Full Reserve Banking and Home Mortgages

One question I hear often about full reserve banking is how a bank would supply capital (money) for a person borrowing a mortgage, or a loan towards buying a house. Since the bank can only loan out money that is deposited, and untouched, by others, some people see a problem in depositing money that is tied up for 30 years. Hopefully this article explains how such a system would work, and why it would be better than the current fractional reserve banking and central banking system.

Currently, the most common mortgage length is 30 years. Even in recent years, the standard length of a mortgage was 25 years. Less than one generation ago, mortgages generally didn’t exceed 15 years. We are now seeing mortgages that go as long as 40-years and even 50-years, something unheard of even a decade ago. Part of the lengthening of the time frame is due to fractional reserve banking and central banking’s creation of new money and debt via monetary inflation. As more money is created, prices tend to go up. Because so much money is created out of thin air by fractional reserve banking and central banking, and used towards buying homes, the prices of homes has also skyrocketed over the past 90 years. It isn’t a lack of supply that causes used home prices to go up, it is the creation of new money. This is one reason that fulll reserve banking would be a positive system: home values would likely NOT go up, as most used assets go down in price over time.

We need to understand the connection between the near limitless credit created from fractional reserve and central banking to understand how full reserve banking mortgages would work. Without the creation of new money or credit, housing prices would likely have NOT skyrocketed to the values they are at now. Also, with actual depositors’ savings on the line, we’d also likely not see risky mortgages made. All mortgages are backed by the asset value of the home. If the home declines in value, and is expected to do so, the mortgage lenders must have both an asset valued at more than the loan, and a reduced feeling of risk associated with the borrower.

In the past, large down payments were the norm. Because money was easily created out of nothing, down payments have been reduced to the point that many modern loans don’t even require them. This is tragic, as the down payment offered lenders a reduced sense of risk. When the borrower as so-called “skin in the game,” i.e. a large down payment, they are much less likely to walk away from the loan and the asset, leaving it in foreclosure. Also, large down-payments have a restricting factor on the growth in home prices. By lowering down-payment requirements, people who would otherwise not be able to afford a home were able to take risks, hoping that their home value would rise enough to offset the lack of a down payment.

By reducing home mortgages to borrowers with a reasonable down payment, such as the 20% normal down payment as required for generations, banks can attract lenders who are willing to give up access to their capital (cash) for a less risky loan than a full-reserve credit card loan. By reducing the risk of skyrocketing housing prices, the market would also not need the risky 30-year loans that are common. A 15 year loan for an affordable home would likely be the norm, with some people paying off the mortgage much faster. Nonetheless, many savers and investors will not want to risk their capital for 15 years.

A bank would be the ultimate middle-man between a lender (saver) and a borrower. Savers would want to maximize their return, while minimizing risk, especially on money they would not be able to touch. Borrowers would want to maximize their loan value, while minimizing their interest rate. Banks would tie the two parties together. Lenders who are willing to accept more risk, and more interest, would be tied to borrowers who may have a less-than-perfect payment history with the bank. The bank would make their profit by taking a small percentage of the interest rate paid. Some banks may also invest their own profits in the form of mortgages, allowing the bank to keep some or all of the interest paid.

Because few savers (lenders) would want to tie up their money for 15 years, the best form of raising capital (money) for a mortgage would be to issue a bond. Let’s use an example of a $100,000 home a buyer wishes to receive a loan for. Most lenders (savers at the bank) would want to reduce risk of the buyer walking away, so they may require 20% down payments. Some lenders might be willing to accept more risk (lower down payment) for a higher interest rate. Based on what lenders and borrowers require, a bank will set up a loan. In the $100,000 home example, the lenders may desire $20,000 to be available from the borrower. The bank would confirm that the $20,000 was saved by the borrower (and not a loan from family or another bank), over a period of time. This shows the bank, and the lenders, that the borrower was able to raise a reasonable amount of equity over time. This shows lower risks to losing money.

Also, the lenders would want to make sure that the home was truly worth $100,000. This is done through appraisers who work only for the lenders. Some appraisers may be hired by the bank, and some may be hired by the savers/lenders. Today’s appraisers generally worked only for the mortgage broker, and were often times asked to appraise a home at a certain value that would meet the broker’s commission they sought. This is not a very market-friendly transaction. When an appraiser only has to work for the lender’s behalf, the actual person putting up the money, appraisals are likely to be much more accurate. Some appraisal companies may also offer insurance premiums against bad appraisals, and lenders are free to accept additional insurance to protect their savings used to loan out for the mortgage.

Once the home has been properly appraised, the bank would verify the borrower as approved by the bank. The bank may ask for 2 years of bill payment receipts to prove that the borrower is able to make payments. The bank may also ask for a history of paystubs, and even letters of references from bosses or family. This was a normal process for loans even less than one generation ago. Once the borrower has been approved, the bank will seek borrowers who wish to purchase shares of bonds in the value of the home. In a $100,000 home, the bank may offer 100 shares of bonds with a $1000 initial face value. Since the borrower already has $20,000 to put down, the borrower would buy-out 20 of the shares at $20,000. The remaining shares would be sold at a face value of initial $1000, with an interest rate attached to the bond. The borrower may be lucky, and sell all 80 remaining shares ($80,000 initial face value) at the interest rate the borrower was seeking, say 8%. The borrower may also be unlucky, and only sell 60 shares at the desired interest rate (8%) but no other lenders are available. The bank may then go to other lenders and offer the bonds at 8.5% or even 10% interest, until the borrower has sold all the bonds to the home. Now, with cash in hand, the borrower takes the check to the home seller, and gives the title to the bank for safe-keeping. Now, there are 100 shares of the home, 80 of them outstanding, with variable rates of interest based on what the lenders were expecting to get. The money the lenders loaned out ($80,000) is gone from their savings accounts, leaving them a partial title to the home.

The borrower then makes their mortgage payment to the bank, who keeps their small cut, and pays the lenders back based on how many shares they own, and what interest rate the shares were set to. Over time, these shares would reduce in price, based on the principal of the shares that the borrower is paying off. Not all investors will want to lose access to their money for 15 years, so they would have the option of offering the shares for sale by the bank. Other investors may want the reduced risk of buying bonds from a borrower with MORE skin-in-the-game (equity) than a 20% down new borrower. These shares of bonds in the home would have a certain value. If you loaned the borrower $5000, and the borrower has paid you back $1000 of it (plus interest over time), your bond would have a value of $4000 to you. Since you already reclaimed $1000, plus interest, you may want to sell the $4000-valued bond to another investor for less money, just to entice them to buy it. Someone, through the bank, may offer you $3800 for the bond. If the borrower has a property that by chance did appreciate in value, you may even be able to sell the bond for more money than the remaining value to you. The bank would handle finding buyers, and handle the transfer of the bond-shares to the new owner, possibly charging a fee for the transaction.

Since the borrower knows that certain bonds are outstanding, they may pay off a certain bond (possibly a higher interest bond) by making a larger payment to the bank, and signifying what bond they want to pay more on. It is possible that the borrower could buy bonds back quicker over time, and pay off the entire loan faster and save on interest. Since the bond-investors have a goal to get back all their savings-investment, plus interest, there would be no penalty to pay off the bond early. This would release their capital held to reinvest in another loan, or possibly a full-reserve credit card line of credit.

In the event of missed payments, foreclosure would be a fast process. Since the homeowner had reasonable equity paid off from the beginning ($20,000), and since we wouldn’t have the central bank manipulating money supply and interest rate, it should be no problem to list the home on the market. When the home sells, the bond-holders other than the home-owner would get the proceeds of the home. Whatever money is left (”equity”) would be written as a check to the home-borrower, who would leave the home, and pay any foreclosure fees to the bank. By providing a reasonable amount of equity from the start (20% for example), the likelihood of the bond-buyer losing money is slim.

This system also would work for “home equity loans” as the home-owner would have bonds available to sell to new investors looking for a nice, safe return. Investors would be told of all outstanding bonds, and would be free to appraise the property to see what the re-sold bonds would be valued at. If for some reason the value of the home fell, and the remaining value of the bonds was close to the value of the home, most investors would not risk purchasing bonds from the homeowner, as it would leave no equity in the home to keep the homeowner from skipping on their obligations.