Building Societies Association
Feature
Claims of lenders profiteering from mortgages are overblown
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Contact: Joseph Thompson Date: 28 Aug 2009 |
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Introduction
The Bank Rate tumbled from 5% in September 2008 to a record low of 0.5% in March this year, and has remained at this low level to date. Yet mortgage rates have not fallen at the same pace meaning mortgage spreads over the Bank Rate have increased to their highest levels for many years. As a result banks and building societies are being accused of profiteering on mortgages. However, the Bank Rate alone does not determine mortgage rates, and there are numerous other factors to consider when pricing mortgages. Once these are considered, it is evident that lenders are not making as much profit as may first appear. Indeed, the results of the large banks show levels of profit at their UK retail operations dropped considerably in the first half of 2009, by about 78% year on year.
The retail market
Most lenders rely on retail savings to fund their mortgage lending, and this is where building societies raise the majority of their funds. Profitability in the retail market has reduced over the past year. Instant access accounts are commonly remunerated below the Bank Rate, and as official rates fell towards zero earlier this year the corresponding reductions in deposit rates could not occur at the same pace. Hence, the spread between instant access accounts and the Bank rate has been significantly squeezed to an almost negligible amount, as can be seen in the chart below. This has reduced profitability for all deposit takers compared to pre credit crunch levels.
The scarce availability of funds in the wholesale markets has seen increased competition for funds in the retail market. This has pushed up the cost of funding considerably in recent months. Yields on fixed term bonds have been rising steadily with the average quoted bond now paying nearly 3%. This partly reflects a steepening of the yield curve, but the spread over swap rates has also risen considerably in 2009.
The cost of wholesale funding
Many lenders source funding from the wholesale money markets. However, since the start of the credit crunch the fear of borrower default became so high that firms effectively stopped lending to each other, and any funds that were available came at a premium that reflected this ‘default paranoia’. Libor has broadly reduced in line with the reductions in the Bank Rate but remains elevated compared to pre-crunch levels, and the number of firms lending to each other is far more restricted than it was in 2007. Consequently, some smaller or unrated firms are unable to borrow at libor and will be offered rates with a considerable mark up.
Firms are now also required to better match the maturity of their funding to their assets, but long term funding comes at a premium. In addition firms must pay a premium for their debt to be guaranteed under the Government’s Credit Guarantee Scheme which further adds to the cost of raising funds.
Margins on lending may be rising…
The two year swap rate is often used as a benchmark for fixed rate mortgage prices. As the chart below shows, swap rates have plummeted over the past year, and whilst the two year fixed rate mortgage rate has decreased, it has not done so at the same rate, allowing for a significant increase in the spread. In recent months the two year swap rate has increased, although it has since fallen back slightly. This movement has been replicated in the average fixed mortgage rates.
Fixed rate mortgages accounted for 78% of all new mortgage lending in June according to the CML and the recent increase in spreads may also reflect the strength of demand for fixed-rate mortgages relative to firms capacity to fund them.
..but so are other costs
Aside from increased costs in funding, firms are grappling with rising costs associated with the turbulence in the financial markets, including levies paid to the FSCS to fund the bailouts of failed banks, and increased regulation. These costs are now eating into profitability. Firms are required to hold additional levels of capital and liquid assets to act as a buffer against possible future losses. This poses a significant opportunity cost, and will again reduce operating profits. With house prices in a downward trend, lenders are appropriately pricing in the increased credit risk associated with new loans, and are now generally more realistic about risk compared to 2007.
Conclusion
Mortgage spreads over the Bank Rate and Libor have risen in recent months, but this does not translate into rising profits for mortgage providers. Any gains that have been made from a higher margin on lending have been offset by shrinking deposit margins and increased costs associated with tighter regulation. There are a range of factors that lenders must consider when pricing mortgages, and when costs outside the control of a firm are rising, mortgage rates must also rise if lenders are to maintain profitability and stay in business.
