Banks Are Businesses Too!

There is still concern that the government did not do the right thing in its bailout of Fannie Mae and Freddie Mac. The Aubry & Eustice team believes that what was done was a necessary, short-term fix. However, many questions remain as to what the next presidential administration will do after the election or what the Treasury Department and Secretary Henry Paulson plan to do specifically in the interim. 

Yet, there are a couple of important questions that we can answer here today.  One being, why do we need a “secondary market” for mortgages?  The other being, why don’t banks keep their loans in-house any more?  Those questions are very legitimate questions to have, and the answers involve two things, profit motive and the advent of money market accounts.

Profit Motive

Banks are in the business of making money, just as any other business. It just so happens that the business of banks is using money to make more money. If a bank sees the opportunity to get a fee for originating a loan and then another fee for selling a loan, which elliminates that mortgage as a risk position for them, the bank is going to do it. Why?  Because in a free market economy, the desire to make more money is essentially the engine that drives the train.  It is what motivates the business to succeed.

(The only factor that may motivate a bank more than the desire to make a profit is the desire to manage risk.  Specifically, the risk of default. When a bank lowers their probability of default by selling a loan, the probability of a loss occuring from that loan obviously decrease as well, and when this happens, the bank’s probability of making a stronger profit increases.)

The Money Market

A client and friend of Aubry & Eustice, Steve Gonzalo, is the Executive Vice President and Chief Technology Officer of the First National Bank of Ottawa. (Steve also happens to be one of the most intelligent persons we have ever met.) After reading Monday’s post, “. . . but not the Hippopotamus,” Steve sent an email to remind us of why there is a need for the secondary market for mortgages: the Money Market.

An excerpt from Steve’s email follows:

“One point of interest that not many people of our generation know or remember: until 1970, there were no such things as money markets, NOW accounts, etc. But today there is more than $2.5 trillion dollars in money market accounts.  The banking industry was (and still is) highly regulated.  The interest rates a bank could charge or pay were set by their regulators, and virtually all deposits were held at banks.  Then the brokers (investment firms) decided they didn’t want to be left out so the Money Market account was created and suddenly a HUGE amount of bank deposits left the banks and went to the brokers.

The effect . . . banks now had much less money to lend out, since the brokers didn’t make mortgages.  This exponentially increased our (the banks) reliance on a secondary market for mortgages.  Banks are restricted on the amount they can lend based on their deposits and capital; less deposits means less loans unless the loans can be sold off the bank’s balance sheet.”

Thanks to Steve Gonzalo for his expertise and insight.

It can be argued that the problem with Fannie Mae and Freddie Mac was that they were essentially two “quasi-governmental” companies, and therefore they lacked the same desire as other banks that have not operated with “an implied federal backing.”  Because of the “implied” guarantee, there was never any real risk; therefore, there was no real profit motive.

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