why do banks give mortgages ?

[drowsy]

It is a simple question, many of you probably know the answer. Well, I do not :(

I read it many times on this forum that when you give your money to PC to get 4% interest, you lose due to inflation and other factors. Thats believable.

But then why do banks give out mortgages for <5% ?
I just do not get it... Just to lower their risks overall ?

[sexpuppet6000]

you dont loss to inflation 4% interest. inflation is 2-3%.

banks charge you interest on your loan. so they make money off you.

whats not to get?

[sh0n]

There are 2 good reasons.

1. To make money as listed by the above poster

2. Banks are simply financial instutitions. Their job is to be a financial intermediary because users - i.e ppl who need to use funds (individuals and corporations) and sources (people who have deposits at banks).\

Without banks think about how the world's financial systems would be.

Where would you go for a mortgage or a loan?
Where would you hold your money? (underneath your mattress?)

[pitz]

I read it many times on this forum that when you give your money to PC to get 4% interest, you lose due to inflation and other factors. Thats believable.

But then why do banks give out mortgages for <5% ?
I just do not get it... Just to lower their risks overall ?

A couple reasons:

1) Banks themselves often don't hold mortgages, but rather just originate them and sell them to investors as mortgage-backed securities. So they give you a mortgage at 5%, and then they turn around and sell mortgage backed bonds at 4.5% to investors, collecting the 0.5% spread for merely the job of arranging the mortgage and packaging the bonds.

2) Banks can leverage their money to extremes. For instance, a bank can take $100 in deposits, pay 2% interest (and expenses...tellers aren't free), and then invest the money at 6% into mortgages or lines of credit. They can leverage that trade 10X, so instead of just making 4%, they make 40%

3) Investors who want a higher rate of return buy mortgage bonds, and apply leverage (or buy leveraged tranches) to give them whatever risk-return profile they want. For example, if an investor wants a 10% return, they simply would leverage 4.5% mortgage bonds roughly 20X against risk-free bonds at 4.25% of the same term/duration. The leveraged play will be more volatile (much higher sensitivity to market fluctuations), but will also produce a higher expected return.

4) And of course, if grandma wants a very secure bond for her portfolio, she can buy the highest-rated tranches of mortgage-backed securities (also sometimes known as Collateralized Debt Obligations or CDO's) which are equivilant in credit rating to risk-free government bonds. Loss in the MBS pool is first borne by the lower-rated tranches, which are considered to be the 'leveraged tranches', and accordingly, have a higher yield, and higher risk profile.

5) Lots of investors are offshore and don't pay exhorbiant rates of income tax on interest like Canadians do. Some Canadian investors (pension funds, RRSPs, governments, etc.) don't pay taxes either. So this lowers the cost of funding for Canadian mortgages because the required pre-tax return is lower for these investors than it would be if mortgages were solely funded by taxpaying Canadians. Since Canada has a very strong inflow of investment capital from overseas, this keeps bond and mortgage rates low.

[drowsy]

Thats a great answer ! Thank you.

There is one thing that I am not familiar with. What is leveraging ? I know it means "spreading", but I do not get how you can make 40%. Any wiki/www pages I can read ?

Banks can leverage their money to extremes. For instance, a bank can take $100 in deposits, pay 2% interest (and expenses...tellers aren't free), and then invest the money at 6% into mortgages or lines of credit. They can leverage that trade 10X, so instead of just making 4%, they make 40%

[drowsy]

I guess
http://en.wikipedia.org/wiki/Leverage_%28finance%29
will be enough.

[bluedcfive]

It is a simple question, many of you probably know the answer. Well, I do not :(

I read it many times on this forum that when you give your money to PC to get 4% interest, you lose due to inflation and other factors. Thats believable.

But then why do banks give out mortgages for <5% ?
I just do not get it... Just to lower their risks overall ?

Take a macroeconomics course

[notanexpert]

Take a macroeconomics course

Macroeconomics has NOTHING to do with this discussion.
As long as banks have a positive spread between the rates at which they loan money out and the rates they pay for deposits, they will make money regardless of inflation!
Of course the real world is more complicated and changes in inflation EXPECTATIONS can throw a wrench in the bank's plans, that's why they pay the big bucks to a few employees to pay a lot of attention when Dodge or Bernanke speak....

[pitz]

Of course the real world is more complicated and changes in inflation EXPECTATIONS can throw a wrench in the bank's plans, that's why they pay the big bucks to a few employees to pay a lot of attention when Dodge or Bernanke speak....

Banks don't play the yield curve like they used to, borrowing short, lending long. In fact, while interest rates have steadily rose in the past few years, bank earnings have been completely unaffected, and in fact, have accelerated. In times past, bank earnings would be hurt when interest rates rise because of portfolio mismatches.

Ever wonder why the banks have seriously been pushing floating-rate products in the past number of years? Because they want to eliminate their own interest rate risk. They simply want to collect fees and spreads, and quite frankly, the banks do an excellent job of such. They only care about Dodge/Bernanke because if rates are too high (or too low), they might suffer defaults in their portfolios.

[notanexpert]

Banks don't play the yield curve like they used to, borrowing short, lending long. In fact, while interest rates have steadily rose in the past few years, bank earnings have been completely unaffected, and in fact, have accelerated. In times past, bank earnings would be hurt when interest rates rise because of portfolio mismatches.
....

But have you looked at the details behind the earnings? Roughly two thirds now come from wealth management, investment banking and trading. This is because the net interest margin (NIM) has deteriorated seriously over the last number of years. So in my opinion its not that they are not interested any more in earning money this way, it has just become much more difficult with the narrowing spreads.

[pitz]

But have you looked at the details behind the earnings? Roughly two thirds now come from wealth management, investment banking and trading. This is because the net interest margin


Exactly my point! Banks mostly make their money engaging in relatively low-risk activities.


(NIM) has deteriorated seriously over the last number of years. So in my opinion its not that they are not interested any more in earning money this way, it has just become much more difficult with the narrowing spreads.

Well so long as Canadians keep shovelling their money into 2.5% MER bank mutual funds, or into principal protected notes (big profits for the bank), or into savings accounts, the banks will remain very profitable.

[notanexpert]

Well so long as Canadians keep shovelling their money into 2.5% MER bank mutual funds, or into principal protected notes (big profits for the bank), or into savings accounts, the banks will remain very profitable.

We are on the same page here, I too have my fingers crossed that the boomers will keep the shovels going for another decade at least. By then the banks will figure out another way to make money.
Do you think the NIM will ever re-bound to the much higher levels of the previous decades? It seems that if money supply was tight, the banks would have a lot more pricing power. I'm not sure that's all there is to it, maybe there is more global competition as well, driving down the NIM?

[pitz]

We are on the same page here, I too have my fingers crossed that the boomers will keep the shovels going for another decade at least. By then the banks will figure out another way to make money.

Yeah, its kind of interesting, they say that approximately 1% of the US markets, by capitalization, are held by ETFs, but that only 0.1% of the Canadian markets are held in ETFs.

Bottom line is that despite the fact that low-costs ETFs were invented and first offered in Canada, Canadians absolutely love to invest using high-cost mutual funds, usually provided by a major Canadian bank.


Do you think the NIM will ever re-bound to the much higher levels of the previous decades? It seems that if money supply was tight, the banks would


No. I believe NIM is being driven downwards because of technology, financial innovations such as CDO's and asset securitization, and competition. These factors will not dissappear.


have a lot more pricing power. I'm not sure that's all there is to it, maybe there is more global competition as well, driving down the NIM?

I think you need to have a prolonged period of an unhealthiness in the banking sector, before you can have a period of healthiness in NIM. Basically, as what happened in Japan (and the United States, with subprime mortgages recently), the banks eventually will kill each other competing on interest margins. Only after bank failures will NIMs start to rise (as they have been in Japan in recent years).

Basically I think, at least in the United States, and with respect to mortgages, we hit a long-term bottom in risk premiums, and now its going to be a long-term road up. Housing prices are falling, theres lots of hungry tradesmen waiting to build more, buyers are few, debt is getting more expensive -- it just feeds on itself as a spiral, and we are already seeing substantial numbers of players in the subprime market going bankrupt.

[ElChico]

Look up the money multiplier. A dollar invested in a bank can be loaned and invested many times over.

[83_gemini]

I suspect Canada's banking structures have conditioned consumers to be far less innovative and pro-active then in the U.S. There could also be a cultural difference; Americans culturally far more comfortable with the market may just be more "into" investing.

It also helps that Canada is far more unionized (private sector unionization is about 30%, compare to less then 10% in the U.S) and so there is substantially less need for private sector employees to rely on personal private benefits because they can get corporate benefits via collective bargaining. This is good for workers (well at least unionized ones; whether it is good for all...) but it inhibits the development of robust consumer friendly investment tools.

[bluedcfive]

Macroeconomics has NOTHING to do with this discussion.


Hmm did you skip the chapter about banking and the money supply? I think you should have a quick read and report back in a much more intelligent state.

Who sets the lending rate to the banks?
Who sets the amount of funds the bank has to hold (which determines the amount they can lend out)?

[notanexpert]

Hmm did you skip the chapter about banking and the money supply? I think you should have a quick read and report back in a much more intelligent state.

Who sets the lending rate to the banks?
Who sets the amount of funds the bank has to hold (which determines the amount they can lend out)?

All of that is totally irrelevant to this discussion - the qestion was why the banks give mortgages, what difference does it make who sets the bank rate or the minimum capital ratios? Pitz answered the question fully in post #3. They can make money on mortgages, that's why they arrange them, package them and trade them!

[bluedcfive]

All of that is totally irrelevant to this discussion - the qestion was why the banks give mortgages, what difference does it make who sets the bank rate or the minimum capital ratios? Pitz answered the question fully in post #3. They can make money on mortgages, that's why they arrange them, package them and trade them!

ok its irrelevant, so the banks get their supply of loanable funds from thin air right? And they also set reserve margins arbitrarily?

[notanexpert]

ok its irrelevant, so the banks get their supply of loanable funds from thin air right? And they also set reserve margins arbitrarily?

1. Banks get their supply of money wherever its the cheapest. Bank rate changes will have an effect on that, but banks can make money on mortgages no matter what level the rates are set at.
2. The central bank sets the capital ratios (4.5% in Canada) in order to comply with the Bank of International Settlements guidelines (4.0% minimum i think), but whatever they set it at, the banks will live with it, and make money - they just won't be able to leverage as much if the ratio goes up, but these ratios change very rarely. Right now the banks have more money than they can deploy, so they don't even approach their minimum capital ratios, therefore they are irrelevant. That's why all the Canadian banks are on the hunt for internaitonal expansion, they need to deploy the surplus capital that they have, leveraging up the whole operation and hopefully making more dough.

[adamtheman]

Short answer is they like diversifying their stock portfolio, just like we like diversifying ours. Mortgages, HELOC's, loans, etc. are all low risk investments. The more of these that a bank has, the more high risk investments they can make.

[bluedcfive]

1. Banks get their supply of money wherever its the cheapest. Bank rate changes will have an effect on that, but banks can make money on mortgages no matter what level the rates are set at.
2. The central bank sets the capital ratios (4.5% in Canada) in order to comply with the Bank of International Settlements guidelines (4.0% minimum i think), but whatever they set it at, the banks will live with it, and make money - they just won't be able to leverage as much if the ratio goes up, but these ratios change very rarely. Right now the banks have more money than they can deploy, so they don't even approach their minimum capital ratios, therefore they are irrelevant. That's why all the Canadian banks are on the hunt for internaitonal expansion, they need to deploy the surplus capital that they have, leveraging up the whole operation and hopefully making more dough.

Yep - sounds irrelevant to me - thanks for proving my point

[notanexpert]

Yep - sounds irrelevant to me - thanks for proving my point

Oh, you are so funny! I'm almost ROTFL.

This is from Wikipedia:
Macroeconomics is a branch of economics that deals with the performance, structure, and behavior of the economy as a whole. Macroeconomists study and seek to understand the determinants of aggregate trends in the economy with particular focus on national income, unemployment, inflation, investment, and international trade.

Now, I've written enough, I'm waiting for your detailed explanation how the above relates to "Why do banks give mortgages?"

[bluedcfive]

Oh, you are so funny! I'm almost ROTFL.

This is from Wikipedia:
Macroeconomics is a branch of economics that deals with the performance, structure, and behavior of the economy as a whole. Macroeconomists study and seek to understand the determinants of aggregate trends in the economy with particular focus on national income, unemployment, inflation, investment, and international trade.

Now, I've written enough, I'm waiting for your detailed explanation how the above relates to "Why do banks give mortgages?"

Have you taken a macro course before or did you get your education through the internet (RFD and Wikipedia)?

Money supply and the banking system is a core element of macroeconomics (even at the beginner level - perfect for you)

[bluedcfive]

I will humour you.

Lets take a trip to Wiki University, your preferred institution for financial education:

http://en.wikipedia.org/wiki/Macroeconomics

Scroll to the bottom to Topics in Macroeconomics

You will find the following:

Central Bank http://en.wikipedia.org/wiki/Central_bank
Money (supply) http://en.wikipedia.org/wiki/Money#Money_Supply
Inflation would be another good one for the OP to read since he was asking about it in the first place http://en.wikipedia.org/wiki/Inflation_%28economics%29

But, I guess macro still has no relevance here, right?

[notanexpert]

Have you taken a macro course before or did you get your education through the internet (RFD and Wikipedia)?

Money supply and the banking system is a core element of macroeconomics (even at the beginner level - perfect for you)

Honestly, I did not think you'd be able to come up with a detailed explanation.

By far the best answer I have seen on this thread is, as I mentioned before - Pitz in post #4, and he mentions nothing about Macroeconomics.

[notanexpert]

I will humour you.

Lets take a trip to Wiki University, your preferred institution for financial education:

http://en.wikipedia.org/wiki/Macroeconomics

Scroll to the bottom to Topics in Macroeconomics

You will find the following:

Central Bank http://en.wikipedia.org/wiki/Central_bank
Money (supply) http://en.wikipedia.org/wiki/Money#Money_Supply
Inflation would be another good one for the OP to read since he was asking about it in the first place http://en.wikipedia.org/wiki/Inflation_%28economics%29

But, I guess macro still has no relevance here, right?

Yes, Wiki is my favourite university!
And I see nothing in your post above on mortgages or why banks give them.

[bluedcfive]

Honestly, I did not think you'd be able to come up with a detailed explanation.

By far the best answer I have seen on this thread is, as I mentioned before - Pitz in post #4, and he mentions nothing about Macroeconomics.

He doesn't need to cite macroeconomics, because Macro governs the way banks operate and the rates they charge (which affects their spread). If there was no profit to be had, they wouldn't be in the business of lending out money in the first place. Its like saying you don't use math to do cash flow analysis, you just use NPV.

[bluedcfive]

Yes, Wiki is my favourite university!
And I see nothing in your post above on mortgages or why banks give them.

I can tell you were internet educated. Did you print out your degree at home?

[drowsy]

I am satisfied with the explanations.
Now I dont get how banks can make 40% off 4% by leveraging. :)

[drowsy]

specifically, I do not understand this :

2) Banks can leverage their money to extremes. For instance, a bank can take $100 in deposits, pay 2% interest (and expenses...tellers aren't free), and then invest the money at 6% into mortgages or lines of credit. They can leverage that trade 10X, so instead of just making 4%, they make 40%

[ramoose]

It is a simple question, many of you probably know the answer. Well, I do not :(

I read it many times on this forum that when you give your money to PC to get 4% interest, you lose due to inflation and other factors. Thats believable.

But then why do banks give out mortgages for <5% ?
I just do not get it... Just to lower their risks overall ?


It is very profitable for them

[notanexpert]

specifically, I do not understand this :
2) Banks can leverage their money to extremes. For instance, a bank can take $100 in deposits, pay 2% interest (and expenses...tellers aren't free), and then invest the money at 6% into mortgages or lines of credit. They can leverage that trade 10X, so instead of just making 4%, they make 40%


It just means that the banks can loan out not just the money they have collected in deposits and GIC's, etc., they can also loan out money that they have borrowed by using various financial instruments such as bonds.
Imagine that you are a loan shark. You have a $100 to lend out at 10%. Someone borrows that from you, and you are happily collecting 10% profit. But, then you think, I have this line of credit that I can access at 6%, why not borrow from there and lend out at 10%? So you borrow $1000 and collect the spread, which is 4% or $40 per year. Therefore, from your original $100 of capital, you are getting, all together, $50 per year, a 50% return on assets, like magic!
Banks have access to more money than just the deposits because all these people paying interest to the banks are like assets that the banks can borrow against, by using various financial instruments.
That is partly how the Canadian banks are getting about a 20% return on assets, even though the net interest margin (the spread between what they pay and what they collect in interest) is only a fraction of 1%. I say partly, because they make loads of money on wealth management (MER's on mutual funds mostly) and investment banking (mostly companies paying them big bucks to finance their operations by finding buyers for large numbers of their shares in the capital markets, i.e. IPO's and secondary offerings)

[jerryhung]

Imagine that you are a loan shark. You have a $100 to lend out at 10%. Someone borrows that from you, and you are happily collecting 10% profit. But, then you think, I have this line of credit that I can access at 6%, why not borrow from there and lend out at 10%? So you borrow $1000 and collect the spread, which is 4% or $40 per year. Therefore, from your original $100 of capital, you are getting, all together, $50 per year, a 50% return on assets, like magic!


Great example