Forum Post: How to Shake Up the Financial System

What we really need is a completely new kind of financial instrument.

Banks provide many services but basically all of them fall into one of two transaction categories; savings or loans. The business model of banking at its most simplistic level is this; banks use our savings to fund our borrowing. This is the binary foundation of the financial system. If you shake the foundation of a building, the entire building above shakes. Similarly a significant change to the savings/loans foundation of the financial system would have a staggering impact on the entire financial system built on top of it. The question is how do we change these fundamental transactions? The answer is quite simple, albeit hypothetical. Introduce a totally new type of financial instrument…a hybrid that is both savings and debt at the same time. Let’s call it a 401K Mortgage. The best way to illustrate how it would work is with a simple example. Say you have $20,000 in your 401K, and need a mortgage of $200,000 to purchase your first home. The new 401K Mortgage allows you to invest your retirement savings into the hybrid mortgage which is jointly owned by the bank and your 401K. Initially the bank invests $180,000 and therefore owns 90% while the 401K invests $20,000 and owns 10% of the hybrid mortgage. You make the same monthly payment as you would on a traditional $200,000 mortgage. The difference is every mortgage payment made it is split proportionally between the bank and the 401K. In this example 90% of the first payment is credited to the bank, and 10% is credited to the 401K. The assets held by your 401K after the first mortgage payment would therefore be the 10% share of the mortgage, plus cash equal to 10% of the first mortgage payment. The 401K then reinvests that cash into the mortgage by buying-back additional share of the mortgage from the bank. The 401K’s share of the mortgage will therefore grow by a small percentage, and the bank’s share will decrease by the same amount. Also each cash contribution you make to your 401K, (typically through payroll deduction) is also used to purchase additional share of the mortgage from the bank. As a result after one month the 401K’s share of the hybrid mortgage may have grown to say 10.1% while the bank’s share has decreased to 89.9%. So a slightly larger share of the second monthly mortgage payment is credited to the 401K, and the process is repeated. Every month the 401K’s share of the mortgage grows at an accelerating rate and the bank’s share declines until eventually the 401K owns 100% of the mortgage. Instead of making mortgage payments to the bank for 20 or 25 years, the bank is paid off much sooner and for the remainder of the mortgage term, all mortgage payments go to the 401K as the sole owner. At 5% over 20 years, total interest paid would be approximately $117,000. In a traditional mortgage all of the interest would go to the bank. In a 401K Mortgage, a large portion of the interest would accrue to the 401K instead of the bank. As long as you make your monthly mortgage payments, (which the vast majority of Americans still do) your 401K is guaranteed to grow. This cannot be said for mutual funds that most of us are currently forced to invest in.

Of course this is all hypothetical and would require a change to the existing rules that have been in place since the early 1980s when rule 401K originally came into law. Much has changed since then…maybe it’s time this rule is re-examined.

The implications of this new financial instrument at a macro level are truly mind boggling. As 401Ks start investing in mortgages potentially trillions of dollars would be pulled out of mutual funds, and therefore stocks, bonds, treasury bills etc.; and would flood into banks. Would the market crash? Where would banks invest all that cash and what impact would it have on the economy? Would they pay off their own debt by buying back their bonds and shares and aren’t most of their bonds and shares held by mutual funds and pension plans? The result would be a massive payoff of debt throughout the economy and a massive redistribution of money. How much of the money from liquidated residential mortgages would banks invest into the economy through new loans to businesses and individuals? Perhaps most importantly, what would be the impact on foreclosures and the housing industry?

Maybe it’s time we rethink some of the most basic building blocks of our financial system and ask ourselves if there is another way. It may not be the answer to the myriad of problems we currently face, but if nothing else this is a new, simple, previously unexplored approach that should be studied and debated.