When interest rates rise, the lender should be quite happy for you to break a fixed rate.

Brendan Burgess said:

When interest rates rise, the lender should be quite happy for you to pay it off ahead of schedule.

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Not true! Fixed rates are purchased by banks on the marketplace. breaking a fixed rate early has a cost to the Bank irrespective of the current movement in rates. Banks do not take a punt on rate movement.

The lender should be happy. Maybe bankers don't understand this, but there is a lot which they don't understand.

The fact that they have matched it with their own funding should not matter. They retain that funding. They don't have to pay it off because someone has redeemed their mortgage.

But I suppose I am applying my thoughts to a normal market place. In the current market where the Irish lenders are able to charge fixed rates about 1.5% higher than they should be charging, maybe then you are correct, the lenders don't want people to pay back these outrageous rates early.

So let me edit my original comment "In a normal market, the lender should be happy for a borrower to pay off a fixed rate early when interest rates rise".

44brendan said:

Not true! Fixed rates are purchased by banks on the marketplace. breaking a fixed rate early has a cost to the Bank irrespective of the current movement in rates. Banks do not take a punt on rate movement.

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Brendan B is right - it benefits a lender if a fixed-rate mortgage is redeemed at a point in time when the interest rate swap rate for the relevant period is higher than the corresponding rate when the mortgage rate was originally fixed.

There is no logical reason for a lender to levy a break fee in such circumstances - if anything a lender should be incentivising borrowers to redeem early.

Black_Adder said:

Fixed rates were never purchased on the market as suggested by 44Brendan to any great extent. What happened was the Retail side of Banks hedged their fixed rate exposures with Treasury. That is not an external hedge or external swap.

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In this context, "Treasury" simply refers to the department that buys the interest rate swap for the bank - it is very much an "external" swap (what's an internal swap?).

KBC's website provides a good description of the relationship between swap rates and break funding costs:-

If, during the Fixed Rate Period, the Applicant redeems in whole or in part or converts the loan into a variable interest rate or to another fixed rate loan, on that date (the "switching/redemption date"), a "break funding fee" will be payable to the Lender. If, at the switching/redemption date the Wholesale Rate is higher than the Wholesale Rate at the date the existing fixed rate applying to the Loan was set, no break funding fee arises. If, however, at the switching/redemption date, the Wholesale Rate is lower than the Wholesale Rate at the date the existing fixed rate applying to the Loan was set, then a break funding fee will be chargeable. The break funding fee will be calculated by reference to the following formula:

B = (W - M) x T / 12 x A, where:

B = The Break Funding Fee.

W = The Wholesale Rate Prevailing at the date of the existing fixed rate applying to the loan was set.

M = The Wholesale Rate prevailing at the switching/redemption date for the unexpired time period of the Fixed Rate Period.

T = Period of Time in months to the end of the Fixed Rate Period.

A = Principal amount which is subject to the existing fixed rate and which is being switched or redeemed.

‘Wholesale rate’ means the rate per cent per annum which the Lender determines to be the market rate applying to an appropriate interest rate swap for the relevant time period.

The following are examples of the calculation of the break funding fee:

A) Where Wholesale rate increases over the term of the loan:

Wholesale rate at the date the existing fixed interest rate applying to the loan was set (W): 7%

Wholesale Rate at switching/redemption date (M): 8%

Break funding fee €0

B) Where Wholesale Rate decreases over term of loan:

Wholesale Rate at date the existing fixed interest rate applying to the loan was set (W): 8%

Wholesale Rate at switching/redemption date (M): 7%

Break funding rate 1%

Unexpired Fixed Rate Period (T) Six months

Break funding fee (per €1,000 loan amount) €5

Break funding fee = (8%-7%) x 6 / 12 x 1,000 = €5.00 per €1,000.00

AureaEos said:

I understand completely what you are saying, but do the smaller banks sometimes externally hedge their fixed rate mortgages ?

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All retail banks hedge their interest rate exposure by entering into offsetting transactions with third parties.

From a bank's perspective, the fixed cost of funds reflects the market cost of long term money. When a borrower agrees to fix the cost of funds, the bank will enter into an offsetting transaction in the market at that time.

Where a borrower decides to repay a fixed rate loan early, the bank will have to unwind this position at prevailing market rates at that point in time. Any break cost to a fixed-rate borrower will be calculated by comparing the fixed cost of funds on the loan with the prevailing rate available in the market to cancel the bank's offsetting hedging transaction.

A cost only arises where the prevailing market rate for the remaining term of the fix is lower that the fixed cost of funds rate (i.e. if interest rates fall). The early repayment cost is designed purely to cover the bank’s costs.

Say a bank lends €500m of mortgages fixed at 5% for 20 years.

Now let's say that after 5 years, rates have risen generally, and the lender can lend for 15 years at 10%.

If the borrowers repay €100m of the mortgages early, it can simply lend on the €100m for the remaining 10 years at 10% instead of at 5%.

Sarenco said:

Where a borrower decides to repay a fixed rate loan early, the bank will have to unwind this position at prevailing market rates at that point in time.

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Why?

Are the funding and lending sides of balance sheets connected?

Whether it has hedged or swapped externally is simply not relevant.

If, in the above example, a bank borrows €500m at a fixed rate of 0.5% for 10 years.

From a funding point of view, it doesn't matter to the lender that the borrowers have repaid €100m earlier. They can lend out this money again at a higher rate.

I should point out that this is how the lenders should approach it.

I have no idea how they do in practice. It would not surprise me if they did not understand this fundamental point and that they do unwind profitable positions. But I would guess that the mortgage side of the business unwinds it with the Treasury side. But Treasury should not do it externally.

Brendan Burgess said:

Why?

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To allow for the fact that rates could move in the opposite direction (i.e. fall) over the fixed-rate period.

In your example, where long term funding rates rose from 5% to 10%, then the hedge would have proved unnecessary because, as you say, the bank can now lend money at the higher rate. However, the original hedge would now be insufficient so would have to be replaced with a new hedge to reflect the new position (the risk that the bank may not be in a position to lend at 10% if the borrower redeems the loan before the end of the fixed-rate period).

A lender could, of course, hedge its position by borrowing long (taking fixed rate deposits or issuing fixed-rate bonds of an equivalent duration). However, it is far more efficient from a capital perspective to effect the necessary hedge primarily by way of derivative contracts. Again, there is no such thing as an "internal" hedge.

I should add that interest rate swap rates reflect the aggregate market view of future interest rates. These rates are incredibly low at the moment, which obviously informs the current pricing of fixed-rate mortgages.

having worked a stint in the Treasury Dept of a major Bank some years ago I would agree that Sarenco's grasp of how things operate is broadly reflective of how things actually worked in practice.
The internal offset/matching as proposed may sound logical but is not reflective of bank practice up to relatively recently.

Sarenco said:

However, the original hedge would now be insufficient

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The bank has borrowed €500m at 0.5% and lent it at 0.5% fixed.

Interest rates have risen, but they still have the €500m which they borrowed at 0.5%.

So the bank does not need to change its position at all.

The banks might be doing something else, but it makes no sense at all.

Brendan

Brendan Burgess said:

So the bank does not need to change its position at all.

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They do if they are now lending at a fixed rate of 10%. No point being hedged @ 5% if you're now lending @10% for a fixed-term.

Again, rising rates is not a problem for the lender in this context. It's the early repayment of a fixed rate loan at a time when rates are below the rate at which the lender borrowed the money for the term of the loan that causes them a problem. Hence the hedge.