Home loans provide the path to homeownership, making them one of the most highly sought lending products available. The increased demand for mortgages has meant that the funding of home loans has changed over the years as the volume of customer deposits has simply been insufficient to cover the loans provided by banks.
With a seemingly endless number of people looking to get a home loan the question arises how do banks finance so many of them? Where does the money come from? While you might suspect that the banks themselves take on a massive level of risk to continue underwriting loans, the shortfall in deposits is made through changes to the way loans are financed. Read on to discover how your home loan is financed.
The Funding Model for Banks
Historically, banks have raised funds for mortgages through pooling customer deposits and then loaning those funds to other customers, charging a level of interest. However, as the composition of funding that makes up banks has changed, so has the way they finance loans. While over 60% of bank funding in Australia is still financed by domestic deposits, the composition of funding also includes long-term debt, short-term debt, equities, and securitisation of assets.
Securitisation & Bonds
There are two main types of bonds – government bonds and corporate bonds. With a government bond, investors lend money to the government for a fixed period of time at a predetermined interest repayment. For example, if you were to place $1,000 into a government bond, with an interest rate at 2% p.a. you would receive $10 every 6 months across the period you held the bond. During periods of low interest, government bonds become quite popular as a government bond is a security that is leveraged against the ability of the government to pay its debts, making it one of the safest investment options available.
Corporate bonds on the other hand, usually involve the financial engineering of non-liquid assets, such as equipment, land or housing, in a form that can more easily valued. Lending institutions have financially engineered a number of products that can be sold off to investors, known as mortgage bonds and mortgage-backed securities (MBS).
A mortgage bond works in the same manner as any other kind of bond, where the owner of the bond is owed debt by the bond issuer. Similarly, mortgage-backed securities allow banks to do this on a wider scale and create a security from pooling a number or mortgages together in support of a bond issue and effectively selling the debt to investors.
The New Model for Home Loans
With banks no longer having enough in deposits to finance all mortgages, the shortfall is made up in large by the securitisation of these home loan receivables.
It’s not uncommon for banks to take a portion of their loans off balance sheet and fund them via the issuance of bonds. This not only allows banks to provide a greater amount of home loans but also enables non-banks, without deposit customers, to issue loans, securitise them, and off the balance sheet, with bondholders receiving returns.
How Does this Affect Interest Rates?
Government bonds share an inverse relationship with bank interest rates, as when interest rates drop significantly, bonds can become more attractive to consumers, which helps the government raise money to fund stimulus packages and for other initiatives.
If you’d like advice regarding investments, your mortgage, mortgage bonds or mortgage-backed securities, don’t hesitate to get in contact with an experienced Morrows adviser today.
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