Are Mortgages a Risky
Business?
By
Jenny Barclay
A bank
or mortgage company is nothing more than a
box in which to keep money. The owner of the box has
to do a few calculations. Firstly, how much is he
going to offer those people who deposit cash in his
box, in return for such a deposit? Secondly, how much
of that money should he keep as cash in case the
owners of that cash want it back? Maybe 5%, maybe
10%, what are the regulations in his jurisdiction?
Thirdly, how much is he going to charge those people
who wish to borrow the money of others, previously
deposited in his box?
The person who
owns the box then sets out to find lots of other
people to put their spare cash in the box, in return
for which he promises to give them their money back
plus interest. In the eyes of some economists, these
people are lenders and not investors. This
terminology is based on the fact that the capital
investment of lenders does not change, whereas the
capital value of investors, in stocks or property for
example, can go up or down. The owner of the box then
has to find other people who do not have spare cash,
but in fact wish to borrow it.
Fixed or
variable?
Both the
lenders and the borrowers can sometimes be bewildered
by the variety of terms offered by such institutions.
The easiest terms to understand are those that are
based on a current rate that will vary according to
the market for interest rates, which alters daily,
although the companies will try to even out such
daily fluctuations with only periodic changes in the
rate. Fixed rates, for a given period, are more
difficult for the average lender or borrower to
understand, a fact that has given rise in the past to
greedy companies being able to reap huge benefits
from such lack of knowledge. The reason for an
institution wanting to attract deposits at a fixed
rate could be based on the fact that their advisors
calculate that interest rates are going to rise.
Should they find it possible to attract deposits at
e.g. 3% over 3 years, and then find that current
rates are 5%, they will be somewhat pleased. In the
case of a borrower finding that they are in this
situation they should be congratulated for being
better at guessing than the company’s advisors. On
the other hand, a borrower tied in to a contract at
say 10% for several years who then finds that rates
have dropped to 5%, will not exactly be celebrating.
In my short experience since I started at university
fourteen years ago, I have seen deposit rates vary
from 14.5% down to 1.5%.
Is a
bank safe?
There is also a
common belief among lenders that their capital is
safe. In the absence of a government or similar state
authority providing such a guarantee, this can be far
from the case. At university one of the cases we
studied, was that of a particular savings bank. A
rumour went around the city that the bank was in
trouble. A great number of people went to the bank to
withdraw their savings. Those that represented the
first few % of the total deposit had no problem. When
the percentage rose to 6%, which in this case was the
amount decided by “the owner of the box”, the
rumour became fact in that there was no cash to pay
out to depositors. As this was in a country in which
the owners of all the boxes were members of a club,
the aim of which was to protect the undeserved, but
perceived, reputation of said members, the members
sent round security vans with sufficient cash to pay
out all those who people who “had taken notice of
an unfounded rumour.” Things quietened down after a
while, and the government decided to introduce
legislation to create a minimum liquidity level.
Another case we
studied was that of one of the world’s largest
banks, the board of which was mainly composed of
greedy souls. They had decided that the stock market
was a good place to keep the liquidity margin, so
that in the event of a bear market, they could create
more profit for the shareholders. A sudden bear
market wiped out the liquidity margin, and the bank
came within a hair’s breadth of going belly up.
Once the
bank has reached a substantial size, the liquidity
should be sufficiently large to cater for all such
panic withdrawals, unless of course the panic is as
great as 1929.
For the
borrower it provides a necessary service, and apart
from penal conditions imposed on borrowers, is a
vital service to our society. From the investor’s
point of view, it depends firstly on the mentality of
the treasury function within the bank, and secondly
the legislation that governs their actions and
accountancy practices. From the investor’s point of
view, considering investing in the stock of such an
organisation, it depends entirely on an analysis of
the bank’s net worth and profitability. Both the
examples mentioned above have since gone from
strength to strength, and have since been bought for
more billions that most of us can count.
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About
The Author
Jenny
Barclay majored in math. and economics, and obtained
a masters in viability of banking institutions. She
is currently studying Spanish in Andalucia, Spain. http://www.regent-estates-group.com/s/apartments-for-sale-fuengirola/index.cfm
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