Gray-area loan practices resurrected

By DAVID MOON, Moon Capital Management
July 25, 2004

In the 1970s, many banks forced consumers to buy expensive insurance as a condition to making loans. The insurance was almost always more profitable than the loans, since a captive buyer will pay more for a product than a consumer in a free market. In effect, many banks required their lending customers to buy ancillary, higher margin services as a condition of receiving loans. In a move to protect consumers, Congress outlawed this practice.

Never underestimate the ability of business to resurrect a bad idea.

A recent study conducted by the Association for Financial Professionals (AFP) found that 96 percent of corporate finance executives at large companies (those with annual revenues exceeding $1 billion) report lenders pressuring them to buy underwriting, merger advice and other services in exchange for loans. Two-thirds of the respondents said they had been denied credit or charged higher rates as a result of refusing to give into this subtle form of blackmail.

Jim Katz, president of the AFP, said the survey results 'clearly demonstrate that these practices are becoming commonplace.' Banks are operating in a gray area where honest disagreement exists about what is illegal and what is a legitimate effort at cross selling. Katz wants federal clarification on the laws. 'It is now time for the Federal Reserve and other regulators to provide a clear interpretation of what constitutes illegal tying.'

The issue is not limited to huge companies borrowing money from multi-national financial institutions. It is not uncommon for the same practice to exist at the local level. A bank will 'suggest' that the continuation of a company's line of credit is contingent on moving its 401(k) plan to the bank. It may not be done in a way that is illegal, but the pressure certainly violates the spirit of the anti-tying legislation of the 1970s.

When a bank tries to tie certain products and services to the purchase of other, more lucrative services, think about what that says about the quality of those other ancillary products offered by the bank. Are they not good enough to compete on their own? Rather than compete on service or price or performance, some banks resort to holding customers hostage in order to sell merger advice or investments. I am aware of plenty of situations where a borrower felt pressured (or even forced) to move his retirement account to a bank as a condition of retaining a line-of-credit or other core banking services. I have never heard of a bank requiring a 401(k) customer to borrow money in order to keep his retirement plan with the bank.

Imagine if Pilot wouldn't sell you gasoline unless you agreed to buy a lottery ticket and a carton of cigarettes.

There is clearly a gray area in this practice. I hope the Fed more clearly defines what is illegal and what is merely aggressive business. Until then, however, seriously question any salesman (not just a banker) who conditions the offering of one product on the purchase of another.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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