Building Societies Association
Feature
More to interest rate margins than appears to be the case at first sight
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Contact: Adrian Coles Date: 27 Aug 2010 |
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The cost of mortgage funding and swap rates have hit the headlines recently, but is the criticism of lenders - that they are widening their margins to the disadvantage of customers - really fair?
Swap rates are certainly one issue affecting the price of fixed-rate mortgages. Typically, the swaps would be used by mutuals (and banks) to hedge a risk. In very simple terms, a building society, for example, might raise variable-rate funding and wish to use that to finance fixed-rate mortgage lending. Clearly there is a risk, if interest rates rise, that the building society will suffer a significant loss – it will have an increased cost of deposits, but no increased income from its mortgages. That risk can be reduced or eliminated by swapping, in the specialist wholesale money markets, the variable interest rate liability on the deposit for a fixed interest rate liability, matching the fixed interest income on the mortgage.
However, other factors are involved in setting mortgage rates, not least, the retail cost of the funds initially attracted from savers. As is well known, retail funding costs – reflecting the competitive nature of savings markets – are significant at the moment and clearly well above the Bank of England’s base rate, for example.
Liquidity
There are four other factors. The first relates to the cost of holding liquidity. As explained in an article in the current edition of the BSA’s quarterly journal Society Matters building societies cannot lend out on mortgage all of the money that they raise in the retail savings market; rather they must hold a proportion of it (typically, between 15 and 35% although it is not unusual for individual societies to have figures outside this range at times) in liquid form so as to be able to meet demands from savers to have their savings returned to them as they wish, and fulfill commitments made to mortgage borrowers to lend. The recent crisis in the banking system has led the FSA to both restrict the type of investment that can be held as “liquid” and increase the amount of liquidity that should be held. This means, in very simple terms, that more money is now held in lower yielding assets, such as deposits at the Bank of England and short-term gilts or Treasury Bills. In other words, many banks and building societies are having to pay, say, 2 or 3% in the savings market to acquire retail funds, but are required to put a significant proportion of it into liquidity that earns only 0.5% - a built-in loss that must be recovered from the margin earned on mortgage and other lending.
Building capital
The second factor is the profit that needs to be earned from lending. Even building societies and other mutual lenders (none of which have external shareholders to whom they distribute dividends) must make a profit so that they have capital to support the business in the event of losses being made. For example, if unemployment rises, some borrowers might be unable to afford their repayments; in a minority of cases the lender might need to take possession, and there is a possibility that if house prices have fallen since the loan was made, the lender will be unable to recover the whole of the loan by selling the property. As a result of the crisis, regulatory authorities around the world are asking banking-type institutions to hold more capital, especially against riskier assets such as 80 or 90% LTV mortgage loans. For mutual lenders in the UK the bulk of their capital is the accumulated profits made over the years. Lenders are now under some pressure to make more profit from lending than was previously the case, so as to hold greater capital, so as to be able to absorb greater losses if these were to occur in the future. This, again, adds to the margin required between the total cost of funding and the mortgage rate that can be offered.
Paying for failed banks
A third factor causing margins to have widened recently is payments into the Financial Services Compensation Scheme. Mutuals (and banks) must generate the profits to make the payments which are being used to bailout Bradford & Bingley bank and the Icelandic banks. An important way to generate the funds necessary to make those payments is to widen the margin between the interest earned on loans and the rate paid for funds – bank rescues are not cost-free to those funding the rescue.
Repricing risk
Finally, it is clear that margins two or three years ago were at an historic, unsustainably, low point. Even if we had not had a severe banking crisis, margins would have risen as pricing became more sensible after excessive competition had driven them down beyond their long-term average.
Mutuals' long-term view
There is, however, one additional helpful factor that mutuals bring to the market. The big plc banks are under pressure to deliver dividends to shareholders. In particular, the nationalised and semi-nationalised banks have to return to profit, so as to give the government the opportunity to recover the huge investment that they were forced to put into the banks at the height of the financial crisis. Mutual lenders are under no such pressure. They are able to take a long-term view, and many have taken steps to shield savers from the full effects of very low base rates by keeping savings rates higher than would have been the case had they just followed the general level of rates down – that is, they have deliberately restricted their margins.
In these circumstances, cost control has become even more important to mutuals. Building societies’ management expenses ratio, across all societies aggregated, stood at 88 pence per £100 of assets in 2008, but fell to 78 pence in 2009, an impressive 11% reduction. Reduced costs obviously go some way to ameliorating the effects of some of the issues discussed earlier in this article.
It is clear to most of those involved in mortgage lending that the criticism that lenders, especially mutuals, are “profiteering” as a result of widening margins between swap rates and mortgage rates charged is unfair. In the current climate of distrust, especially of nationalised and stockholder-owned banks, however, it is difficult to convey a more rounded analysis of the situation. It is hoped that this article will give some insights into the pressures facing those who have to determine the rates on which mortgages are offered.
