Bank Profits from Mortgages, Interest Rates and Competition

This summer I am part of a group of young researcher reading and discussing a book by the late Wynne Godley and Marc Lavoie titled Monetary Economics – An Integrated Approach to Credit, Money, Income, Production and Wealth (Palgrave). The authors make the point that the financial and real economy cannot be understood in isolation, that credit and money are essential to a modern industrial economy. Prices are not clearing markets, as Marc Lavoie has recently pointed out at naked capitalism:

In the Cambridge tradition, prices reflect unit costs, or more precisely normal unit costs, that is unit costs estimated under normal operating conditions (at normal rates of capacity utilization or at target inventories to sales ratio). How large is the profit margin – the difference between the price and the normal unit cost – is not so easy to ascertain, but several post-Keynesians argue that it is a function of the growth rate of the industry sales. Thus prices – except perhaps in financial markets and some commodity markets – do not have as a purpose to equate supply to demand. Prices are instead the means to obtain profits sufficient to finance expansion. Variations in output demand are absorbed by fluctuations in quantities or in rates of utilization of capacities, as was argued by Keynes and the Keynesians.

The other adjusting mechanism underlined by Wynne Godley is fluctuations in inventories. Stocks of inventories act as buffers that absorb fluctuations in demand or in production. When demand falls, the slack is taken by a rise in inventories, not by a fall in prices. One of the key notions that we try to emphasize in our book is that all sectors incorporate a buffer. In the case of firms, inventories are the obvious buffer. On the financial side, the counterparty to the (undesired) fluctuations in buffer are the fluctuations in the credit lines drawn upon by firms. It is the existence of these buffers that makes the economy relatively stable.

This kind of thinking about the economy is at odds with neo-classical theory, of course. In neo-classical theory, it is assumed that (perfect) competition drives prices to the point where supply equals demand and firms make no profits. This description is not very realistic. Is this relevant? Most neo-classical economists would probably say that this simplification is of no importance. However, the NY Times reports today:

Interest rates on mortgages and refinancing are at record lows, giving borrowers plenty to celebrate. But the bigger winners are the banks making the loans.

Banks are making unusually large gains on mortgages because they are taking profits far higher than the historical norm, analysts say. That 3.55 percent rate for a 30-year mortgage could be closer to 3.05 percent if banks were satisfied with the profit margins of just a few years ago. The lower rate would save a borrower about $30,000 in interest payments over the life of a $300,000 mortgage.

“The banks may say, ‘We are offering you record low interest rates, so you should be as happy as a clam,’ ” said Guy D. Cecala, publisher of Inside Mortgage Finance, a home loan publication. “But borrowers could be getting them cheaper.”

Mortgage bankers acknowledge that they are realizing big gains right now from home loans. But they say they cannot afford to cut rates even more because of the higher expenses resulting from stiffer regulations.

The article continues and it is said that ‘mortgage lenders may also be benefiting from less competition’. The question how interest rates are set is important since it influences the distribution of money. According to neo-classical theory, the price of everything on a market should be ruled by supply and demand. However, it seems that banks that are ‘financially challenged’ set interest rates in a manner that maximizes/increases profits instead of competing fiercely by offering the lowest possible interest rates. If that is the case, then the description by Godley and Lavoie on p. 340 fits reality quite nicely:

Our argument is that banks can ensure that all their operations are profitable, notwithstanding the passivity in their responses which we have assumed, by appropriate adjustments in at least bone of the rates of interest they charge on loans, relative to the bill rate, whenever their profitability falls below a certain threshold [..]. Similarly, when profitability exceeds some upper threshold [..] they reduce lending rates, for fear of government regulation or consumer outrage.

The class of models developed by Godley and Lavoie seem to bring a lot of insights to those interested in the functioning of the economy, spreading light to a lot of spots that are left in the dark by traditional neo-classical theories.