A (post)Vacation Question – Part III

Now that we’re back from vacation I can retain my blogger’s right to semi-anonymity, yet risk little by answering Mike’s [and, some of our other readers’] question:  “Which beach in Australia is this?”

Noosa in Queensland.

After discussing the real-estate ‘deals’ of Bill the shaved ice man, and Massimo the ice-cream man [AJC: did I mention him?], while buying – naturally – shaved ice and icecream, as one does when in Noosa on vacation, now that we were finally home and ready for a change of scenery …

… we discussed bank-financing of real-estate on our way back from buying ice-cream at the 7-Eleven store not far from our own home 🙂

The conversation went something like this:

Son: “Why has the bank invited you to their private corporate box at [a certain upcoming international sporting event]?”

Father: “Well I have a lot of money on deposit with them”

Son: “But, they have to pay you money [interest], aren’t their important customers the ones that they lend money to and who have to pay the bank money?”

Father: “Good point!”

So, I explained to my son that I am now both a borrower and a lender to my bank:

– As a lender, they pay me roughly 3% on the money that I have sitting in their bank,

– As a (recent) borrower, they charge me roughly 7% (interest + bank fees and charges) on the money that they lend me.

Son: “So, they only make 4% interest … is that enough for the bank to make money on?”

Father: “Don’t feel too sorry for the banks!” 😉

As I explained to my son, the bank is like any other business buying a product for $3 (or, in the bank’s case, borrowing money for 3%) and selling that same product for $7 (or, in the bank’s case, lending money for 7%):

They are operating on (at least in this example) a 133% Gross Margin.

Most people DREAM of having a business that operates on 133% Gross Margin …

… of course, the banks have costs:

– They have to carry stock (i.e. pay interest on funds deposited) even if they don’t sell it (i.e. lend it) … unlike a ‘normal business’ the bank has these great treasury departments who simply put this ‘spare money’ into the short-term money market and earn interest,

– They have the usual staff, office lease, and overhead expenses of any other business,

– They have the risk of fraud / credit default on the money that they lend out.

All of this is factored in to produce a Net Profit that is amongst the best of any type of business (GFC aside). This got my son thinking:

Son: ” So, why don’t you put your money in a safety deposit box and lend it out to other people instead of letting the bank make all the profit on your money?”

Well, as I explained, I actually do: I have a finance company of my own, and we look at our finances this way; the interest that we charge our clients is treated as ‘fees’ … we divide that Fee Income (very roughly) into three parts:

– 1/3 goes to pay the bank’s interest and fees on the money that we borrow from them to lend to our clients,

– 1/3 goes to pay our staff, rent, and overheads, leaving

– 1/3 which goes to our [AJC: my] profit.

This is strikingly similar to the ‘standard’ restaurant formula:

– 1/3 goes to pay for the raw material [AJC: pun intended 😛 ],

– 1/3 goes to pay their staff, rent, and overheads, leaving

– 1/3 which goes to their profit … of course, that’s the theory but the reality for restaurants and many other businesses is vastly different (but, that’s a subject for another post).

So, why don’t I do what my son suggests for the bulk of my money?

Simple: I don’t have the ability to handle the credit / fraud risk!

But, the bank can because they have the people, the systems, and the sheer bulk of money out there which effectively spreads their risk (IF they have followed sound credit lending policies ….enter housing crash and GFC).

Later on this week, though, I will tell you how YOU can become the bank … without the risk.

Stay tuned!

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8 thoughts on “A (post)Vacation Question – Part III

  1. There is a fairly easy way to become the bank- peer to peer lending. It doesn’t remove the risk of default but does allow for diversification and there is a framework to asses the risk. They break loans into many small pieces that different individuals fund, so you don’t risk too much on any one loan.

    I’ve been experimenting with the lending club- so far no defaults and I’ve earned a bit over 10% interest on a conservative loan. I like their interface and it seems like a viable way to invest.

    BTW there is a promo offer you can invite friends to try it they get $40 to start investing. Leave a comment on my web page http://www.ponderingmoney.com if you want an invite.


  2. Rick, Adrian, if you find out a way to invest in peer to peer lending at a reasonable scale let us know.

    P2P lending requires you to pick through hundreds of loan apps, and filter it to the set that you believe has the best risk / return ratio.

    Then you have to diversify – invest in many loans so that a single default will not wipe you out. I think that you should invest no more than 1% of your portfolio into a given loan – so lets say you need to invest in at least 100 loans. Unfortunately, that requires you to pick through probably 1,000 applications hand-by-hand (you already discard the vast majority based on search criteria).

    Thats frankly just too much work to be worth it, no?

  3. @ Rick – Yep, P2P certainly helps to spread risk, just like the banks … but, is there a P2P version of FICO and the banks’ other risk-assessment tools?

  4. Look forward to this next post on how to become the bank(without the risk 🙂 ). My girl and I are sort of Banks in The Philippines , as we do lend money out .

  5. Yeah, I thought of P2P as well, but the model doesn’t easily scale well enough to be worth my time.

    Beautiful location. Maybe my next trip down under I’ll get to visit Queensland.

  6. Adrian,

    Lending Club categorizes lenders by FICO score- higher scores get lower rates.


    Their interface allows you to put in a amount to invest, adjust the % return (assuming no defaults) and it will pick a set of loans from the different categories that gives you that average return. Of course if you want to pick loans one by one and read over all available loans it could take a long time to invest a large sum.

    -Rick Francis

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