How do the lenders fund mortgages?

[visigoth]

Guys, not sure if this is the correct thread to ask, but I could not find the answer in other threads and I always wondered. I do not work for the banks so I am genuinely curious how they do it. A lot has been discussed about arrears as the primary reason behind high SVR rates, so that the banks "have to charge 4.5% because they have 15% mortgages in arrears" and the like.

But how does one compute? Suppose you have a 30-35-y mortgage. First 10 years you cover 3/4 to 2/3 in interest. If I understand corectly, the bank does not borrow your loan for 30-35y at the same time as you do, they fund on an ongoing basis. The bank then borrows for 1-3 years at 1-2% annual rate, so that the cost of money for 3 years is say 6%, and then again, and again, right? But they extract 60-80% in interest from you in these 1-3 years. I must be missing something obvious because even if there is one nonperforming loan for one performing loan, the difference between compound interest in long-term loan and short-term interest the bank borrows money at is huge. Certainly, once you include shorter terms the difference is lowered but still, a short-term comound interest amount is so much lower than a long-term one, beats every time. Even if there are mass arrears, they should be in profit regardless.

I must be missing something fairly obvious, this cant be right?

 

[Brendan Burgess]

Hi visigoth

I can't really figure out what you are asking.

But the correct way to think about it is on an annual basis. Forget compounding. Forget 30 years.

Bank of Ireland charges 4.5% on its Standard Variable Rate loans.
It's cost of funding is currently 0.7%
So this year, it will make a margin of 3.8% on those loans.

Out of this, they will have to pay for bad debts, administration and a return on the shareholders' capital.

Brendan

 

[visigoth]

Hi Brendan, thanks. Apologies again for a possibly stupid question. I don't understand why should I forget compound interest and term length, why is it not relevant?

Suppose there is a mortgage of 300,000 for 30 years, at 4.5%. From Karl's calculator: https://www.drcalculator.com/mortgage/ie/
One pays circa 120,000 in interest during first 10 years so that the loan itself is reduced to 240K. Suppose the bank is able to borrow at the same 0.7% cost like you said in the same period. The bank does not have to borrow 300,000 for 30 years, it can borrow for 1 year, or for 3 years, again and again. The interest amount the bank pays at 0.7% for 1 year is 1,140 to cover 300K. If it is able to do that every year for 10 years = 11,400. if it borrows for 3 years 3 times, somewhat larger amount then, etc. The amount of 300K is reduced over 10 year period so the bank borrows less.

My point is that the bank has 120,000 in play money to cover its own borrowing of circa 11,400. How can it not cover bad debts, profits and administration and still not leave a huge premium? My calculation cant be right - what did I estimate wrong?

 

[Sarenco]

Out of this, they will have to pay for bad debts, administration and a return on the shareholders' capital.

...and will provide for future defaults largely on the basis of historic experience.

Banks borrow short (deposits) and lend long (mortgages). With a typical yield curve, interest rates increase as you move further out in time and banks make money on the difference.

 

[visigoth]

Yes, but is my hypothetical of 120K v. 11K for the first 10 years correct in terms of numbers or I made a mistake? It can't be right, cant be that big.

I understand the logic of borrowing from deposits and lending long. But I have a near zero interest from my deposit - the bank borrows my money for free - and then the same bank lends me at 4.5%. To a layman person it does not make any sense, what am I missing?

As for future defaults, this is another thing I was always unclear. Dont banks have insurance for this sort of thing? So our mortgages are packaged together, then banks buy insurance for these products, and if some are nonperforming, the insurance company pays the bank. In the future the bank has to pay more for the insurance based on experience. But they must have a system in place for their own protection, to spread the risks dont they?

 

[44brendan]

Interest is calculated on a point in time scenario. I.e. Cost of borrowing to the bank for 1 day is X%. Cost of borrowing to the customer for 1 day is X+Margin %. At .7% cost of funds to the bank and 4.5% rate charged to the borrower the bank will make a gross profit of €11,400 in Y1. This profit will reduce in Y2 & ongoing in line with the reduction in outstanding loan balance. As you point out, currently the net margin to the banks on this level of interest spread is extremely high. However, this margin also has to make allowance for other admin costs plus loan loss risk. Taking a 1% off the profit to cover admin costs leaves a margin of €8,400 to cover loan losses which seems pretty good at face value. However if that loan becomes a bad debt the downside loss is 300,000 plus associated legal costs.
In essence in order to recover a bad debt of 300,000 from interest revenue the bank would need to lend a further €8.1mln in loans for 12 months and if any of these loans should turn bad they are back to square 1.
The bottom line here is that lending money at these margins is only profitable if you can maintain a very low level of bad debts.

 

[cremeegg]

Visigoth.

To try to answer your question. Over any given period of time the banks income is the difference between the interest they charge you and the interest they pay on their borrowings. So if they charge you 4.5% and their cost is 1% then their income is 3.5% per annum. It makes no difference what time scale is involved though 3.5% per annum indeed is over 10% in 3 years. .

However as you point out, and I think both Brendans miss this point, there is a difference between borrowing over a long term and a short term. Banks lend long-term say 25 years for a mortgage but stupidly (I will come back to that) they fund themselves short-term. There may be a cost advantage to this, banks may find it cheaper to borrow for 2 years than 25 years, that is a part of the reason why their cost is so low, but that does not make any magic extra profit.

In my not so humble opinion banks, and anyone else should match the timing on their assets and liabilities. You wouldn't get a car loan over 25 years because you would still be paying long after the car was scrap. Banks do not do this, they lend to you long term and get most of their own funds short term. This exposes them to the risk that when they come to refinance your loan the cost will have moved against them. Of course with the variable loan common in Ireland they can pass this cost on to you. However this was the basic problem for the banks with the trackers. They lent money at ECB +0.5 when they could borrow at a rate that which made this profitable, then when they went to refinance it was costing them more than that.

Banks of course don't finance each loan individually, however neither do they refinance the entirety of their loan book on a daily basis as 44Brendan seems to suggest. The term of their financing is a risk that banks manage on an ongoing basis just as they manage the cost. The financial crises would never have happened if they matched their assets with their liabilities.

 

[RichInSpirit]

Interesting question Visigoth!

 

[Brendan Burgess]

Hi visigoth

When looking at any question like this, it's meaningless to look at it on a long term basis. You should only look at it on an annual basis to work out the profit or return.

A tenant will usually say "my rent is €1,000 a month". It would be unusual for someone to say "my rent is €240,000 over twenty years".

It's sort of hard to explain why. Firstly, there is a time value of money. Secondly the figures will all change - as capital is repaid and as interest rates change.

Mortgage lending in Ireland is ridiculously profitable at the moment for the non-tracker business. If that continues for the next twenty years, the banks will make a lot of money. However, at some stage our campaign to reduce the rates will make these mortgages a lot less profitable.

Brendan

 

[Brendan Burgess]

In my not so humble opinion banks, and anyone else should match the timing on their assets and liabilities. You wouldn't get a car loan over 25 years because you would still be paying long after the car was scrap. Banks do not do this, they lend to you long term and get most of their own funds short term.

I think you are confusing a few different issues here.

1) Ideally banks should match their funding to their lending. If they give out 20 year fixed rate mortgages, they should try to finance them with 20 year fixed rate bonds or deposits.

However, Irish borrowers don't like fixing for 20 years (well at the quoted rates anyway) and we don't like putting our money on deposit either.

So that is matching the lending to the funding.

2) Matching the term of the loan to the underlying asset is a separate issue.

It would not be a good idea to lend for or to borrow for a car over 25 years as there will be no underlying assets

In the same way, it is my opinion and the opinion of Swiss Banks, that there is nothing at all wrong with indefinite interest only loans for house purchase. Of course it's a good idea for borrowers to pay down expensive loans. But if they can only pay the interest, their loans should not be deemed unsustainable.

Brendan

 

[cremeegg]

I think you are confusing a few different issues here.

I dont think I am. I am looking at the loan from the banks point of view.

1) Ideally banks should match their funding to their lending. If they give out 20 year fixed rate mortgages, they should try to finance them with 20 year fixed rate bonds or deposits.

However, Irish borrowers don't like fixing for 20 years (well at the quoted rates anyway) and we don't like putting our money on deposit either.

So that is matching the lending to the funding.

Agreed

2) Matching the term of the loan to the underlying asset is a separate issue.

It would not be a good idea to lend for or to borrow for a car over 25 years as there will be no underlying assets

The loan IS the bank's asset. They have an inflow of cash for 25 years that is their asset. They then borrow money for 2 or 3 years. This means that they need to refinance the loan several times over its life time. Thats only a good model where the banks ability to borrow does not disimprove over the course of the loan.

In the same way, it is my opinion and the opinion of Swiss Banks, that there is nothing at all wrong with indefinite interest only loans for house purchase. Of course it's a good idea for borrowers to pay down expensive loans. But if they can only pay the interest, their loans should not be deemed unsustainable.

Brendan

From a borrowers point of view this is a great idea. Although what it would do for house prices if it became the norm in Ireland is anybody's guess.

I wonder if Swiss banks fund themselves in a different way. Do they make greater use of shareholders funds or long term bonds ?

 

[Sarenco]

Yes, but is my hypothetical of 120K v. 11K for the first 10 years correct in terms of numbers or I made a mistake? It can't be right, cant be that big.

In H1 2015, BOI's net interest margin (NIM) was 2.21% (don't forget the backbook of low margin trackers and legacy higher interest borrowings).

A NIM of 2.21% is not particularly high by international standards - the average NIM for US banks is currently over 3%.

 

[visigoth]

I am still not clear how they arrive at 4.5% and not at say 3%. it is because they can aka "what markets will bear" right? There is no underlying calculation as to what goes into their interest calculation surely?

Suppose their borrowing costs are at 0.7%. Since the interest they pass to customers on their deposits is effectively zero, I am not sure why it is 0.7% and not say 0.1% - I find it odd that my own deposit does not make me 0.7% but OK, suppose it is from bonds they sell. Second. We do know if their administrative costs 1%, it can’t be that high, can it? The bank simply does monthly DD from your account, a cost of e-transfers would be miniscule, no more than one hundred euro per annum not 1%, 3K per year that is. If they charge trackers 1.2% and still make a profit, admin costs can’t be 1%.

It is with bad debt/loss where it gets really opaque. Does the bank have total discretion how and from where it covers its losses? So say the bank extracts 3.8% margin over 0.7% because of “bad mortgages” + costs + admin + profit. Does the bank decide to cover bad mortgage debt from SVR/fixed profit alone? Or does it finance bad mortgages from its investment returns also? And vice versa, if say the bank loses 3 billion hypothetically in a stock market tomorrow, or from its commercial lending, can it cover those losses from SVR mortgage profits? I guess I never expected that an individual mortgage was supposed to finance bank losses elsewhere, I thought it was only about the costs of funds + profits, simple.

 

[cremeegg]

The borrowing costs figure is an average (which seems to be calculated daily!) over all the banks costs of finance. Money from depositors maybe 0%, money from long term bonds may be 2%. I understand that the also put a cost on their equity funds though this is notional rather than real. All this gives an average of say 1%

As for there costs well, I dont think its the dd charges, after all who would they pay those charges to, but golf club memberships are expensive, trips to premiership games even more so.

Does anyone know how many AIB staff have golf club memberships, in effect paid for by the taxpayer. Certainly back in the day it was in the hundreds and I don't think it reduced by all that much.

 

[visigoth]

A NIM of 2.21% is not particularly high by international standards - the average NIM for US banks is currently over 3%.

I do not know the data, can't say about averages. Perhaps the average NIM you refer to is skewed by subprime lending rates. My evidence is anecdotal. I know three persons who hold mortgages in the states and none of them pays over 3%. One pays at 1.65 (or 1.75) 15 years fixed, and two pay at low 2%-something, 20 or 25 year fixed. It is true if you take a mortgage in the states now, it would be over 3% but in 2011 and 2012 one could find a lower one.

I have no clue how their banks make profits. It is related to the point that Cremeegg made on the timing or lending and borrowing. Perhaps banks borrow at below 2% themselves for 20 years, and then their customers repay the premium over that rate for the same duration even if the prevailing rates go up during that period. This is in contrast to Irish banks which give a 30 year commitment to lend at 1% fixed over euribor yet themselves borrow at shorter terms oftentimes at a loss. Hypothetically, if the Irish banks borrowed themselves at 0.6 over euribor for 30 years in 2007 and then simply charged their customers 1.2% over euribor during those 30 years, thus making a 0.6% profit regardless, perhaps it would have resembled what the US banks do. But I admit I have no idea how they are able to offer 20-year fixed mortgages at low rates. They can somehow. Many EU banks can also. If the BOI offered a 20 or 25-y mortgage at 2.5-3% fixed, I think most customers would have taken it, there is no aversion to fixed rates but aversion to high fixed rates.

 

[visigoth]

cremeegg - really funny about golf club memberships, khe khe. I can imagine a loan contract that includes a clause that "Your interest rate under no circumstances would be lower than our costs of funds including the costs of 1 (one) annual golf subscription and 20% of the annual service for the company car for our staff that you agree to co-sponsor hereby" or something like that.

 

[Sarenco]

I do not know the data, can't say about averages. Perhaps the average NIM you refer to is skewed by subprime lending rates. My evidence is anecdotal. I know three persons who hold mortgages in the states and none of them pays over 3%. One pays at 1.65 (or 1.75) 15 years fixed, and two pay at low 2%-something, 20 or 25 year fixed. It is true if you take a mortgage in the states now, it would be over 3% but in 2011 and 2012 one could find a lower one.

Well, the average rate on BOI trackers is 1.12%, and trackers represent roughly half its mortgage book. You need to look at the overall book - banks don't finance loans individually.

 

[44brendan]

Club sub comment is redundant & somewhat mischievous! Banks have not being meeting this expense since the bail-out!

 

[visigoth]

Well, the average rate on BOI trackers is 1.12%, and trackers represent roughly half its mortgage book. You need to look at the overall book - banks don't finance loans individually.

I am getting confused what one should and should not include each time. When arrears and bad debt is discussed, we cannot include trackers because they are insulated in their contracts and SVR are to bear the costs so that God forbid if we even mention that the costs of arrears are shared across the whole loan book. When the govt discuss mortgage rates then trackers and SVR are suddenly aggregated to show average interest rates in Ireland that are not too bad. If a mortgage market is a quasi-insurance market where your interest is determined not only by your traits but also by others' performance (as in car insurance) then the costs of defaults should be shared across the loan book. If a tracker loan book is different, then make SVR pay for defaults and arrears among SVR holders, and make trackers pay for non performing trackers in their own loan book. This is precisely what I could not figure out - what goes into their calculation of "bad" debts when setting interest rates. Why dont we add commercial loans, or business loans and defaults also? Why cant SVR pay for losses in commercial lending if it is all totally discretionary.

If the bank had been clear that "at discretion" in their SVR contrast they meant it literally, I swear I would have rented and kept saving to buy a house for my kids when I turned 60 or so, maybe getting a fixed 5-year loan in the end. Like after Fukusima my car insurance has a wording about limited liabilities in the event of nuclear contamination (I hope it did not imagine it) - but I treat it like I treated "at discretion" in 2008. To borrow at 0.7% and then turn and charge 4.5% for the same amount simply because they can is not business, its exploitation, or innovative banking if you will. In effect, one's SVR turns into an indirect tax to support strangers in need, i.e., in arrears, and for banks recapitalisation.

 

[orka]

My point is that the bank has 120,000 in play money to cover its own borrowing of circa 11,400. How can it not cover bad debts, profits and administration and still not leave a huge premium? My calculation cant be right - what did I estimate wrong?

I make it just under 18K for the bank at 0.7% over the 10 years but essentially your calculation is correct. A performing mortgage at 4.5% will give the bank 120K over the first 10 years even though the cost of borrowing might currently be a fraction of that. Performing SVR mortgages are making huge profits for the banks at the moment.

If a mortgage market is a quasi-insurance market where your interest is determined not only by your traits but also by others' performance (as in car insurance) then the costs of defaults should be shared across the loan book. If a tracker loan book is different, then make SVR pay for defaults and arrears among SVR holders, and make trackers pay for non performing trackers in their own loan book.

That can't be done though because the tracker is legally a fixed margin and not 'a fixed margin plus whatever we have to put on top because other trackers aren't performing'.

Your last post pretty much sums up the problems. The banks are extracting super profits from performing SVRs because they can. SVRs are close to a captive audience - many can't move because of negative equity (or changed circumstances), others don't move because of the perceived effort involved and/or relatively small amounts left on the mortgage. SVRs are not typically managed this way - competition usually prevents exploitation on the scale we are seeing now. But there is little competition here and unlikely to be any time soon. Despite the large profits, if you were a foreign bank looking at Ireland, do you think it looks structurally attractive? How easy is it to repossess a family home if the loan is not repaid? Does the government dabble in and out with rule changes? If I were working in a foreign bank, I wouldn't come here...