Bank cost of funds versus mortgage prices

Eurodollar or LIBOR cost of funds is a common phrase in banking, what does it mean or do though?

Banks borrow short term and lend out long term, they call it ‘maturity transformation’ and in doing so they aim to make a mark up on the money, it’s the same concept that a shop uses in selling cartons of milk, fundamentally the idea is the same.

The LIBOR rate is ‘London interbank offer rate’ and represents the cost of funds for a high quality non-governmental institutional borrower.

To get an idea of the cost of funds (and this is currently speculative because Irish banks don’t get offered funds at Euribor [euro equivalent of Libor]) all you have to do is a simple calculation.

We know that banks tend to use three month money and that means that any calculation will always have the interest rate reduced by multiplying it by 90/360 (3 months = 90 days, and 360 = 1 year [I know that in real life 1 year is 365 days but that small change of 5 days gives a micro margin for the transactions to occur in and therefore allow interest to acrue by pro-rating])

So a bank wants to borrow $22million for three months, what does it cost if the rate is 4.678%

22,000,000 x [1+ 0.04678*(90/360)] we’ll use the precedence of multiplication over addition – it saves me faffing with brackets too!

22m * [1+0.04678*.25] = 22m*[1+0.011695] = 22m*1.011695] = $257,290 so the cost of borrowing $22,000,000 over 90 days on the LIBOR market would be just over a quarter of a million dollars at a rate of nearly 4.7%.

In Ireland, due to Euro membership we’d use the Euribor, 3 month is currently 1.068% . Irish banks are often paying about three to four times or more for that money, if you start to apply that to implied loan costs (before we look at impairments) you can see that mortgages are likely under priced at the moment, that isn’t likely to continue. We’ll cover the swaps aspect of why we think fixed rates will end in 2011 in a later post, but for now it should be spelling it out loud and clear for variable rate holders, yer gonna get leaned on this year again!

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