis by adding these stocks to your watchlist now:

Fool contributor Cindy Johnson does not own shares in any security in this story. No way. The Motley Fool owns shares of Wells Fargo. The Fool owns shares of and has opened a short position on Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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  • Report this Comment On June 07, 2011, at 4:48 PM, ionthemarket wrote:

    The problem with the banks racing to the bottom is they want to take you, me and everyone else with them. Of course not without management making a ton of money while that is happening.

    Personally I am tired of financing questionable practices and outright white-collar crime. I didn't vote for the bail out (giveaway) but I bet you know who did.

    Even if some analysts think B of A is not "as bad" as other banks or B of A is "oversold" (see link), I will put my investments in other areas.

    No thanks on banks.

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