How do the lenders fund mortgages?

[cremeegg]

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

Really? Do you know if either AIB or Bank of Ireland have sold off their art collections.

 

[visigoth]

Orka - thanks for confirming the logic of a captive audience making sense. I brood about it all the time, but then when I put it in writing, I am surprised how stark it is, that it can't be right, can it? And then other people on this forum read and confirm that in fact yes, this is in fact right. I cannot believe that the FG-L govt does not address it as an urgent manner by either speeding up repossessions dramatically or looking aggressively for new banks with sweeterners to entice them into the market or something. And it has been almost 4 years since the BOI stopped reflecting ECB rate in its SVR and nothing, we could do nothing about it.

The banks are intermediaries that borrow at say 0.7 and then lend at 4.5 and pocket the difference. I could understand the system whereby they borrow from their depositors at 2.5% or issue bonds at the same rate - and pass 2.5% interest to the said deposits, then lend at 4.5% and pocket that 2% difference. And pocketing would include admin costs, share profits, covering bad debts. But the current margins for an essentially intermediary business are suspicious. Whether you compare 4.5 v. 0.7 or 120K v. 14-18K, the premium is too huge not to be questioned by the competition authority or consumer protection, CCPC that is.

 

[visigoth]

And I wondered if one could design a system where borrowers and lenders could bypass intermediaries. We do it all the time on ebay these days. Hypothetically, if I could issue personal bonds at 2.5% over ECB rate for 20 years, and sell them to the current deposit holders who make 0.5% at best on their deposits, with an ironclad legal contract, we bypass the intermediary and each gain something. The lenders can examine my employment, credit history, etc. Why would we need intermidiaries then - the idea is that the banks could assess risks better, attract lower interest than otherwise, but they seem to have failed on all counts. I, as a hypothetical lender would have never extended 100% loan for house purchase and would have had very strict lending standards to protect my money. The only problem is how hypothetical lenders can access their security if it goes belly up, but the banks seem to have the same problem anyway.

Really, if the current system is grossly unfair and broken, I wonder if there is a way to exit the system and design more equitable solutions that bypass the current rent seekers as in quasi mortgage ebay or something.

 

[Sarenco]

And I wondered if one could design a system where borrowers and lenders could bypass intermediaries.

You’ve just described peer-to-peer lending.

Would you borrow money at 0.89% to lend it to someone at 3.58% if there was a 15% chance that they wouldn’t pay you back?

Of course you wouldn’t!

However, you might lend on the basis of those rates if the default risk was spread across tens of thousands of borrowers and multiple product types (commercial loans, credit cards, personal loans, various mortgage types) and you had a large amount of risk capital available to absorb the cost of any defaults. In a nutshell, that describes the current trading position of BOI.

Again, from a lender’s perspective, you have to look at the totality of the loan book and funding position - you can't just look at the rate charged on a single loan.

 

[Sarenco]

Incidentally, I would argue that the current high rates being charged on variable rate mortgages (and indeed other loan products) are largely because of two key Government policies:

• The reduction of competition in the banking market by consolidating the existing banking sector (the "pillar banks policy"); and
• The deliberate policy of frustrating the enforcement of security where borrowers default (the "keep families in their homes policy").

The later policy has the following effects:-

• Reduces incentives for borrowers to maintain repayment discipline - if there are limited consequences for defaulting then rational borrowers will behave accordingly;
• Reduces the ability of lenders to replace "bad" loans with "good" loans secured on the same properties leading to a higher aggregate cost of credit within the economy; and
• Reduces incentives for new entrants to the market - would you lend on a secured basis where you can't enforce your security when a borrower defaults?

There is no question that SVR borrowers are paying a disproportionate price for these policies but brooding about it won't change anything.

I think you know what I believe would be the appropriate policy response to this issue.

 

[visigoth]

Sarenco, nicely summarised and itemised. Oddly, the govt response is almost bipolar: we are pro-market and pro-business center-right government and we will not regulate bank rates for the fear or deterring new entrants and let the competition sort it out; at the same time we are anti-business and rather see no new entrants than let lenders sell their security. As it stands, the combination of the govt inaction and the bank's extortionate rate makes this item increasingly appealing each passing day:

The later policy has the following effects:-

• Reduces incentives for borrowers to maintain repayment discipline - if there are limited consequences for defaulting then rational borrowers will behave accordingly;

I have no magical solution, dont think my income suddenly jumps so that I can reduce LTV and switch, not that 0.75% interest reduction will make much difference anyway.

 

[visigoth]

And another point. I do not think I misunderstood what “at discretion” clause implied in the SVR contract, I feel rather misled. In fairness this is why I am so angry about the whole shebang ever since. I asked for a tracker, and the BOI officer who said it was unavailable (June 2008?) however explained to me that trackers and SVR varied together and that the difference was that the trackers had to reflect euribor rate changes immediately while in case of svr it may take time before they reflected ecb rate ups and downs. I remember they even showed me a plot where they varied. My solicitor said the same thing, that trackers and svrs varied in line with euribor but svrs not straight away, at discretion.

When I took SVR mortgage in 2008, it was over 1.2% euribor rate. It reflected it more or less to mid 2010. And now it is over 4.45%. If I took SVR after 2010, I would have no problem with the bank as I would know what it meant by then. But they should not have misled like that.

Irrespective of my personal take on the BOI and its SVR, there must be better disclosure requirements re how much banks can charge with or without competition. If the banks are no longer willing to anchor their variable interest charges to some baseline as in trackers, “at discretion” svr clause must go and they must stipulate an interval where one’s interest may vary, as in many EU countries where banks stipulate “here is the variable rate, and it can vary plus/minus 1.5 or 2%.” I doubt they can come up with objective criteria as to their funding costs but maybe.

 

[cremeegg]

And another point. I do not think I misunderstood what “at discretion” clause implied in the SVR contract, I feel rather misled. In fairness this is why I am so angry about the whole shebang ever since. I asked for a tracker, and the BOI officer who said it was unavailable (June 2008?) however explained to me that trackers and SVR varied together and that the difference was that the trackers had to reflect euribor rate changes immediately while in case of svr it may take time before they reflected ecb rate ups and downs. I remember they even showed me a plot where they varied. My solicitor said the same thing, that trackers and svrs varied in line with euribor but svrs not straight away, at discretion.

As I understand it trackers vary with the ECB base rate not Euribor, and these are two different things

 

[visigoth]

Yes, the ECB base not Euribor of course, thanks for correcting me. But this is not the point, the point is they themselves probably believed all variable rate products were to reflect their funding costs anchor, the ecb base rate, albeit svr at discretion not immediately. I would like to think they were not evil to mislead intentionally, you know.

 

[visigoth]

Does anybody know if the fixed rate over ecb rate in trackers was approximately equal to the banks' profit margins or the profit margins could be higher (or lower)? That is, could the banks borrow money at the rates below the ecb base rate in the past?

I struggle to understand how the banks price their products now but the pricing policy in boom years is equally unclear. For instance, with the ECB rate of 4% in mid 2008, all BOI products, whether trackers, svr or fixed were roughly 5.2 to 5.6%. Could the bank access money at the rates below 4% then so its profit exceeded 1.25% or its profit margin was approximately equal to the tracker rate, i.e., 1.2% or so? It is also conceivable that they could only fund at the rates over 4%, say at 4.5%, so their profits would have been 0.7% or so. Were their profit margins on home loans approximately equal to tracker rates or were they higher?

Sarenco earlier said the bank's profit margin in 2015 is 2.1%. So the BoI borrows at 0.7% and takes 0.5% from trackers at 1.2%, and takes 3.8% from those on svr. On average, profit is roughly 2.1% from both. The margins seem much higher than in the past.

 

[Sarenco]

Sarenco earlier said the bank's profit margin in 2015 is 2.1%.

Eh, not quite.

I said that BOI's net interest margin (NIM) was 2.21% in H1 2015 but that's not its profit margin. BOI also has capital costs, administration costs, etc.. Again, you have to look at the loan book as a whole - banks don't finance loans individually.

However, your core observation that trackers were sold at very low margins is certainly correct. During the 2004-2008 period, Irish banks were able to borrow on international wholesale markets at, or close to, the ECB refi rate. Until the end of 2008, variable rates for all lenders closely followed changes in the ECB's policy rates, short-term wholesale rates and tracker rates. Thereafter, as you know, the relationship breaks down, in large part due to a dramatic increase in the number of defaulting loans and the withdrawal of a number of market participants.

 

[visigoth]

Surely its net interest margin equals its net profit margin if they decide to cover their administrative and capital costs using funds from elsewhere, say from the capital markets unit, and if there are no defaults? So it is an internal accounting decision, “the costs” are not in-built in how they calculate them, after all if they include “costs” in trackers calculation then they are in red, always in red by design? But I take your point, I appreciate the difference.

Thanks for confirming that the banks even in 2004-8 could only borrow “at, or close to, the ECB refi rate” – that is, their NIM could not exceed the average 1.2% tracker and svr and fixed premia over ecb at the time – that was my Q. I wondered if their NIM could have been bigger than that. But surely they had to deduct admin and capital costs then also, and defaults, while not as common as now, were also present? Were they content with very low profit margins?

I am afraid I cannot understand the assumptions at that time. In other threads you argued borrowers should have been more prudent, should have realized the value of trackers v. other products, etc. In fairness, I think most people in 2004-8 would have opted for trackers and only chose fixed rates when they were lower. But regardless, we are talking about irrational economic agents with limited knowledge of finance. In contrast to our banks.

The bank however was willing to provide money at very low interest margin not for 3 or 5 years like in typical fixed interest products in Ireland, but for the whole duration, i.e., 25 to 35 years. This is what I do not understand at all. If a bank has limited knowledge of future interest rates and its borrowing costs and therefore cannot offer 25 to 35-year fixed interest rate mortgage, how is it different from a fixed tracker rate for 25 to 35 years? The logic has to be same. I understand if they had offered trackers for 3 to 5 years. Was the assumption that no matter what happens, during 25-35 years the bank can somehow always make profit after the costs of funds, admin costs, arrears, a zombie apocalypse, etc etc – at the same fixed interest margin regardless? But this makes even less sense than assuming that the house prices will only go up.

 

[jpd]

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

Isn't that the whole point of a bank - matching short term savers with long term loans?

 

[cremeegg]

The bank however was willing to provide money at very low interest margin not for 3 or 5 years like in typical fixed interest products in Ireland, but for the whole duration, i.e., 25 to 35 years.

This is what I do not understand at all. If a bank has limited knowledge of future interest rates and its borrowing costs and therefore cannot offer 25 to 35-year fixed interest rate mortgage, how is it different from a fixed tracker rate for 25 to 35 years?

I understand if they had offered trackers for 3 to 5 years.

Was the assumption that no matter what happens, during 25-35 years the bank can somehow always make profit after the costs of funds, admin costs, arrears, a zombie apocalypse, etc etc – at the same fixed interest margin regardless? But this makes even less sense than assuming that the house prices will only go up.

You are right, it made no sense, it was a colossal mistake.

The banks issued loans of €x million for 25 years at 1% and financed themselves at say 0.5% but for an average of only 2 or 3 years. When they had to refinance the cost to them was much higher.

If the banks had matched the maturity of their loans issued to their own finance raised e.g. issued loans of €x million for 25 years at ECB +1% and raised finance of the same amount for the same time period at 0.5% it would have been a great thing for banks and customers.

Were they stupid, not understanding the problem or stupid thinking that they could refinance at low rates for ever? Or greedy just not caring what would happen in the future, after all it was the bank shareholders who lost out not the bank staff. Maybe not so stupid.

 

[44brendan]

The World's banking system is based on a mismatch. I.e. banks borrow short and lend long. This is why capital adequacy ratios are imposed and monitored by Central Banks. There is no real issue for rate mismatches as the majority of lending is done on a variable rate basis. I.e. based on COF + an appropriate margin. The difficulty with tracker mortgages for banks is that they assume that banks can borrow at ECB rates which is not necessarily the case. Fixed rates are always matched by banks. I.e. when a client enters a fixed rate the bank will hedge that risk by fixing the rate themselves for a comparable period. This is why there is always a cost in exiting a fixed rate early.
I would agree that the 2tracker rate" product was a monumental error by banks in general and unfortunately is a major part of the reason why SVR's are now so high.

 

[Gerry Canning]

Brendan,
{unfortunately is a major part of the reason SVR,s are now so high}

If there were other lenders in our market , would SVR,s not be a lot lower ? because the good SVR payers would move.
Only as now when there is minimal competition can the encumbents hike SVR.s as they have.
Only when there is no Political will to ease the burden on Svrs can the artificially high rates persist.

In my view the reason SVR,s are so high is because Banks can get away with it , in so doing they will repair their own damage quicker on the back of SVR holders.

Maybe that's the way it has to be ?

 

[visigoth]

If I understood correctly some of the replies above, our banks during the boom did not pass the risks of defaults to insurance companies or to other investors by bundling and securitizing home loans and selling them elsewhere. This does not make any sense. I always thought they were so reckless and they relaxed their lending standards because ultimately they could pass it all along. But if they kept it all on their books, why did they relax their lending standards? And this on top of selling 50% of home loans as trackers that guarantees minimum margins if any, and equally guarantees that other customers are screwed to overpay regardless. The problem is systemic and I don’t think the solution is just to wait 10 years when the tracker book shrinks.

Another thing I have learnt from this thread is that the banks’ profits never exceeded 1-1.5% over the ECB base rate up to 2010 and because all rates, whether variables, fixed or trackers, were all approximately 1-1.5% over the ecb rate, not over 4.45% like now. No matter how you look at it, the margins during the boom were much smaller than during recession and that is almost oxymoronic.

Basically, the banks charge super high SVR rates because they have higher losses than expected, and because they can.

 

[visigoth]

The basic idea of central banks varying their rates is that those rates are reflected in lending rates of commercial banks. By varying the rates, they can restrict credit or stimulate economic activity, correct? Otherwise, what is the whole point of the ECB base rate changes? Our banks do not reflect the ECB rates in their lending rates for 5 years now, i.e., their variable rates do not vary. I take it as axiomatic that commercial rates reflect central banks' rates over time. It almost feels like came up with the idea of the loan to value variable rates that vary according to customers’ own deposits to distract from the fact that their variable rates do not reflect the central bank rates any longer.

And the situation has continued for far too long to regard it as temporary. If high rates are driven by bank losses and no competition, the govt could have addressed the arrears problem, or incentivized new entrants to the market. It did not. Instead, it could have regulated the rates by introducing some kind of caps or something, at least on a temporary basis, for the next 5-7 years or so. It did not. What is the plan? For the SVR holders to keep subsidizing their trackers brethern and banks for life, blissfully unaware of what is being done to them? This is beyond business, this is really an exploitation of a captive audience.

 

[44brendan]

Our banks do not reflect the ECB rates in their lending rates for 5 years now, i.e., their variable rates do not vary

Why should they? Banks are just commercial institutions with a maximize profit perspective. They impose high margins when they can and have no social obligation to keep margins low or to track ECB rates. Thinking that they "owe the country for bailing them out" may be populist but is unrealistic.

the govt could have addressed the arrears problem, or incentivized new entrants to the market

Are these proposed solutions not conflicting? Encouraging competition to enter the market would involve keeping rates high and bad debts low! Realistically there would be a very low interest in any foreign bank entering the Irish mortgage market given the high level of arrears and difficulties with re-possessions. Arrears problem could be more readily addressed by speeding up the re-possession process. Would this garner votes for any party?
Putting a cap on rates in an open market would be extremely difficult to enforce. This is one price we pay for living in an open economy.

Yes it is tantamount to exploitation of a captive audience and you will hear rhetoric from many of the opposition parties that "something must be done about it". However, talk is cheap and you will find that no matter who you vote for in an election the "Government" always wins and promises evaporate when reality bites.

 

[Andy836]

The basic idea of central banks varying their rates is that those rates are reflected in lending rates of commercial banks. By varying the rates, they can restrict credit or stimulate economic activity, correct? Otherwise, what is the whole point of the ECB base rate changes? Our banks do not reflect the ECB rates in their lending rates for 5 years now, i.e., their variable rates do not vary. I take it as axiomatic that commercial rates reflect central banks' rates over time. It almost feels like came up with the idea of the loan to value variable rates that vary according to customers’ own deposits to distract from the fact that their variable rates do not reflect the central bank rates any longer.

And the situation has continued for far too long to regard it as temporary. If high rates are driven by bank losses and no competition, the govt could have addressed the arrears problem, or incentivized new entrants to the market. It did not. Instead, it could have regulated the rates by introducing some kind of caps or something, at least on a temporary basis, for the next 5-7 years or so. It did not. What is the plan? For the SVR holders to keep subsidizing their trackers brethern and banks for life, blissfully unaware of what is being done to them? This is beyond business, this is really an exploitation of a captive audience.

This is completely incorrect.

The ECB rate is 100% reflected in a huge portion of Irish mortgages. Those on trackers.

54% of the BOI Irish mortgage book is tracker mortgages,
38% of AIB's Irish mortgage book is tracker mortgages.

SVR mortgage holders are compensating for those on trackers and to a slightly lesser extent for those in default.