Irish Mortgage Brokers Blog

O.k. I lied, they care, but when it comes to new lending (and the secular trend that has already started in Irish lending rates) the underlying prices is of secondary concern as long at the loan (which is the banks asset) is performing.

There is a disconnect between the way that consumers think of property and the way that financial institutions think of it, the consumer thinks of price, the financial thinks of long term loan value. They are two different things, take the example below

Property price: €200,000
Loan (90%): €180,000
Term: 30yrs
Rate: 3%

Total Cost of Credit: €273,199
Credit Cost: €93,199

The bank have a buffer in terms of the quality of the underlying asset, but that isn’t of concern, as long as the loan is performing it will be valued at €180,000 (or whatever the balance is), which is why the lenders are instead going for a different approach. Values have dropped to the point where they believe that we are somewhere near the bottom, not there yet but equally not at the wild over-valuation stage either, if they underwrite strongly, and only lend to the best candidates then the property prices can fail and they don’t need to fear impairment.

Once the borrower continues to pay there is no impairment irrespective of the underlying asset value. The second wing of this is to find margin in lending, we reported in early 2010 that rates would go up this year by 100 basis points or 1% starting in the first quarter, this has turned out to be true, if they go up by a further 50 basis points next year and prices go down 10% look at what happens.
Property price: €180,000
Loan (90%): €162,000
Term: 30yrs
Rate: 4.5%

Total Cost of Credit: €295,498
Credit Cost: €133,498

The lender has made an additional €40,000 on this loan even though the property price was less - because the credit gain outweighs the difference. Consumers often confuse price with cost, the smart thing to do would likely have been to take out a loan in Q4 of 09′ or Q1 of 2010 - if you believe that over the long term that the property will increase in value, if you don’t believe that then stay out of the market. The ECB might stay at 1% until 2012 according to some commentators, even if that happens rates are still going to increase as banks look for ways to find profit to fill the ongoing holes in their balance sheets.

Which is why they don’t care about property prices for new lending, rather they care about the financial strength of the applicant and about how much margin they can obtain on lending to new applicants.

We have been saying for quite some time that banks would start to find ways to induce people away from their loan book. The first mention is from a post here back inn 2008 where we mentioned ‘early redemption bonuses‘  and then we also said something similar which Niall Brady from the Sunday Times picked up on in July of 2009.

The basic premise is that banks want rid of certain types of borrowers and loans in particular, and in some cases loans in general. We’ll take a look at the loans that bother them the most below.

1: Sub-Prime loans: this is definitely the clearing house recently Fresh Mortgages sold their loan book in a private deal believed to be well below 30c on the euro. This was for a book that was secured on sub-prime mortgages and serviced via a centre in Northern Ireland, something Fresh did was to offer their borrowers an inducement to go elsewhere or pay off their loan. You can take it that for all the hard talk about sub-prime lenders, that they will be the most generous when it comes to inducements.

2: Tracker mortgages: Bank of Scotland recently offered incentives to borrowers to get off their loan book and at €1,150 it ain’t chump change either (see picture below)

This is the first time a definite incentive has been offered to get people (in prime lending) to go somewhere else, and it is most certainly directed at tracker holders (which represent the bulk of their loan book). Bank of Scotland have a legacy issue to deal with in leaving, for a start, they have to continue to service these low margin products which comes at a cost, and secondly, they are not producing the kind of profit they had hoped for, so an ideal end game for them is for people to switch and go elsewhere.

The current incentive will likely be followed by greater incentives in the future, I’m not saying this will be a bonanza, but it could well be a five figure sum eventually.

3: Other loans: There are other loans which banks would like to be rid of, people who have full contract interest only options (rather than for a set period with reviews stitched in) are going to become persona non grata. These loans do very little to facilitate additional lending if the securitization market is not functioning correctly. And in an era of collapsed property values it also makes things worse for a banks asset position because repayments are not reducing the level of loan versus the value of the property. These loans will be the last ones that a bank can sell on, and that means the best solution (from a banking perspective) is if the borrower goes elsewhere, what’s worse is that in many cases the people on these contracts also have low margin trackers!

Serious non-performing loans would also fall into this category, in an ideal world the borrower would pay off their loan in full or go elsewhere but as that is not possible in an impaired loan it means banks will be stuck with loans that are not performing which, at the same time they can’t move on (due to the new code of conduct on mortgage arrears) and also which they are afraid to move on for fear of realizing market values when they do.

All said, there are many borrowers that the banks want off their book, the question is how will they do it and how can you make sure to benefit from it when the time comes? De-leveraging can only be partly achieved by the institution through repayments, so they’ll need to find a way to encourage quicker repayment/prepayment, the stick will be rates, the carrot will be incentives, watch this space!

The Examiner carried a story about the number of options available to borrowers in the present market and the fact that they have dropped over 50% since 2008.

In 2008 there were 380 different mortgages available on the market across all banks and all rate suites, today, that number rests at 179 meaning that at least 50% of the choice is gone. That is also reflective of the fact that so many lenders have exited the market. Below is a list of several who are no longer lending here.

Halifax
Fresh Mortgages
Springboard
Stepstone
Nua Homeloans
First Active
GE Money
Leeds

Many of these providers were in the non-prime/specialist/sub-prime category, however, a drop of 50% in choice doesn’t mean that there are no options left. Certainly tracker mortgages are a thing of the past as are Standard Variables (referring to new business for these products, existing clients will keep their existing product).

The other factor that makes this less spectacular is that many lenders replicate offerings, so when each lender pulled out, their two year fixed rate product being discontinued means that there were 8 less two year fixed products available, but it isn’t the case that the market leading 2yr fixed was necessarily with any bank that quit the market.

The idea that the more mortgages there are, the wider the choice is true in respect of their being more ports of call, but if you wanted baked beans does it matter whether the shop you go to stocks 6 brands or 70 brands of the same thing? Mortgages are not rocket science, there are intricacies and nuances that a practitioner understands better than a day to day consumer but in terms of choice there are still plenty of options and navigating your way through them is perhaps made easier given that there are fewer choices, even if all of the players remained in the market tracker mortgages and standard variable mortgages would not be on offer, so it doesn’t mean that the consumer is definitely gouged when one or more banks stop lending or close up shop.

‘I have a tracker mortgage so I don’t care’ a man recently said to me when I was talking about the near definite increase in margins that we will start to see in mortgages as lenders seek margin and reprice risk.

It was almost said in a smug manner, a kind of ‘yeah, times are hard but I have my tracker mortgage’, and then it struck me, most banks have a get out clause, they don’t have to use it, but they might. So I thought it might be interesting to point out exactly how this could come about, and essentially the relationship it has with falling property values, so if your lender ever calls you out of the blue asking you to let a valuer into your gaff be sure to say ‘no’.

The way that trackers could be wholesale removed from borrowers is via an up to date valuation where the tracker rate is connected to the loan to value (LTV) of the property, many tracker mortgages only exist because of a covenant where the loan was at a certain level or band of LTV at the time it was taken out (such as <60% LTV), and the danger is that the best of them were based upon low LTV’s which are more exposed to price drops.

Huh?

O.k. say you got a loan that was just a ‘general tracker’ at ECB+1.25% (no LTV restriction or an inverse LTV - eg: this was a rate for loans of 80% and above), then the value of your home isn’t really an issue, but some were ultra low margin loans along the lines of ECB+0.5% if your mortgage versus property was less than 50%. So put that in figures. Bought a place for €300,000 in 2003, property market goes wild, refinance in 2006 because the top end of the market is now at €600,000 and the ECB+0.5% loan commences.

But then prices fall 30% (take any figure you want the idea behind the example remains the same) and now the place is worth €420,000 and the loan is at €270,000. You are now in breach of your LTV covenant, the lender knows it, and you know it too, but nobody has reacted yet…. key word ‘yet’.

If a lender gets an up to date valuation and you are not within your agreed LTV brackets then they could potentially take the loan away from you and replace it with the appropriate LTV product, now that trackers don’t exist any more that replacement case would invariably be a variable rate.

That would represent a huge win for banks, essentially removing low margin low profit loans which likely still have a great LTV and replacing them with higher margin variables during a time where refinancing is extremely difficult, if a bank does this their customers won’t be able to do a thing about it, jump up and down perhaps, but otherwise helpless.

Who would do such a thing? The first will be (if it happens) a bank that isn’t covered by the State Guarantee or NAMA, they have nothing to lose and no political pressure to bow to, I hope I’m wrong, but when there is money on the table somebody tends to take it eventually and in this instance there are piles of cash for the taking and the thing that puzzles me is why this move hasn’t already been made.

We are going to look at the Euribor yield curve today considering its moves from 20th of June against two dates in August with a view to deciphering what it means for rates in the Irish residential mortgage market.

First of all we see that the June vs August lines on the 11th showed a drop in short term rates, this would normally imply an increase in liquidity (generally) as well as a lack of inflation expectation until circa the 2yr mark at which point the blue euribor line trends higher. We would take it that the expectation is for low rates to prevail for the next year then rise to about the 1.5-2+% range.

The prices changed from June to August and the implication is that sentiment changed from low short term rates to rising longer term rates to depressed short term rates and much higher longer term rates. This is a goldilocks scenario for the banks because they will be able to justify and earn large margins on the short end as the yield curve steepens to the right.

Moving on to the 24th of August we can see that the expectation of low rates remains, and thus, compared to the 20th of June the line is still trending below the base rate on the 3mth money (which is what banks generally rely on). Then the two lines sync up, and that would imply that some of the scare is gone from the inflation argument (for now) but nonetheless the rate expectation is higher from the 2yr mark.

What does it mean for mortgage holders or potential mortgage holders? Basically rates will increase, as already discussed in the past, variable margins will rise significantly, but the yield curve is telling us that fixed rates after the 1yr mark are going to start to go up, you can’t have the current fixed rate environment lasting for much longer. Does that mean you should take out a mortgage now or fix it if you have one already?

Yes and no, prices do have further downward adjustment and you need to determine what you believe that will be and then work out the margin difference over the life of the loan to determine how it might affect your overall cost of credit.

The story seems to be the same in the USA and the UK, short term low rates then a return to a healthy upward curve, below are the comparisons from the 6th of July to today for the GBP Libor and the US Libor, the only difference at the moment is that the US is factoring in higher inflation after 2yrs than previously.

That banking in Ireland is a little irrational at present is a given, however, there are occurrences in the market which will change pricing structures in the near future, interestingly, by trying not to compete for business, several banks will ultimately make the market more profitable for all of the banks, achieving almost the opposite of what they had hoped to do.

I’ll explain, at the moment we have seen widespread Sovereign Credit Retrenchment, that’s a fancy way of saying that banks who are bailed out by certain countries are only really focusing on their indigenous markets because it is those markets that bailed them out. Irish banks have done this, Irish owned UK operations are closed. Equally, UK banks here are doing this by making their existing business rates higher and their new business rates exceptionally high.

Bank of Scotland’s new business variable rate is 6.19%, a whopping 5.19% over the ECB, they are doing this to avoid lending, and they are also paring back LTVs so that you have to have greater equity in the deal to borrow, in effect they have shut off the tap to lending.

Irish banks on the other hand are on the market with new biz rates of 2.25% which are totally out of touch with the ceiling rates that BOSI are selling, equally, we are in a harder credit environment and credit is scarce, scarcity value alone should make loans more expensive, currently it is only political will holding them down. However, at some point a happy medium will need to be reached, and for that to happen the Irish lenders will need to jack up their rates. Why would they lend at what are essentially discounts given the scarcity value of credit and the prices that competitors are charging?

The divide will be filled, and when that happens it means that margins on all lending will rise, and because of that we will likely see foreign banks start to lend again here because the proposition will be attractive enough for them to do so profitably, and by that happening it will be the inverse of their intentions, which are on the whole, to pull out of the Irish market where possible.

When margins rise considerably, and banks downsize to meet the ‘new normal’ in terms of capacity and market requirement, it will make for profitable banks, and thus, by trying not to lend, the banks will save their hide on the lending front. By closing the market they are in effect opening the market in the future.

When there are monopoly powers at play there is no need to find efficient pricing, or value, however, in the case of Irish banks, that is not the case, the only ones with money to lend are selling at rock bottom, and it isn’t due to economies of scale, and when they do start to charge more they can thank foreign tax payers for having given them the ability to do so, whilst being saved by indigenous tax payers.

Today the FT has reported that the ECB will offer unlimited 12 mth repo facilities to banks, this is a big step for the generally hawkish bank. Note: Unlimited.

We have said on this blog/radio/national papers that the 1% mark is not likely to be passed due to the compression it causes on banking profits (the ZIRP policy was one of the inherent issues with Japan’s lost decade). So the opportunity to get in at what is being touted as the historic low, not to be repeated, will have an effect and the belief - at least in this house - is that it will be on the right hand side of the yield curve.

Undoubtedly banks will now gather every available piece of collateral and cash it in. Remember you heard it hear first: this will cause a problem in about 12 months time when the piper has to be paid and everybody is cashing out/back in at once.

While this doesn’t equate to strict ‘Quantitative Easing’ the availability of unlimited funds for assets, at rates that the market are being told are historic lows will have virtually the same effect.

Back to the yield curve though, this unlimited 1yr funding means that any money below the 1yr mark will probably be at an artificial low, why pay interest when you can just pass all of your assets to the ECB?

However, we pointed out the disconnect that already exists in money beyond the 1yr market at present, and this is likely to increase. If everybody has access to short term money then scarcity value will naturally fall on the 1yr+ prices, for mortgages in Ireland this will probably translate into a new-new-best-deal 1yr fixed rate from one of the institutions, however, if the existing inflation expectation is built into the future prices, and then you add some scarcity to the mix then it could mean we see short term rates drop (1 to 2yr fixed, perhaps some over priced variables too) and longer term fixed rates start to rise, leaving a void in the middle.

It’s kind of getting old at this stage, but if you want to fix your mortgage rate then get off the fence and do it.

Trackers are dead and gone, there is one on the market but it’s at a margin so high that it is effectively worse than a bad variable rate. Evidence from the UK indicates that Co-Operative Bank’s tracker offering which is 2.39% tracker mortgage.

Will Irish banks follow suit? Probably not in the short term, when the market turns there will be some bank who have accumulated more than capital required and they will then turn this into lending, having said that, it will likely be a self underwriting product, one where the LTV is <= 50%, minimum of €200k borrowed but no more than €450/500k, and a qualifying income of €90k combined needed (stripped of overtime/bonus etc.).

If trackers come back I would be totally satisfied that they will operate as a client cherry picking operation more than anything, having said that, with time a competitor might follow suit!

There are winners and losers in every rate cut, so literally somebody, somewhere loses out every time, this can be the bank, a borrower or a saver. To a degree Jean Claude Trichet uses the euphemism ‘rate cut’ in place of the more accurate ghetto expression ‘bitch I’ll cut you!’, but ultimately there are those who get hurt.

Who exactly? Well, people on fixed rates who may want to break them are made worse off, people who are saving generally are made worse off too. And banks themselves are also hit on their margins when rates drop.

How does a lower rate affect these three situations?

Breaking a fixed rate: If you are on a fixed rate and want to break it then there is a breakage fee, this is one of the times under the Consumer Credit Act 1995 where a bank can hit you with fees for early redemption or changing to another rate, the examples we are seeing are all c. €20,000 so it’s serious amounts of money.

Rate brake penalties are calculated on the difference between the rate that the loan was taken out (thus when rates were higher in the current examples) and the rate money is bought at today, so the lower it gets the bigger the gap between the two and thus it means that breakage fees get higher as rates drop. It is no coincidence to see more stories in the papers about ridiculous penalties being quoted to home-owners looking to break their fixed rate, the numbers are getting bigger as rates hit historic lows.

Savers: People who are not in debt are not rewarded when rates drop, typically the rates available on their savings drop as well. We have seen deposit rates (while at historic highs) drop in line with mortgages, and in some cases lenders are saying they won’t pass on rate cuts to mortgage holders in order to help out their depositors (post here shows that’s a bit of a farce in some cases).

Banks: Banks have a fine line to walk, in particular with deposit rates when they are focused on their capital positions. The lower rates go the more their margins are compressed, we have spoken about this before and the situation arises when rates drop because mortgage holders want the rate cut (and public pressure often ensures they get it), while depositors don’t want the rate cut so banks are in a position where they have to drop the price they are getting paid but they try to avoid dropping the prices they pay, because if they do depositors are a fickle bunch who will move their account to a different institution and thats described as ‘margin or rate compression’.

The market is really made up of two sides, those who owe money and those who don’t, who are the lenders. When you put money on deposit you become part of a more efficient money lending machine, the bank lend on your behalf as it is a better method than doing it personally, they are more expert and efficient at it and risk is reduced as its not a case of one persons money in particular going to any borrower.

So it is kind of strange, given that depositors really are the lender, that people with money on deposit are not calling out for the banks to hold their mortgage rates and not pass on any savings. Or perhaps they are and it just doesn’t make the papers. Banks need depositors more than they need borrowers, you can always lend money but if you don’t have a capital base you are nowhere, equally if you don’t lend you can’t pay depositors but even if this was the case, you could always put the money on deposit in another institution and play arbitrage (if you could keep that ruse going of course).

So if you have a mortgage, and money on deposit, the next time a rate cut comes along take some time out to think about both sides of the coin, the ‘good news’ is only partially good news depending on your position.

The ECB meeting is due to meet this week on the 7th and a further 0.25% rate cut is expected which will bring European base rate lending to 1% which is the lowest it will go according to guidance given in the past by Jean Claude Trichet. For mortgage holders this will be a further advantage for those on tracker mortgages and for those who hold variable rates where the cut is passed on.

The question currently is whether or not there will be any stimulus packages mentioned or any idea on what to expect in the coming months, with very concise plans afoot in the US, UK, China, and elsewhere it is likely that the Eurozone will need to make some formal plan as well and move beyond the monetary options of only playing with interest rates.

The EU has a problem other currency zones don’t, that of political cohesion, the USA is all dollar denominated and all under one flag, the UK is the same, as is Japan, Australia, China etc. The EU is made of of a monetary union without a traditional political union so it means that any quantitative easing cannot take the same guise as it has in other countries (buying up corporate bonds for instance).

Thus it narrows down the options, any easing will have to be directed at certain member states and this will have to be under two paths, first, you could offer relief to governments based on the predicament they are in, this would help out the PIGS a great deal. The other is to set a certain level or % of GDP or some other country specific figure and do it based on that.

The working mechanism would need to be that Governments can get a near zero coupon bond sale repo’d by the ECB and this would release money into the member states to spend as they see fit (which may then be to buy corporate debt etc.). There is a confounding issue in this crisis and it is this: how does Europe react in the face of disaster? Perhaps the EU is not as powerful as we thought it was or perhaps, and conversely, it is…. But in order to find out we will need to see evidence of some cohesion in the financial plan that will be rolled out, German austerity is likely to break down soon as they realise that despite savings, nobody is immune in a synchronised world.

There will have to be something beyond interest rate changes and it will have to come soon if Europe is to feel that there is any form of central plan, but in a largely decentralised power base (each country is still a sovereign) it means the routes open for rolling out any stimulus package will need to go via the arteries where it will work and that is via the sovereign members.