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What is the Traditional Banking Model?

In a post-Great Recession world, banks are leaders in safe lending. With the introduction of the Dodd–Frank Act, financial institutions have stiff regulatory compliance standards to maintain and rigorous capitalization requirements.[1]In short, banks that survived the financial crisis are stronger than they’ve ever been and new regulations, no matter how begrudgingly followed, are keeping them there.

Of the major changes the Dodd–Frank Act introduced to banks, two of the most interesting are the stricter requirements for mortgage lending and better safeguards for banks that follow them. One such change is found in the eight underwriting factors lenders are asked to consider when determining a borrower’s ability to repay.[2] Another is found in the legal protection offered to lenders who keep borrower loan payments from going above 43 percent of their income.[3]

Sounds good for banks, right? But what about for investors? Well, if you’re investing in mortgage loans that have been originated by banks under these stringent guidelines, it results in an inherent risk mitigation that might not exist with other investments.

It’s not just newly originated loans that have risk-adjusted benefits for investors. Even loans originated before the 2008 Great Recession can have tremendous value with limited risk. Because these loans were issued to borrowers who kept up their payments, even while underwater during the financial crisis, most of them have already regained the equity lost during that stressful time.

But beyond safety, mortgage loan investing offers an opportunity for alternative investors to find high profits—similar to those that banks secure for themselves. How? By taking advantage of the spread and amortization intrinsic to the traditional banking model.

When I talk about traditional banking, I’m referring to depository institutions, such as commercial banks, savings and loans, and credit unions. These are “banks” in the traditional sense; they accept deposits from borrowers and part of their business is lending out their depositors’ funds to borrowers in the form of mortgage loans.

The traditional banking model is surprisingly simple. In its most basic sense, it works like this:

ABC Credit Union accepts deposits from customers, paying interest of 2 percent on their deposits.

These deposits are pooled and funds are used to originate a mortgage loan to Joe Customer at 8 percent.

The bank requires a 20 percent down payment from Joe Customer, allowing them to finance 80 percent of the home’s value.

The credit union’s net interest spread is roughly 6 percent, which is the difference between what they receive in interest on home loans and their cost of funds, or what they pay in interest to their deposit customers.

Banks are in the business of money. Loaning it, securing it, and earning it. This is clearly seen from the simplicity and net interest spread built into the traditional banking model. While these factors lay the foundation for why mortgage loan investing can be low risk and profitable, there’s a lot more to it than that.

Another way that banks profit in mortgage lending is through the fees involved in originating a mortgage loan. If financial institutions can keep recycling their capital and charging borrowers fees that total 3 percent of each mortgage loan amount, it would make more sense to sell loans as quickly as possible.

If a financial institution originates only $20 million in loans per year and makes 3 percent of that total just in fees, that equals $600,000 profit per year! When you further consider that home buyers routinely finance their closing costs as part of the overall mortgage, the profits grow exponentially.

Banks also profit on lending through amortization. If you’ve ever taken out a home loan, you have seen the required Truth in Lending disclosure in Figure 3. Did you get sick to your stomach when you saw that making each minimum required payment over the life of the loan would drive up the total amount paid back on your loan almost three times what you originally borrowed?

Consider the following example for a $50,000 loan at 8 percent over thirty years:

You might think that this means a bank would want to hang on to your loan as long as possible to get all of that 300 percent markup, but thanks to amortization, which requires the largest percentage of interest at the beginning of the loan, banks don’t need to. Because in addition to earning money from the spread we talked about in the last section, banks are earning most of the interest on your loan up front, in the first several years of payments.

Take a look at the amortization schedule for the loan discussed earlier:

The first monthly payment of $366.88 only applies $33.55 to principal. In fact, one year in, at your twelfth payment, you’re still only paying $36.09 toward that principal balance—for a total of $417.65 paid toward your principal. In a YEAR! During that same time, you’ve paid $3,984.91 in interest. And that’s only for one loan! Multiply that by a thousand loans, and you can see what money machines banks are.

Finally, banks cannot just continue to lend endlessly. They are bound by reserve ratios, or the amount they are required to keep liquid. If a bank is approaching their lending limits, but still wants to originate loans, it may decide to sell some of their older loans, or least desirable loans, in pools in order to create liquidity and continue lending and collecting origination fees.

And that’s where you come in.

[1] [2] [3]

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