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Currently I'm learning about finance and I want to understand the following. In the Netherlands the interest on a mortgage is about 3%-4% depending on the payback period. When learning about stocks and ETF, I learned that the average market return is around 10%.

My question is therefore, why are banks bothering providing mortgages, while they also could invest the capital in markets?

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    $\begingroup$ Is the market return always 10%? So far this year the Amsterdam Exchange Index has been providing a return of negative 34% per year. $\endgroup$ Commented Jul 11, 2022 at 10:41
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    $\begingroup$ I see, but mortages are often for a long term period 15-30 years. So wouldn't it be more fair to use the same timescale to calculate the average return of the market? $\endgroup$
    – Tim
    Commented Jul 11, 2022 at 10:54
  • $\begingroup$ depends if the bank has enough money so it can still pay all of its debts if the market goes down 90% or so (i.e. has 10 times as much money as it needs). Does it? $\endgroup$ Commented Jul 11, 2022 at 10:58
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    $\begingroup$ If my bank was making risky maneuvers with my money I'd bank elsewhere. $\endgroup$
    – Turbo
    Commented Jul 11, 2022 at 19:22
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    $\begingroup$ @Tim, speaking of the Netherlands, the AEX index was 682.45 on June 16th 2000 (22 years ago) which is above the current level of the AEX. So even if you look at the average return over 20 years, mortgages were providing more return to banks than investing purely in the AEX would have. Your return number is most likely from the s&p500 which is NOT what you can expect on average across all stocks or countries. $\endgroup$
    – Alex
    Commented Jul 13, 2022 at 22:49

8 Answers 8

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A bank (or anyone else) considering possible investments needs to consider both return and risk. Stock market investment is risky in two respects: a) individual stocks may achieve more or less return than the market average; b) even if an investor has a well-diversified portfolio of stocks so that their combined return in any one year is close to the market average for that year, the market will have good and bad years reflecting general economic conditions.

Investing in mortgages, by contrast, is less risky because: a) the interest rate is defined in advance (or perhaps variable at the lender's discretion); b) if the borrower cannot keep up their payments, the lender has the security of being able to obtain possession of the property (which they could then sell to recover their capital). This does not provide complete security because the market price of the property may have fallen and become less than the amount lent, but it greatly reduces the risk to the lender.

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    $\begingroup$ Indeed, for b) to happen large-scale, the most likely scenario is an economic depression, in which case there's probably less money in the market that wants to buy those houses $\endgroup$ Commented Jul 12, 2022 at 4:52
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    $\begingroup$ @HagenvonEitzen Indeed, that's what happened during the Great Recession. Real estate crashed, but so did the stock market. $\endgroup$
    – Barmar
    Commented Jul 12, 2022 at 13:59
  • $\begingroup$ Not to mention mortgages are one of many diversified revenue streams for a bank. IBM, as example, may be a good stock, but I would be remiss to dump all my resources there. $\endgroup$ Commented Jul 13, 2022 at 17:56
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  1. Banks are in the business of lending money. If they didn't do this, then they wouldn't be called a bank. They would be called a fund manager or stock broker or some sort.

  2. Mortgages are safer investments. If a bank buy a stock for $100,000 and the company goes bankrupt (which most companies do even over short period so this is an eventuality) then the stock becomes worthless and the bank loses 100% of it's investment. If a bank lends a person 100,000 to buy a house and the person goes bankrupt, the loan is collateralized so the bank can repossess sell the house and recuperate the costs of the loan. In theory, the interest rate is supposed to be a calculation of how much money the bank can receive before an individual goes bankrupt and combined with the depreciated value of the collateral it should meet some target value (usually some percentage of the value of the collateral like 110%). In reality of course, you're more likely to sell a house for more in the future than when you bought it so it's generally a safe bet even with 0% interest.

  3. Revenue is less variable. Stocks can grow by a lot, a little, and even lose value. Interest on a loan, collateralized or not, has a fixed rate or a variable rate which is known ahead of time. This allows a bank to efficiently plan for future revenue since the value they are getting is fixed. Even in the case that a person defaults on a loan, since it is collateralized, the bank will likely not lose any money if they did their due diligence in underwriting and charged an appropriate amount of interest.

  4. Banks need to lend money. This means that the bank need to get paid in money so they can lend more money. A stock going up means that the bank can theoretically get money if they sell at that moment. Since selling and rebuying stock every time you need money is a huge waste of money (because taxes, broker fees, etc.) the only alternative is to leverage, which would be taking out a loan against the value of a stock. A bank buying a stock and borrowing money against the stock to lend to someone else is a house of cards that is waiting to fall (not to mention the bank loses money paying interest to someone else).

Although I'm not understanding the aim of the question. If you wanted to give someone money to invest it, there are fund managers for that. Banks are basically providing a public good by giving the public a well regulated, insured, and safe way to borrow money without the risk of a loan shark breaking their kneecaps.

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  • $\begingroup$ Well regulated implies a partial remediation against marginal damages, and insured investment is regulated how? The government allows borrowers to not be physically harmed for lenders’ failures? $\endgroup$ Commented Jul 12, 2022 at 3:06
  • $\begingroup$ @Nickcarducci I'm not sure I understand your comment. Almost everything a bank does is regulated from charging interest, to savings accounts, to how much money they must have on hand, to transfers, etc. I didn't say anything about insured investments. If you money in a (US) bank, then you are protected from (e.g.) a bank run for quite a large amount of money (usually 1/4 million). Perhaps banks work differently in your country? $\endgroup$
    – uberhaxed
    Commented Jul 12, 2022 at 5:06
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    $\begingroup$ 5. When banks offer mortgages, they're bringing in customers that are likely to use the bank's other revenue-generating services as well. $\endgroup$
    – bta
    Commented Jul 12, 2022 at 16:31
  • $\begingroup$ @bta this goes for every consumer facing business so I figured it wasn't worth mentioning. E.g. a gas station selling gas, a movie theater selling tickets, a ball game selling tickets, etc. $\endgroup$
    – uberhaxed
    Commented Jul 12, 2022 at 19:15
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Because it is still profitable for bank to do so.

Your question is analogous to the question, "why do some car companies create cheap cars with low markup when there are luxury cars that often have higher profit margin" (eg according to this article regular cars have profit margins around 3-8% and luxury cars 8-10% with some as high as 25%).

There is only so much demand for money on capital markets the same way as there is only so much demand for luxury cars. If there are other profitable markets even if they are much less profitable it makes sense for firms to service them.

Also banks do not just lent out their own capital but they can always borrow more reserves. If interest rates on reserves is sufficiently lower than the interest rate on mortgage banks will be happy to issue the mortgage.

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  • $\begingroup$ "Because it is still profitable for bank to do so" is this actually the case? I can think of two instances in my lifetime where banks lost mind-boggling amounts of money related to mortgage loans going bad and had to be either bailed out at great expense or have their creditors simply eat the loss. I mean, I guess in a sense it is still profitable for the bank since society at large implicitly subsidizes and insures against systemic risk for them, but it still seems weird to me to say that they're profitable. $\endgroup$ Commented Jul 14, 2022 at 12:52
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    $\begingroup$ @JaredSmith yes they are and were profitable. That period had more to do with moral hazard. Banks knew the system was set up in a way they have to be bailed out. For economic decision making you care about profitability in terms of benefits - costs, if costs are paid by taxpayers then from the view of the bank the their costs are 0. In addition there is difference between ex ante and ex post profitability… for example, decision to enter a gamble where you get 1million dollars with 99% probability and you will loose 1 million dollars with 1% probability would be still profitable and $\endgroup$
    – 1muflon1
    Commented Jul 14, 2022 at 13:08
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    $\begingroup$ Profit maximizing decision to take, regardless that you can end up in a scenario where there is loss. $\endgroup$
    – 1muflon1
    Commented Jul 14, 2022 at 13:09
  • $\begingroup$ @jaredsmith I think this is a very bad characterization of the financial crisis in 2008. If banks did their jobs, they would not have lost money in the financial crisis when people defaulted on mortgages. That's because they are supposed to take an expected default into account and charge enough interest such that when the default occurs, the costs are already recuperate. The problem is that there is government regulation on how much interest can be charged so if the interest exceeds this value, they should have been declined the loan. Instead, people who were likely to default still got loans $\endgroup$
    – uberhaxed
    Commented Jul 14, 2022 at 19:30
  • $\begingroup$ @uberhaxed I'm not sure you are actually contradicting what I'm suggesting: that mortgage lending is not actually profitable. It doesn't really matter (at least not to me, for the purpose of this exchange) why: whether it's government regulation or principle-agent problems (moral hazard) or whatever. Although 1muflon1's points are well-taken, especially ex ante vs ex post notions of profitability, they answered my question pretty well. $\endgroup$ Commented Jul 14, 2022 at 20:01
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Traditionally, Banks are in the business of converting interest rate periods.

Suppose you want to lend 1000\$, but get at it whenever you want. If there are 1000 of you, that is 1 million dollars.

Now, you know some people who want to borrow money, but want to be able to keep it for a period of time without having to replay it on demand. Say, they want to spend 1000\$ on an upgraded tool, which will make them an extra 100\$ a year for the next 30 years. They won't have the cash to pay off that tool for a decade or more; so a loan that can be called back "on demand" might bankrupt them.

The bank facilitates this. The bank takes the million\$ of demand deposits, and lends some of it out as a term loan. Most of those people depositing 1000$ in a demand account won't take it out all at the same time; so the bank can "safely" lend that money for longer terms than they guarantee.

They can even do a bunch of 6 month rotating deposits and make it even less likely that the money will be needed before the long term loans finish.

The profit comes from giving the short-term deposits a lower interest rate than the loans you hand out.

This is a kind skimming out of being the middle man.

If things go really badly, that bank can sell the loan it owns for short-term cash to pay off the short-term deposit demand for cash. So long as the loan is healthy and the market is liquid, this can return a profit long before the loan actually matures.

Now, suppose if instead of doing a long term loan, they went off and invested in the stock market. The problem is that the value of stock market assets are less stable than the loan.

So now the bank buys up a bunch of stocks with the 1 million dollars in deposits. The stockmarket drops by 50%, and a bunch of people lose their jobs, and start withdrawing their savings from the bank. Now the bank has to pay off the bank account withdrawals with a distressed asset!

In theory, the mortgages are more stable than the stock market assets. The same economic crash that cause stocks to drop by 50% might drop real estate by 10%, which in turn makes (healthy) mortgages worth 5% less (as they are guaranteed against the principle).

The same call on deposit cash is then easier to answer; sell off some mortgages, and cash is easy to provide. While the asset is slightly distressed, it isn't half value.

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  • $\begingroup$ Bank don't lend out deposits. It's the other way round. Loans create deposits. $\endgroup$
    – BrsG
    Commented Jul 12, 2022 at 8:37
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In the United States at least, mortgages are subsidized by the federal government via Fannie Mae and Freddie Mac. These quasi-public entities are required by law to purchase mortgages from loan originators (i.e. banks), even during unfavorable markets, and can themselves borrow at very low rates because they're backed by the government and seen as very unlikely to default. Because there is a guaranteed buyer of mortgages - assuming they meet certain conditions set by public policy - there's a constant downward pressure on the interest rates of loans within those parameters. (One of those parameters is no penalty for early repayment, which is somewhat mystifying to see in such a long-term low-interest financial instrument, without the context that the government is subsidizing loans with that condition.)

From the bank's perspective, issuing loans that meet the purchase criteria need not even be an investment - they have a guaranteed way to cash out immediately, and use that cash to make money elsewhere. Most banks will sell some fraction of the mortgages they originate, while keeping others. Some banks buy mortgages from other banks, but they're competing against the guaranteed buyers.

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  • $\begingroup$ Question is about the Netherlands, which works a bit differently. There's a quasi-governmental scheme ("Nationale Hypotheek Garantie") which insures the default risk. This means the bank doesn't carry the risk, so it can offer a lower interest percentage. $\endgroup$
    – MSalters
    Commented Jul 14, 2022 at 11:50
  • $\begingroup$ @MSalters that sounds like good info to add as an answer - I just wrote from what I know and tried to clearly state that I was giving context from elsewhere in the world. I don't know Dutch so it'd be a bit hard for me to research with confidence how similar the situation is in the Netherlands. $\endgroup$
    – Willa
    Commented Jul 14, 2022 at 15:20
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Some reasons have already been mentioned, another would be that banks lend not only their own money, but also the money of private individuals and let them share in the interest income.

If a bank lends 3% and half of the money comes from private individuals/investors, then the bank's interest rate is 6% on its own capital. If the bank now gives 2% to investors, it still has 4% interest on its own capital. In this way, banks can increase the interest income on their own money.

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Because they are allowed to lend you money they don’t actually have.

When a bank releases money for your mortgage, it actually comes from nowhere. They magically¹ make it appear on your account, or magically¹ transfer it to the seller party or notary. They simply record that you now have them a loan, and that the other party has the money – assuming it is in the same bank.

This is basically the main mechanism of money creation in the current economical system. It also means that, when you reimburse your mortgage, the money actually gets destroyed¹.

Of course, there are limits to the amount of money a bank can create like this, mainly the reserve requirement. This reserve money will be used when money is transferred to another bank: over a day, you have a lot of transactions between banks in all directions. At the end of a day, the balance is computed for all banks, and reserve money transfers will compensate them (possibly with loans between banks).

Let’s say this requirement is 10%, it means that if a bank has \$100 in reserve money, they are allowed to lend \$1000 to customers. As you can see, the interest rate will be 3-4% over \$1000 and not \$100, which would give them \$30-\$40 a year.

Commercial banks are not allowed, however, to use this money creation mechanism to invest on markets. So if they place the same \$100 on the markets, they can only hope for that \$10 yearly return, with possibly more risks.

Risk assessment is also obviously an important factor as well, as described in the other answers. Loans are usually less risky than investing on the markets, but creating money for a loan increases that risk. If loans don’t get reimbursed, the bank might end up without enough reserve money for when customers ask to retrieve it, leading to the bank bankruptcy.

¹ As you know, there is no magic in this world. Even if this process does not actually move any money, the created money corresponds to an asset of the bank, i.e., your loan. Read What is money? and Banks do not create money out of thin air – thanks to @Dick Larsson and @csilvia for those links.

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    $\begingroup$ This answer is incorrect. First, banks do not create money "magically", they do it out of central bank reserves and by maturity transformation of future cash flows of borrower. The money also does not magically appears in your account it is transferred from the reserves banks can borrow from other banks or central bank. Second, banks can invest their money into stocks and so on, what they ordinarily can't do is to borrow extra reserves to do so from central bank (which can create as many reserves as it wants). However, there are whole investment banks that specialize in capital market $\endgroup$
    – csilvia
    Commented Jul 12, 2022 at 0:02
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    $\begingroup$ While this answer not completely wrong, it still greatly oversimplifies how fractional reserve banking works. $\endgroup$
    – Philipp
    Commented Jul 12, 2022 at 10:21
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    $\begingroup$ Didier is totally right. Privat bank money is just that, bank money, it is NOT real money. Will be super interesting to see how central bank digital currency will affect the market. The Swedish central bank explains this on its web site. riksbank.se/en-gb/payments--cash/what-is-money People still today believe that banks lend out money that other customers has deposited with the bank...and that is totally wrong. $\endgroup$ Commented Jul 12, 2022 at 18:08
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    $\begingroup$ @DidierL You don't know what you are talking about. First, that investopedia article does poor job explaining this and has no references for its explanation of the mechanism so that is just a person behind the article talking about something they do not really understand like this answer. Investopedia also often has mistakes in their articles. Serious research like McLeay et al 2014 or voxeu.org/article/banks-do-not-create-money-out-thin-air explain how the money creation process actually work. Banks can't just create money without meeting their capital requirements $\endgroup$
    – csilvia
    Commented Jul 12, 2022 at 21:38
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    $\begingroup$ and to meet their capital requirements they need to borrow reserves from other banks or central bank. Plus they cannot just lend indiscriminately as that practice would lead to situation where they are unable to satisfy their capital requirements, so private banks (as opposed to central bank) cannot just create money out of nothing, they create them from reserves and by maturity and liquidity transformation. You are just spreading common misconception that laymen that do not really understand the mechanism have $\endgroup$
    – csilvia
    Commented Jul 12, 2022 at 21:40
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Let me try to give a Dutch-focused answer.

Dutch banks are sitting on the largest amount of savings accounts ever; in 2021 it exceeded half a trillion euro's. Banks aren't paying any significant interest on this money. 0.01% is common enough. That may sound bad, but the situation can be even worse. Banks themselves, if they can't find a better destination, may be forced to park this money in either ECB accounts, or other low-risk assets like Dutch treasury paper - both of which have negative interests at the moment. In comparison, mortgages that pay 3-4% look very good.

Now, there's of course a long-term risk that somewhere in the next years the house owner can't afford to repay the load. The bank has to price this default risk in. But this is mitigated by two factors in the Netherlands. One, a large number of Dutch mortgages have semi-governmental default insurance ("Nationale Hypotheek Garantie"), where the insurance will cover under-water loans on default. Secondly, the risk of a loan being under water does depend quite a lot on the housing market. It's generally agreed that the Dutch housing market is missing about a million houses. The government has plans to build those in the upcoming decade, but many people have little trust in the Dutch government to deliver anything in a reasonable timeframe. So banks are reasonably considering the current housing market to be absolutely stable.

Is there a risk of a US-style forced sell-off due to recession? Here the larger Eurozone crisis comes into play. The Dutch economy, mostly despite the government, is quite overheated. The ECB sets monetary policy to keep the southern countries competitive; the Netherlands really don't need that. When the unavoidable recession hits the EU, the Netherlands is going so see a slow cooling-off. In addition, Dutch social unemployment benefits are pretty right-sized: most home owners who lose their jobs will be able to find a new job before being forced to sell their homes - even when the EU is in a recession.

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