One of the primary philosophies of Weakonomics is the status of the financial industry. No I’m not talking about Bear Stearns, Countrywide, and the credit crunch. They play a part and we’ll get to them shortly. How Banks Make Money covered the basics but they aren’t the only institutions out there. We have investments/brokerage, insurance, financial planning and all that jazz.

The journey leads us first to financial planning and investments. I must say the advent of the Internet has taken broker fees from hundreds down to a handful of quarters, which is great. But, have you asked the guy that comes to work to “help” you with your 401(k) how much he makes? We won’t go into mutual fund fees, but you should know that the suit he’s wearing is not from S&K (by the way, great place for a cheap suit). Many mutual funds nickel and dime through all kinds of fees, and then you can get slapped around with “admin” fees charged by your “advisor”. It is likely that your company pays him a fee, you pay him a fee, and he gets kickbacks for pushing certain funds over others. Obviously, the funds with the most fees offer the most kickbacks, so you just paid him again. This just isn’t right but can be unavoidable based on your employer. Encourage your HR team to investigate these fees and recommend the likes of Fidelity and Vanguard as alternatives.

Let’s look at fee only financial planning. Instead of commissions and hidden fees, all costs will be disclosed up front. A company would be wise to hire one by the hour. They can set you up with the right people and it does them no good to hide anything from you. This is also the best solution for individuals that don’t have a lot of money to invest. The other type of fee-only planner is best suited for people with more money to invest. Basically, I give this guy my money and he will do just about everything for you. They can custom design a portfolio based on your needs and continue to manage it as long as you want. A typical rate is 1% of assets, this is a bargain compared to other services.

Our 2nd checkpoint is with banking. Do you know what an interest only mortgage is? Its a very profitable product for banks. In short, it allows you (for a period of time) to make your payments on the interest only. So instead of a $1,000 a month payment I might pay just $200 or less! Why do banks like this? Because the principle is never paid down on that monthly payment. Its like renting. So what are they for? A house flipper would like one. If I’m going to own the house for just 6 months, it doesn’t do me much good to pay into principle when I’m making money on the sweat equity. Well some people figured out this was a great way to get into a house they couldn’t normally afford on a 30 year fixed mortgage. Mortgage officers are often paid per sale, and loans like the interest only paid better than a 30 year fixed. Lenders began pushing these and other non-conventional loans. To keep up with the Joneses, all of a sudden typical families and single parents were now getting into homes they could not afford because of these loans.

In How Banks Make Money I explained that banks are now making more money on the fees than the spread from a loan. The hole gets bigger Alice. In the 1980s, a trend caught fire behind the scenes in the loan world. Instead of keeping the rights to the loan the bank gave you, they sold it to someone else (heard of mortgage backed securities?) at a small discount. The bank was now getting all their money up front. The loss from the discount could be supplemented with those fees, and the risk of default was passed off to someone else. Great for the banks! Bad for you. As each level gets more complicated, everyone has to get their cut. This is called overhead. Who pays for that overhead? You of course! Cut out the overhead, cut out the costs. Online banks know this, its a basic concept.

Our last stop is with the insurance people. I’m currently working on a story with auto insurance. Buying direct almost always is the best. You bypass a middleman that would normally take a cut of everything. I don’t know how this guy managed to do this, but my mom’s insurance guy convinced her she needed life insurance on her two fine sons (one being the finest!). For 15 years she paid a few bucks a month for minimal coverage. Why does my mother need to get a check if I died? An emergency fund should be able to cover a death, which she has always had. Let me tell you something about life insurance; if someone relies on your income, you need life insurance. If you’re single with no kids, who needs $250,000 if you die? Life insurance exists to take care of people that relied on your income. If you are retired with grown kids and a good retirement fund, you don’t need it. Pensioners are another thing, but we won’t get into that here.

Americans are over covered. Many get covered through work for free (myself included), but still get sold on additional coverage through a 3rd party! Why? Because salesmen know how to scare you. Final note: never get whole, only term.

So the story is “Which came first?”. Who do we blame? Was it the salesmen that push bad products for commissions? Or was it the company management that offered more incentives for said products? Well then it could have been the executives and their big salaries looking to pump up numbers. Of course they were just getting pressure from shareholders to grow profits. Assuming its a publicly traded company, I might own stock in it. So is the public responsible for screwing the public? I have a headache. But really, it is a cycle and blame can be placed at every level. We are all motivated by greed, and if we can put in a dollar and get two back, we don’t care who had to give up their dollar, even if it was us. There is a happy medium between profits and gouging the public. There is also a way to be profitable without playing on greed.

Being a capitalist deep down and an employee of one of these banks, its almost hypocritical to write this. ALMOST. By working at a bank I’m learning about this greed and I’ve met people that agree with my philosophy. There are commissioned salesmen out there that do not offer inappropriate products. There are business models out there that keep company interests in line with consumer interest: the old banking model, fee only financial planning, and providing insurance as a service and not a sellable product. Seek out these services and tell their providers how much you appreciate what they do, they don’t hear it enough.

Thanks for reading, this has been my favorite piece so far.

Related posts:

1. Weakon 151: Banking Industry Explained, Part 2
2. Weakon 149: Financial Licenses and Certifications
3. Weakon 231: How the Mortgage Industry Works (or Worked!)
4. Ken Thompson Canned: Financial Services Industry Shakedown
5. Weakon 151: Banking Industry Explained, Part 1

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