WITH official interest rates stuck at rock-bottom levels, consumers could be forgiven for wondering why mortgage rates remain so high. The answer, I’m afraid, is that the era of excessively cheap mortgages is gone forever in the UK. Over time, this will be no bad thing but in the short term it will prove cripplingly painful to those of us with large home loans. And no, profiteering by greedy banks isn’t the reason for the demise of the cheap mortgage, as I will try to explain.
Research by Michael Saunders of Citigroup reveals that the gap between the cost at which money is available to the banks (swap rates) and the cost at which it is lent to consumers has shot up. No surprise here: banks are being ordered to retain more capital for every pound they lend out. They need to make higher margins on new loans merely to maintain previous levels of return on capital for their investors. Given the risk involved in owning bank shares, shareholders want decent returns – or else they will pull out, sending shares plummeting and driving banks into the arms of governments.
Every institution is facing the same problem at the same time: they must all build up extra capital to satisfy regulators, and hold far greater amounts of low-yielding, low risk gilts and other government securities. So there are no competitors around to undercut the market; the entire industry is boosting its margins as fast as it can. The shift from raising funds from wholesale markets (with very low transactions costs) to relying on sight deposits (collected from millions of
individuals) is also increasing costs.
There has been plenty of gleeful comment recently that harsher capital and liquidity requirements will slash returns on capital, which were at unsustainably high levels during the bubble. But those cheering the banks’ pain were typically short-sighted, as they didn’t seem to understand that the pain would be transferred to consumers. Basic microeconomic theory has long shown that when costs go up for an entire sector of the economy, these are always passed on. There are other reasons why UK banks are hiking their margins: the spread between short rates and gilt yields isn’t that steep (partly because quantitative easing has cut the latter), reducing opportunities for banks to enjoy profitable carry trades and make money that way. Banks are pricing in a greater probability of a second wave of drops in house prices. New consumers are having to pick up the tab for the explosion in defaults.
The average spread between 2-year fixed mortgage rates (with a 75 per cent loan to value) and 2-year swap rates hit a new record high of 2.59 per cent in September, versus 2.33 per cent in August. The 1998-2007 average spread was just 0.1 per cent – clearly, there was no way banks could have been making any money at all on these particular products, after costs (branches, staff and overheads) were accounted for. This points to another reason for higher margins: we are returning to the real world, where credit is no longer handed out at artificially and unsustainably low cost. Risks premia are becoming more realistic: during the boom, these figures show that borrowers were assumed to be as safe as the banks themselves. This was absolute madness.
Those days are gone forever. My advice: prepare for permanently higher borrowing costs.