Wallopalooza Financial, Inc., believes that it can successfully “intermediate” in the mortgage market. At present, borrowers pay 7 percent on adjustable rate mortgages. The deposit interest rate necessary to attract funds to lend is 3 percent, also adjustable with market conditions. Wallopalooza’s administrative expenses, including information costs, are $2 million per annum on a base business of $100 million in loans.
a. What interest rates on mortgage loans and on deposits would you recommend to obtain business?
b. If $100 million in loans and an equal amount of deposits are attracted with a mortgage rate of 6.5 percent and a deposit interest rate of 3.5 percent, what would be Wallopalooza’s annual before tax profit on the new business? (Assume that interest rates do not change.)