Before the credit crunch, the spread between deposit and mortgage rates had been narrowing over a prolonged period. That process accelerated quite sharply in the middle part of this decade. The highly competitive mortgage market and relatively easy and cheap access to wholesale funding meant that mortgage rates fell compared to most rates against which they are usually benchmarked.
With the onset of the credit crunch the narrowing of the spread between deposit and mortgage rates came to an end. At first, spreads levelled off and then began to widen again. There are a number of reasons why this has happened.
Going forward, all lenders will be under much greater pressure from the Financial Services Authority (FSA) to have a better match between the duration of their sources of funding and their mortgage assets. Lenders are already responding to a regulatory requirement to raise more longer term funding – but it is more expensive to do so.
The impact of the Basel 2 regime also means that the cost of capital is greater for loans with higher loan-to-value ratios. That is part of the reason why, until very recently, we have seen both a tightening of lending criteria and higher borrowing costs. Finally, investors providing equity for lenders now expect higher returns, and this is exerting upward pressure on mortgage pricing.
The ‘back book’
In sharp contrast to the early 1990s, lenders nowadays have fairly limited discretion to vary interest rates on their existing loan book. Half of all mortgage lending has been taken out at a fixed-rate, with a further significant tranche of lending contractually tied to the rate set by the Bank of England’s monetary policy committee. Additionally, lenders have recently been under significantly greater political pressure to reduce standard variable rates.
As a result, there has only been a modest increase in spreads on business already underwritten – that is, on existing loans or the ‘back book.’ And that increase is by no means sufficient to compensate for the much higher funding and other costs that lenders are now facing.
Higher costs
In recent times, firms have shown forbearance to larger numbers of customers experiencing payment difficulty. They are also bearing higher – although still relatively modest – mortgage losses and, at the same time, remain under considerable political pressure to lower mortgage rates in line with official short-term rates. These factors raise the cost base for lenders, while suppressing income.
In addition, the FSA now expects firms to hold more liquid assets and more capital, and this has further driven up operating costs for firms. Regulatory pressure on costs is likely to persist – and may intensify – as a result of the mortgage market review currently under way, and lenders need to plan ahead for this now if they are to run their businesses prudently.
For most lenders, sources of wholesale funding have largely evaporated, except for very short term money. While government measures, notably the credit guarantee scheme, have helped keep lenders solvent – where firms are able to gain access to them – they are nevertheless relatively expensive sources of funding.
The funding shortage
The sharply reduced capacity to access money markets means that quoted interbank lending rates, which have fallen sharply in line with official rates, no longer reflect the rate at which most institutions are able to borrow wholesale money. As a result, it has become rather misleading to look at the London inter-bank offered rate (libor) as a proxy for wholesale funding costs.
The shortage of wholesale funding has led to much more intense competition for retail sources of funds – or savings – extending the pain of margin pressure across all firms, regardless of their funding model. Competition has been particularly acute for retail time deposits – fixed period income bonds and the like – because this usefully extends the maturity profile of deposits beyond the three months typically available in wholesale markets currently. For example, some five-year bonds are currently paying 5% a year or more.
The very sharp fall in official short-term rates since late 2008 has added to the pressure on retail-funded institutions on two counts. Firstly, as deposit rates cannot fall below zero, a growing proportion of retail savings rates effectively reached their floor with each reduction in official rates, and further interest rate cuts have resulted in progressively smaller reductions in funding costs. The other, often unrecognised, effect has been to shrink the yield firms earn from their own capital and other low interest rate liabilities.
While it is not possible to quantify fully and accurately the effects of all these developments on all firms, overall it is clear that lenders are facing higher costs than they were before the credit crunch.
New loans
The inevitable consequence of rising costs and limited discretion to change rates on existing mortgages has been to put pressure on lenders to raise spreads on new loans.
In the difficult economic climate we are experiencing currently, lenders also have to price new loans for higher risk. This is another factor pushing lenders to raise new mortgage rates.
Firms have widened new business spreads as short-term rates have fallen (in essence, by lowering rates on mortgages less than rates on deposits). But so far this has barely been sufficient to maintain the whole-of-business spread between mortgage rates and funding costs, let alone to help repair business margins overall.
Two-year fixed-rate mortgages have been a case in point.
There has been considerable press coverage of the fact that quoted swap rates have fallen while fixed-rate mortgage prices have risen. But the recent decline in swap rates is not necessarily a clear indication that the cost of raising fixed-term funding has fallen.
A swap rate is the cost of exchanging a variable income stream for a fixed one. But simply looking at the fixed rate does not account for the fact that not all lenders will be able to raise funds at libor rates, especially in the current environment. And the spread between raising funds at fixed and variable rates will vary for different firms.
There is no truly representative information on the cost of raising fixed-term money on the wholesale markets. Comparing commercial bank liability rates, which are published by the Bank of England and which are a proxy for the cost for banks of raising funds over a fixed term at a fixed rate, show a different story to swap rates. This measure shows that the cost of fixed-rate wholesale funding remains high relative to new fixed mortgage rates – and that the spread has actually narrowed in recent months.
With lenders set to face increasing costs for some time, firms will remain under pressure to increase mortgage spreads on new products. There is no single measure of lenders’ funding costs, and spreads on wholesale or retail funds are, in reality, just pieces of a complex jigsaw.
Conclusion
Lenders need to ensure they deliver fair treatment to all their customers – both new and existing – but the cost pressure on new business, and the lack of discretion on ‘back book’ rates, create real pressures for the sustainable pricing of new business.
Firms face higher costs for a variety of reasons, including:
requirements, some of which are imposed by the FSA, to hold more liquid assets and more capital, and to have a better match between the duration of their sources of funding and their mortgage assets;
increased competition between institutions for savings business;
the scarcity and cost of wholesale funding;
the need to show increasing forbearance to larger numbers of borrowers in difficulty;
the cost of funds made available by the authorities through the credit guarantee scheme; and
the reduced returns for lenders because of the low interest rate environment.
Lenders will face increasing costs for some time, so upward pressure on spreads on new mortgage products is likely to persist in the coming months. As well as covering their costs, firms also need to make a reasonable profit. But it is misleading to assume that higher costs, for example on fixed rates, simply reflect a desire – or a capacity – for lenders to increase profitability. A better way of viewing things is to understand that moderately more expensive mortgage deals go hand-in-hand with higher lending volumes.
