Why do banks invest in mortgages

[jelleisgoed]

I have been reading a lot about investing, and often numbers of around 6% per year of added value pops up.

Where I live, in the Netherlands, mortgage interest is around 2.5% right now. I can't understand why banks would opt for giving out a mortgage, instead of just putting this money in the stock market. In the stock market they should get a greater return.

[honeybbq]

Well, in the US it's 3.5-5% depending on terms and quality of buyer. It's virtually no risk because yo have an asset to snag if the home owner doesn't pay. Plus closing costs, etc. People also like to 1 stop shop so it's likely their checking, savings, and other accounts might be through the same institution.

[jda1984]

There are also regulations about what they can invest in and how much.  Mortgages have historically been low risk and long positions so it serves as a good base for the bank to park some of their capital.  I guess I'm thinking of more traditional banks and not investment banks.  At least in the US there is a difference.

[tooqk4u22]

The biggest component is that banks borrower for almost free (the deposits) and lend out the money at 3-5%.  Banks are also 80-90% levereaged that further amplifies returns. 

So a very very simplistic example is and varies by bank and mix:

Cost of Bank Equity..........15% for 15% = 2.25%
Cost of Bank Borrowing.......1% for 85% = 0.85%
Wtd Avg Cost of Capital  = 3.10%
30 Year Mortgage = 4.00%


Assume $1mil mortgage translates to a 6% return on equity ($1mil x (4.00% - 3.10%)) / ($1mil x 15%) for something that is secured by a home, presumably the owner has some equity in it 5-20%, and is 3% greater than 10 year US treasuries but with comparable risk (i.e. low risk).

But banks do so much more though with this....think about credit cards at 18% interest rates, personal and auto loans at 5-12%, etc.

Individuals investing in mortgages doesn't make sense because you won't have the scale or leverage for it to make sense, with the exception being if you want to get control of a distressed property.  Best way to invest in mortgages is through mortgage backed securities.

[Kaplin261]

Banks do not lend money that exists, banks create iou's

[NorCal]

Banks operate on lots of leverage that increases returns.  They are taking deposits (0-0.5% interest) and loaning it at 3-5%.  Since these deposits don't actually belong to the bank, they're making 3-5% on other people's money.  When you combine the money they make on their own money with the relatively small portion of bank-owned money in mortgages, banks actually make quite a lot. 

Per Investopedia, banks average about 8.5% return on equity (bank money)

[mozar]

In the USA, because Fannie Mae will buy them.
http://www.mtgprofessor.com/A%20-%20Secondary%20Markets/what_do_fannie_and_freddie_do.htm

But I think you are thinking of a deeper question? Why would anybody start a business, for example it costs 1m to buy a McDonalds franchise. Why do that instead of put the money in the stock market?
I think there are 2 categories of people. 1st category is people who either don't trust or don't understand the stock market and therefore want to put money into something they can touch. Like my dad, who wanted to buy a painting as an investment, but I can't convince him to save more in an index fund, or even a CD. 2nd category is people who are so rich that they can look for ways to get a higher risk/ higher return things to do with their money or have a "passion."

[MrSal]

I have been reading a lot about investing, and often numbers of around 6% per year of added value pops up.

Where I live, in the Netherlands, mortgage interest is around 2.5% right now. I can't understand why banks would opt for giving out a mortgage, instead of just putting this money in the stock market. In the stock market they should get a greater return.

Because stock market is riskier.

The business of banks is selling money.

The get loans at 0.1% currently more or less and then they turn around and loan out at 2.5%. The difference is their profit.

You dont want to invest the float of the bank or at least most of it in the stock market. That is not their business. althouigh of course they have departments that they use to invest in a lot of securities to hold their assets.

[Kaplin261]

Banks don't loan out money!!!! So many people are under the impression that the money the banks are loaning out is money that there customers have deposited. That's only 15% true.

If I take out a loan for a house for $100,000 the bank has to loan out $15,000 of real money. The other $85,000 is made up and does not exist.

[LAGuy]

If I take out a loan for a house for $100,000 the bank has to loan out $15,000 of real money. The other $85,000 is made up and does not exist.

LOL, wut?

Anyways dunno how it is in the Netherlands, but as others have alluded too, the banks don't lend any money. They're just middle men that get paid a fee for originating the loan. The GSE's (Fannie, Freddie, Ginnie, etc) buy up the mortgages from the banks freeing the cash up for the banks to make more loans. The GSE's package the loans into mortgage backed securities that then trade on the open market. If you own something like Vanguard's Total Bond Index, go look at the top holdings. After US government debt, it's all mortgage backed debt.

So, a better question to ask is, if you think mortgage backed securities have bad yields right now, why are you buying a bond fund thus enabling the low rates?

[MrSal]

If I take out a loan for a house for $100,000 the bank has to loan out $15,000 of real money. The other $85,000 is made up and does not exist.

LOL, wut?

Anyways dunno how it is in the Netherlands, but as others have alluded too, the banks don't lend any money. They're just middle men that get paid a fee for originating the loan. The GSE's (Fannie, Freddie, Ginnie, etc) buy up the mortgages from the banks freeing the cash up for the banks to make more loans. The GSE's package the loans into mortgage backed securities that then trade on the open market. If you own something like Vanguard's Total Bond Index, go look at the top holdings. After US government debt, it's all mortgage backed debt.

So, a better question to ask is, if you think mortgage backed securities have bad yields right now, why are you buying a bond fund thus enabling the low rates?

Its what he means.

Let's imagine an economy with only one bank.

Person A goes into the bank and deposits 1000 dollars.

Now the bank has 1000 dollars in deposits. Since the reserves needed are around 10-15% it means they can loan out 90% of that value.

Person B comes along and gets a loan for 900 dollars.

In this simplistic case, because there is only 1 bank, those 900 dollars will be deposited back into the bank. So, now the bank has 1900 dollars in deposits and 900 dollars in loans... those 900 dollars the bank lent to the Person B, now provide another 810 dollars available to lend out... and so forth and forth. In actuality, 1000 dollars of real money, can create almost 10k dollars in new money just because of this mechanism.

[Paul der Krake]

The term you are looking for is fractional reserve banking. The money multiplier may differ slightly by jurisdiction, but every modern banking system uses money made out of thin air to some extent.

[messymoneymay]

If I take out a loan for a house for $100,000 the bank has to loan out $15,000 of real money. The other $85,000 is made up and does not exist.

LOL, wut?

Anyways dunno how it is in the Netherlands, but as others have alluded too, the banks don't lend any money. They're just middle men that get paid a fee for originating the loan. The GSE's (Fannie, Freddie, Ginnie, etc) buy up the mortgages from the banks freeing the cash up for the banks to make more loans. The GSE's package the loans into mortgage backed securities that then trade on the open market. If you own something like Vanguard's Total Bond Index, go look at the top holdings. After US government debt, it's all mortgage backed debt.

So, a better question to ask is, if you think mortgage backed securities have bad yields right now, why are you buying a bond fund thus enabling the low rates?

What LAGuy said. The banks are not lending depositors money.  They broker the deal and the mortgages are sold to investors.  The bank takes a cut in the deal.

[chasesfish]

Mr. Sal and Kaplian, you're a bit off.

The funds lent do exist in the form of deposits.  Most banks are operating with 75-90% of loans relative to their total deposits.  The difference is invested in short-term bonds or other liquid assets.

If part of a Bank's funding is coming from the Federal Reserve, then you get into the "money created out of air" debate.  Its just not the case right now with your commercial banks.


To the original poster's question, Bank's have to reserve different levels of capital (shareholder equity) based on the risk level of the assets they invest in.  Stocks have a higher risk weighting than mortgage debt, which is backed by a house if the borrower doesn't pay.   Banks are averaging ~ 8.5% return on equity today, which starts making them uninstallable.  You'll see mergers because of this trying to consolidate costs.

[LAGuy]

Mr. Sal and Kaplian, you're a bit off.

The funds lent do exist in the form of deposits.  Most banks are operating with 75-90% of loans relative to their total deposits.  The difference is invested in short-term bonds or other liquid assets.

If part of a Bank's funding is coming from the Federal Reserve, then you get into the "money created out of air" debate.  Its just not the case right now with your commercial banks.


To the original poster's question, Bank's have to reserve different levels of capital (shareholder equity) based on the risk level of the assets they invest in.  Stocks have a higher risk weighting than mortgage debt, which is backed by a house if the borrower doesn't pay.   Banks are averaging ~ 8.5% return on equity today, which starts making them uninstallable.  You'll see mergers because of this trying to consolidate costs.

This.

I'd like to know what exactly "real money" is. Money is just money...it's 100% created out of air. It's really just an accounting gimmick used to represent the value of your assets and to pay for goods and services.

[regulator]

In the US banks (i.e. FDIC backed depository that has a Federal regulator) are generally forbidden to just go out and buy equity.  Simple as that.  If I saw that when I was doing what my handle says (for my sins, which must have been whoppers whatever they were) I would be breaking the glass and taking out the proverbial air horn and sledge hammer.

[Kaplin261]

So the general thought here is. The Bank takes deposits from Bank accounts, CD's and other low interest bearing savings schemes. The bank then loans that money to homeowners to buy homes at 3-4% interest??

So if this were the case, the average home mortgage for americans is $200k. The average savings for americans is $6k. So the theory that money lent by banks is money taken from deposits does not add up.

A good video that explains how all this works:
https://www.youtube.com/watch?v=jqvKjsIxT_8

[marty998]

Lets not turn this into a debate about how banking works (this has been explained in other threads)*.

Banks earn their money on the interest rate spread + fees. Home loans are quite sticky - a customer is unlikely to change home loans every 6 months. A sticky customer allows the bank to try and sell a product such as a credit card or personal loan to the customer which carries a much higher interest rate spread.

Banking (in it's pure form) is a function of 2 metrics. Volume (size & number of loans) and Price (Interest rate).

For some banks the volume of home loans is 10x the volume of credit cards, but the spread on credit cards is 10x the spread on home loans (even taking into account customers who pay off the balance in full each month).

*Having said that, Kaplin261 is correct (except for the average deposits comment - you can't leave out the gigantic cash balances held by corporations, mutual funds and pension funds). I hate the term "fractional reserve"** but it is what it is.

The system only works because depositors don't generally withdraw all their money at the same time.

**This feeds into the whole M0, M1, M2, M3 thing. I am no longer smart enough to explain it properly.

[jelleisgoed]

Thanks for all the reply's, it's more clear for me now.