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you so we want to get back to our discussion of banking same box with the dollars coming in the dollars falling out the sources of funds and then the uses of funds what do bankers do with those dollars after they get them primary reserves secondary reserves these are both liquid assets the primary reserves earn no interest so bankers a little or no interest so bankers do not like to hold primary reserves for the most part during ordinary circumstances so after they get all the liquidity illiquid assets they want to hold then they're very happy to move any other dollars that come in down into this third category of loans and they do that because loans are the assets that earn the highest interest rate and the most profitable category of assets during normal times okay and normal times is what banks are making policy for we talked about different types of loans last time we talked about mortgages or real estate loans would I tell you this is about sixty percent didn't I say of loans it's not sixty percent of assets with 60 percent of loans loans themselves are about two thirds of total assets 65 percent of total assets and then of all loans mortgages real estate a very big percent you know this didn't used to be so big but what made it get a lot larger was that back in the early 1980s I think at the time the biggest real estate lender were savings and loans and we went through a savings and loan crisis where hundreds and hundreds of savings owns failed and then that kind of gave the Savings and Loan industry a bad name at least at the time and so a number of other savings Alone's changed their charters went over and got a bank Charter and so basically the savings and loans have failed we're no longer able to make home loans and so then people that wanted to a homeland started going to banks instead banks had the money because when the savings or loans closed then people didn't put their savings in a savings alone they put it in banks and so the funds shifted from the failed save his loans into the banks and then people borrowed their money for the homes from the banks and then as I say the other thing that happened was some saved it alone just shifted over to bank charters so they had the deposits and they made the loans and so at that point the the banking industry became the dominant lender in the real estate market but this is not only residential real estate it also is commercial real estate and we talked about those things last time us a second category of loans see and I remember what that stands for commercial and industrial loans missus if I can tell from my notes how far we got into that I think not real far this is about 20% of total loans or about a fifth and this is to finance you remember the terminology ongoing business activity and so what I'm saying is this is for operations this is not ease are not loans to buy assets such as a building or a factory or something of that nature of parking garage shopping mall office building okay so anyway this is for ongoing business activity a lot of it not totally but a lot of it we're talking about inventories inventories and stores inventories and what car dealerships motorcycles and so forth and then also to purchase other types of inventories materials like a fewer manufacturing let's just say refrigerators you might go out and buy a bunch of steel and a bunch of motors and things like that and these are not finished products these are materials that would go into production but you could borrow money go out and buy an inventory which is what I'm talking about here maybe a million dollars worth of stuff all these materials set it over in your warehouse and then bring those out and assemble refrigerators to sell the refrigerators and then when you do that you pay off the loan for this these materials and so it's not just retail inventories that we're talking about here okay and that is mainly what we're talking about here let me talk about the interest rate we've already used this terminology before but these loans are priced usually not always priced off of the prime rate remember what that prime rate refers to the general interpretation of the prime rate is this is the interest rate banks charge their best business customers I'm not best their buddies for golfing their low risk business borrowers okay and so bankers will have a formula to set this prime rate we'll talk about that in just a moment and then as they make loans to other borrowers other business borrowers that are not their safest then they'll just have in their formula prime light rate plus a half percent primary plus 3/4 prime plus 1 or 2 or 3 or whatever but it'll be prime plus something and then that something depends on the amount of risk okay and so if you have a small company and it's sales or they've fluctuated a lot over the course of the year or the business cycle they might be paying prime plus four or five percent and if you have a really big safe country the company they may be paying prime now let's talk about this prime rate itself first of all every business or every bank sets its own prime rate if I own a bank I get to say my prime rate is four percent or 12 percent or whatever I want okay but what we find is even though legally every bank can set its own prime rate what we find is this is that the leading banks the big money center banks and a few of the very largest regional banks they have their prime rate and then to others follow the leader they don't have to that's just what happens in practice so and each one of those big banks the reason they are setting a prime and there there's a following the leader is in order to set that prime rate at the right level or if you don't set that prime rate I should say at the right level then here's 20 percent of your loan portfolio and we are talking about 20 percent of trillions of dollars okay so we're talking about I don't know maybe a couple trillion dollars here if you don't set the prime rate at the right level then you've got your loans priced wrong incorrectly so anyway these big banks have got a staff of economists and financial experts and they are studying these credit markets all the time and then they say hey here's what our prime want to be and so then the other banks the smaller ones are community banks and so forth so sort of piggybacking on all that expertise and saying hey here's what Citibank is doing here's what Bank of America is doing and so forth we'll do the same here's what Chase Bank is doing okay we'll do the same thing and use their expertise no charge now they have these research departments are doing a lot of work several years back Citibank had a formula Citibank is one of these money center banks that we talked about before one of the two or three largest banks in the United States okay and I'm not saying they all follow this formula and I'm not even saying I don't know what Citibank does today they can change that any time they want but this is a formula they used to have and it will give you some idea of the logic that goes into this they had a formula for their prime rate and here's what they did they said the prime rate at that time was equal to the interest rate on 90-day CDs plus one and a quarter percent now the CDs certificate deposit this was a source of funds for Citibank right you remember they've got banks have sources of funds deposits transactions deposits non transaction of the non transaction CDs certificate deposit and so a vast amount of money is brought into the bank through these CDs and then the 90-day we're talking about a three-month deposit in essence here's what Citibank Racine hey how much do we have to pay to get dollars what's our what is this source of money what is it costing us so here's the cost of funds and then they said hey let's mark that up by one and a quarter percent markup and that's how much we will set our prime rate at when the dollars go out to our best business borrowers and then for other business borrowers it'll be prime plus one or two or three or whatever and the fractional rates - of course prime plus one-half or one and a half okay so anyway what I'm saying to you is this is that that prime plus approach is what is used almost always with CNI loans okay and then as we see interest rates going up on deposits we're gonna see interest rates go up on these loans so another thing I'm telling you is this when I say the prime plus I also mean this these businesses don't go down and say oh I want to borrow money and then the bankers say okay 4% and that's it what they say is you know our formula tells us 4% today if the prime changes your rate changes there is no locked-in interest rate on this okay and when can the prime change anytime they really took an average on this it wouldn't just be that days 90 day interest rate but anyway the point is that these business loans are not at a fixed interest rate mortgages are too fixed interest rate residential mortgages and a fixed interest rate but these loans are very seldom at a fixed interest rate you just pay whatever market conditions demand any questions about this let's talk about any line of credit and I'll come back and talk about this a little bit more before we get done with this topic sometimes what businesses do and now we're still talking about CNI loans commercial loans or business loans sometimes what will happen is a business manager will go down to the bank and say you know I want to talk to you about a loan a banker says have seed they talk a little bit I'm thinking about buying I don't know I like to say delivery trucks but I'm thinking about buying a warehouse or I'm thinking about this or that and I want to go out and do some negotiation I don't have the the delivery truck or the warehouse I don't have it picked out right now but I think I'm gonna do this and so what I'd like to do is talk with you and say would you make me alone if I get to that point and so then what the banker does it says I have a seat and we'll talk this over and after they talk and there's a lot of will check into your credit reports and all this kind of stuff then the banker might say something like this your salt will do I will promise to lend you let's say half a million dollars anytime you want up to a half million dollars and here will be you know and then it might be prime plus 2% or whatever the number is here's the formula here's how we're gonna set the interest rate and so forth but you've got a line of credit of a half-million o or some another business might be five million dollars it depends on the business and their needs another reason to do this you might not even be saying oh I'm thinking about buying a delivery truck or a warehouse you might just say you know if things kind of get rough over here at the business we're kind of going into a difficult time if things just get rough I may need some cash for what I don't know exactly but still you can use the line of credit you go to the banker you say I wanna talk to you and this is a pre-approved loan essentially so you go in and negotiate the loan everything is worked out the banker commits the making the loan but just not today and then they say to you okay now that we got a deal sign all this paperwork all you have to do is write a check and as soon as you write the check will honor it this line of credit is not but it's a lot like what we consumers would think of is just a credit card right with the credit card you fill out a bunch of applications and then they say something to you like we approve you up to a certain amount and then anytime you want to use a credit card you do I personally I've got a credit card and it's a line of credit up to three hundred dollars anytime I want to use it 300 bucks quite a bit huh that shows their confidence in me anyway and so then what happens you go out maybe the terminology has draw down the line but a business can draw down their line of credit by let's say go out write a check for a hundred thousand dollars paid that off if they want you know whatever rate they want they still had that line of credit there about half million dollars for some period of time okay and so this provides flexibility these businesses they always know they got some liquidity they can draw on and this is very common and it's not just big businesses to do that small businesses get lines of credit and so do farms and if our managers and so forth even small farms a lot of times I'll have a line of credit for people not only do we have credit cards but we have something called like a home equity line of credit and a home equity line of credit it's the same thing where you pledge your house as collateral for the loan then they give you a checkbook and then anytime you want the money you write a check and then pay it off whenever you want or keep it for a longer period of time and so anyway this line of credit thing is something that banks do quite a bit of and so when we're looking not just we but bank regulators well we're looking at those banks to see are they safe or risky it might be that when we look loans they have we say pretty safe but you know if they promise they'll lend a bunch of money promise they're committed to lend a bunch of money to people and companies it could be that without any more decisions being made and no longer under their control somebody just with all I know credit goes out writes a check and now all of a sudden the bank's made a risky loan and the decision was made months ago to do that this is part of generally sort of a continuing a relationship between a business and their banker so you just go hey I'm doing business with you the business was said to the banker I'm doing business see I'm a regular customer this is something I need I need a source of liquidity big businesses if they need money a big business gonna go up and print up some bonds and sell the bonds but if you're running a small business you know that sales are 1/2 million or million or 2 million dollars a year you don't really have access to going out there and printing up bonds all the time and it may be that things are a little bit tight it's a small business after all so at times business is not great and so then it's nice to have that line of credit so you're not always worried about gee I wonder if I could get the money if I need it you know Wednesday three months from now and so this way you would always know the answer to that so anyway any questions about this a third kind of loan third category of lon as a personal owner consumer loan personal and consumer loans and this is about 10 to 15 percent of all loans you can see and we're not gonna get into much detail after this what do we have 60 80 90 percent of loans or more with these three categories okay now these are loans to people go figure now people get loans from other places not just the bank a very common source for people to borrow money is credit unions and millions of millions of people have credit union accounts and credit unions are really set up to sort of provide to hold the savings usually savings they have little checking accounts but usually the savings of people small savings usually and then a few thousand dollars would be typical but anyway and then to make small loans to their members okay but bankers do some of this as well the big category of consumer lending by banks is credit cards okay and so when you go get a credit card Visa and MasterCard are the most common not the only ones but we've got these companies Visa Company MasterCard Company and they are in the business of putting on the commercials on television and getting the the readers out you know the card readers out in each store and each restaurant and things like that and they do that sort of thing but the actual lending that is to say if I go to the store and I you know scan my credit card swipe it the credit card at that moment that retailer gets paid and not at that moment but the retailer's gonna get paid and I don't pay my bill and tell well in my case several years from now but you don't pay your bill for a few weeks what happens in the mean time and the answer is basically somebody else steps in and pays that retailer on your behalf and you pay that somebody else and that somebody else is making a loan to you they don't hand the money to you
the hand of somebody else and then send you a bill and who is that somebody else well it's really a banker you're really borrowing the money from a bank okay Citibank for example I've already talked about them a couple times they issue millions and millions of credit cards and this is consumer loans for them personal loans consumer loans okay so but that Citibank card says I don't know it's got the little MasterCard logo on it or the visa logo okay and you might think oh look these are loaned me money no they didn't visa issued you a card and which they license the Citibank okay and then you get five applications a month for a new credit card come into your house anyway so banks are making a lot of loans to consumers through the the plastic to credit cards interest rates reasonable yes no kind of high aren't they on credit cards why well one of the reasons why is there's kind of a high default rate on those anyway very often not always but very often these personal and consumer loans are to finance the purchase of consumer durable goods now credit cards you can use for anything lunch right you can just use a credit card anytime you want but other than the credit card purchases or loans I should say at other times as we go to the bank and say hey I want a loan I a consumer one alone you don't actually have to like label yourself AIA consumer they know you are consumer but when you go to the bank and say I want a loan what for a car a boat a motorcycle and so that would qualify as a consumer loan or a personal loan and it's to purchase durable goods durable goods long lasting goods big-ticket items some people have enough cash to go out and buy a car but most people don't and so most people are going to go to the bank or a credit union or savings alone and so forth and get a loan and so this would include that so we're really talking about the durables and then also the credit card debt and then I mentioned the home equity lines of credit home equity loans are secured by your home but it's just a loan to you as a person for whatever you'd like to and that's really what we call it consumer loan does everybody know what I mean by a home equity loan let me give a simple example let's say you buy a house it's a hundred thousand dollar house you put a $20,000 down payment so you borrow $80,000 okay the years go by and as the years go by you pay off some of this loan and so you started off with an $80,000 loan as the payments are made maybe you've got this loan down to $60,000 you've paid off 20 and then also what happened was over those years the value at the home very likely went up now it's a hundred and forty thousand dollar home hypothetical numbers but anyway the point is this is if you've got a hundred and forty thousand dollar home today and you've got an eighty thousand debt against that home then the difference between these two things is $80,000 I don't really mean for that to be the same as that 80 let me change it some up 50 you still owe 50 and now you've got $90,000 of what of equity in your home equity ownership if it's $140,000 home and you old 50 then $90,000 is what you would keep if you sold that house and paid off everybody you all owe I get 90 thousand bucks that's my equity now you might say I feel good I got $90,000 with equity but it's tied up in that house I can't get it and the banker says yes you can we get a special way for you to get that we will make a loan to you a home equity loan and we will use this $90,000 as collateral and since the home is collateral pretty safe loan from the bankers point of view it's secured by good call lateral so here you go pretty good interest rate in addition to being pretty good interest rate since the loan is secured by the home then on Tax Day April 15th when it's time to report your and pay your taxes report your income pay your taxes you get to deduct any interest on a home equity loan from income and so if you paid let's just say hypothetically we use a number here let's say you've earned $50,000 then you've got certain deductions and exemptions and things like that and let's say you've got a I don't know $40,000 taxable income you go out and go and get a home equity loan and pay maybe two thousand dollars worth of interest on that loan you get to subtract at two thousand dollars in interest on h-e-l-l-o C home equity line of credit and then your taxable income was just thirty-eight thousand dollars now and so not only do you get a good interest rate but you also don't have to pay taxes on that part of your income that is paid on now that that particular loan and that's another benefit is that a lot it's not a lot how much would it be if you paid two thousand dollars then if you're in D we'll say thirty three percent tax bracket both federal and state income then a third of that six hundred and sixty six dollars will be how much you would save on your tax bill pretty significant a third of the interest and so that would be like oh I'm paying six percent but after my tax saving I'm only paying four so that's kind of a nice feature and so if you're borrowing money you know what a lot of people do is they say I'm not going to go down and get a car loan if I get a car loan and they say six percent I pay six percent in the story if I go get a home equity in line of credit and pay for that car they say six percent but then I get a tax break four percent after the tax break so this is a very desirable kind of Valen and also by the way the car is secured by the car the home equity line of credit is secured by a home that is better collateral you're very likely to get a better interest rate it may be that the car loan 6 and the home equity line of credit be five and a half so you're gonna save something there on just the interest anyway here's the problem you've run into in recent years over the last decade people said oh I bought a hundred thousand dollar house it's now worth one hundred forty thousand I'm gonna go get along and then they go get a loan and then the value of the house goes down to one hundred thousand dollars and then they say oops I was borrowing against equity that went away and then the banker says whoops we were lending with collateral that no longer exists and so normal times that doesn't occur but if you get into a situation when the housing markets weak then these home equity lines of credit are riskier than they appear and then people to go I can't believe I was borrowing you know cuz the thing that drove them to borrow is to say I've got ninety thousand bucks it's just locked up but I'm gonna borrow against that I don't feel bad and then all of a sudden if this happens they say oh I got fifty thousand bucks oh I wouldn't have borrowed so much if I knew that my net worth wasn't as much as I thought so anyway that a little bit of that has happened lately so anyway we have these various types of consumer loans personal loans and bankers are into that pretty big and it is the third category of bank loans other kinds of loans let me do a little erasing here we're not really going to get into other than just to kind of tick a few of them off other and her bank loans that is to say loans to other banks farm loans how about this one loans to investors when I say interbank loans I really meant loans not only to other banks but savings on loans or credit unions and so forth but other financial institutions loans to small governments local governments occasionally okay anyway all of these add up all of the others let's go through their 60 and 20 is 80 and 10 will be 90 so the most this could be is 10% so we're talking five to ten percent of bank loans or four all these other categories and many of the features of these other loans are kind of like what we've been talking about questions about this now so four is kind of interesting five five or 10% of all loans are and as these other categories and of course it can change it really depends on what's going on in the economy at any point in time there are certain times when you say gosh I just don't want to lend nearly as much to consumers and I want to do more lending to big businesses or whatever so I'm giving some broad averages so the bank has got all the liquid assets in needs or finds desirable both in primary and secondary source then they say we're going for loans if they could after they get their liquid assets if they could they would just make everything else is loans that's the end of the story but they want to get that money back and so really what they're going to do is make all the loans they can consist that with the concept of being repaid and generally what that means is they say that's it and the next guy comes in says I want to owe and they go No so then there's still money left over what do you do and so there was a residual here the residual is just this overflow of anymore dollars that come in and we've got liquidity and we're making the most profits we can often make a loan loan loan whatever is left over it goes into this last category and these are called investments or securities now there were already some short-term securities up here in the secondary reserve category and really what we're talking about here are bonds we talked about securities as secondary reserves the secondary reserve securities were short-term very liquid and so what we're talking about here is a medium term also a medium and longer term what's this curve called anybody Bueller Bueller another movie Ferris Bueller's Day Off pardon me yo ker here's what that Yoker tells me that is of interest to this there is a secondary reserve their short term liquid and they also pay a low interest rate or earn a low interest rate and so the banker is thinking this you know I made all the loans I can I could hold more secondary reserves but gosh they don't pay much interest depends on the year but maybe one to three percent again it depends on credit market conditions those rates are very low right now so then the banker says you know I think what I'm gonna do since I can't make any more good loans and I don't need any more liquidity with a low interest rate I think what I'm going to do is come out here and acquire these what I call investments these bonds of longer maturities and boy it will be seldom that they would say 30-year bond it's possible but five years would be kind of common and then they're gonna get a higher interest rate right or a higher yield off of those types of assets so anyway what are we talking about let's just make a shortlist Treasury notes and bonds just a little bit of review here Treasury notes have a maturity of two years up to ten Treasury bonds have a maturity over ten years up to thirty so mainly what a banker would be interested in for reasons we'll come back to be Treasury notes but Georgia bonds qualify as these investments okay how about this one corporate bonds investment grade bonds no junk bonds and you remember the investment grade Triple A down to B Double A and then not beyond that no B a and so forth later all right this is the Moody's classification with Standard & Poor we go that forward a triple B and no BB or lower bankers got to lay off of those they don't have to the thing is if they start buying these lower quality higher risk bonds they have to hold a lot on reserve for those assumed because it's assumed that there'll be a considerably higher default rate on those and so then bankers just say that's not worthwhile so they're buying these higher quality corporate bonds not a vast amount but they're doing it they buy municipal bonds sometimes Muniz or sometimes just municipal will be the terminology but the initial bonds are issued by government lower than the national level so they're not Treasuries they are city states counties hospital sewer districts not Hospital answer but hospital district sewer districts school districts issue by government you ever drive out on like the highway and you're just driving along and just out in the country you're on the interstate and you look off and kind of in the trees way back there maybe a half mile back you see a water tower sticking up back there and then there'll be letters up on that water tower and there may be something like this P WS d then you go okay well that P would be for I don't know you just named a town Pittsburgh Pulaski whatever Pomona and then a WS d Water and Sewer District and what happens is the people living out there in the country they say you know just because we went on in the country you still like to have a little electricity still like to have some running water still like to have some sewage treatment and so what they will do is people out in that area will get together and form a power water and sewer districts sometimes it's just water and sewer you know it's whatever they want to form but they formed their own little it's kind of like a government now they don't have a mayor and stuff like that they're living out in the country but they've got their own little government and I say hey let's get together and generate some electricity mmm basically bring water to us we'll run lines out to everybody's house we'll treat the sewage and so forth and so they say oh well we have estimated and for you know these 200 homes or something like that it's gonna cost us six million dollars and then what they'll do is print up some bonds they'll go to a investment bank and say help us out and now print up some bonds and they'll sell those bonds to investors and now every month they're paying a water bill in a sewer bill and and so forth an electricity bill every month they're paying the bill and partly that's for the water and the sewer and so forth but partly it's to pay interest and to pay off those bonds well who's buying those bonds well gee banks this is kind of like a bank making a loan to those people living out in the country for their power water and sewer but they don't actually make a loan where it's negotiated it's done in this more impersonal way of in the credit market or in the bond market the bank can go out and just buy those bonds so when you're driving along and you look out there in the country and there's this little water tower with those big letters on it what's going on there is there's kind of like this financial market aspect of what's taking place and also this kind of governmental aspect of what's taking place ok you remember that one desirable thing about these is if you own these bonds and you're earning interest on those it is not taxable as income by the federal government so if you earn $10,000 on interest and you're in I'll just pick out a number the 25 percent tax rate you say oh look I got ten thousand dollars of income I don't have to pay federal taxes that's twenty-five hundred dollars of federal taxes I don't have to pay and so the people who are in the higher tax brackets find that even more desirable people in lower tax bracket and say you know if you're in like the ten percent tax bracket you go well that's great but I don't have that much to invest on those bonds and then I'm not gonna save that much so I'm not really in the market for that the fourth category of bonds termination and we've discussed these briefly before our agency bonds gese or agency bonds they're normally called agency bonds but we've talked about these government-sponsored enterprises such as anybody remember a name Fannie Mae see I didn't have to mention that but I like to say Fannie Mae so Fannie Mae Freddie Mac Ginnie Mae Sallie Mae and so forth these government-sponsored enterprises issue bonds and you remember what they're doing with that when they issue the bond they get cash from the investors and then they take that cash and buy for example mortgages and they adalah quiddity to that mortgage market so anyway what I'm saying to you is who's given the money to those GSEs who's buying those bonds could be you could be me could be the government of China but I'll tell you somebody does it is the bank the bank is saying hey we want some interest the thinking is Fannie Mae Freddie Mac are backed by the Treasury that's the assumption it's not written into law backed by the Treasury so just as safe as buying a Treasury bond but it pays a little bit more interest and so rather than buying a Treasury note or bond let's buy an agency note
r bond we get the same amount of safety and yeah we get an extra quarter percent of interest there's a quarter of percent mean much doesn't mean much if it's a hundred dollars you're lending but if you start talking about millions of dollars an extra quarter percent it's decent what's 1% of a million bucks ten thousand dollars right and so if you could get a quarter of a percent that's $2,500 yeah that's not a lot 2500 well what if it's a hundred million we're talking about oh oh it's a hundred times twenty-five hundred dollars and I don't even know what that number is it's more like a trillion dollars no I don't know what it is anyway but it I can do the calculation 100 times mm hmm two hundred thousand is that right yeah so anybody 250 thousand bucks so anyway these are the types of things that bankers are investing in not because they hate them it's because these things don't pay as much as loans and so bankers really don't want to get into this but bankers do want to get the high interest final point for the day since this is a residual then what happens is over time we see banks are loaning more and lamb or or or less here's loans and this is as a percent of their portfolio their assets and so what we find is this is that when loan demand is strong and bankers are making a lot of loans then not so many bonds and then when loan demand is falling we do that when loan demand is falling off a bankers aren't making so many loans they got more money to buy these bonds and vice versa so these things are moving in the opposite direction just of my pictures aren't the best okay and so here's the bond portfolio that's going up and down in the opposite direction if a banker says oh what customers are coming in they want to borrow a lot of money let's sell our bonds off and make those loans the loans are the best and then when people aren't borrowing let's buy it we got more funds let's buy some bonds that is what we'll stop with it for today this is the end of looking at the bank's portfolio of assets and liabilities so long have a good weekend
