CML news & views

Partly in response to the deepening credit crunch, the Bank of England has cut interest rates three times in the last six months. Mortgage rates are one of the most important routes through which monetary policy affects economic activity. But in recent months, concerns have been voiced by some politicians and commentators that cuts in the Bank rate are not being fully reflected in mortgage rates.  And as politicians have become increasingly concerned about the squeeze on household budgets from a combination of rising food, fuel and tax bills, they have started to push lenders for a commitment to pass on cuts in official rates in full to mortgage borrowers.

The most striking example of this was in January when following a quarter-point cut in the rate set by the Bank of England in the preceding month, Alistair Darling said that lower rates for mortgage borrowers were “part of the deal.”

The reality is that, contractually, lenders retain the right to widen or narrow their margins and are free to do so at different times in the economic cycle, unless a borrower has a loan that tracks a particular rate. The Financial Services Authority has recognised this in its regulatory guidance. 

In fact, mortgage rates reflect a wide range of factors, in particular the cost of funding and business margins in a competitive market, and not just the rate set by the Bank. The situation is complex and reflects a number of pressures on lenders. There has never been a simple relationship between Bank rate and the rates paid by most mortgage borrowers. In this respect, recent behaviour is not unusual, and margins on most products are not unusually wide in a historical context.

Who is affected? 

Who is affected, and how, depends on the contractual arrangements of individual mortgage products.

Close to 50% of existing borrowers are on fixed rates. With their mortgage payments set for a specific period, these borrowers will not be affected by any movements in the Bank rate or other mortgage rates until their fixed rate period comes to an end.

On top of that, more than 25% of other borrowers have mortgages where the rate payable tracks the Bank rate or some other specified rate, such as the three-month London interbank offered rate (libor). These borrowers are only affected if there is a movement in the benchmark rate to which the margin is attached, at least until the contractually agreed tracker period ends. 

The Bank rate has fallen by 0.75% since December and, for those on Bank rate trackers, these cuts will be fully reflected in the rates they pay, following a (typically short) contractually agreed lag to allow lenders to adjust their systems.

The experience of borrowers whose mortgage rates are contractually linked to three-month libor - predominantly adverse credit and buy-to-let borrowers - is somewhat different because the margin between Bank rate and libor has been unusually wide and volatile since the start of the credit crunch.

The rate paid by these borrowers is re-set every three months to reflect the level of libor on contractually agreed dates. So, these borrowers could have seen their mortgage rates rise or fall (or both) since the start of the credit crunch, depending on the level of libor on the re-set dates. But the margin over libor will have remained unchanged. 

The remaining 25% of borrowers have products with a different type of interest rate.  Of these, about two-thirds by number - around two million customers - are borrowing on lenders’ standard variable rates (SVR). The reality is, however, that those paying an SVR tend to have smaller than average mortgages. So while they represent less than 20% of customers, the size of their loans means that they account for only around 10% of mortgages balances outstanding.

As we might expect, movements in SVR tend to track movements in the Bank rate in a general way, but there is no contractual agreement between lender and borrower on what this margin should be, or how and when lenders change their SVR in response to movements in the Bank rate.

Chart One shows effective mortgage rates on outstanding mortgages. The rate for all borrowers peaked in the autumn and by March had fallen by 0.15%. 

However, the effective rate on variable rate mortgages, which peaked last August when financial markets were expecting the Bank rate to rise from 5.75%, had fallen by 0.45% by March compared with the second half of last year. So up to March, lenders had passed on 90% of the 0.5% cut in Bank rate to existing borrowers.

Chart 1: Bank rate and effective rates on outstanding mortgages

Source: Bank of England

The somewhat more modest fall in the effective rate for all borrowers is the result of the steady upward trend in the price of fixed-rate mortgages. This reflects the influence on the existing stock of the rising trend in fixed rates on new business.

For those looking to borrow for the first time or to remortgage, the situation is rather different.

Although SVRs and rates on new base rate tracker mortgages are lower now than they were last autumn, the margins on each of these products had, by March, widened by about 0.2% relative to Bank rate. Margins have also widened on new fixed-rate mortgage products, although here it is less clear what the relevant benchmark rate should be. 

Lenders’ margins 

Although it is common practice to look at the margin of SVR over Bank rate and the margin on fixed-rate mortgages over the equivalent maturity commercial bank liability or swap rate, these “lending margins” are only part of the picture as far as mortgage lenders are concerned.

All mortgage lenders are in business to make a profit. An important element in this is to ensure they deliver satisfaction to their customers through competitively priced products and good standards of service. The commercial decisions they make will reflect the balance between these objectives. 

Deposit-taking lenders have to consider the interests of those who save with them, as well as those who borrow. They need to attract funds from depositors while offering attractive rates to borrowers. 

In order to make a profit and remain in business, lenders need more than to cover a range of operating costs - such as their deposit-raising infrastructure, customer acquisition and mortgage servicing - from the difference between the cost of funds to them and the income they receive from borrowers in the form of interest and fees. 

The relevant margin for the lender is that between funding costs and lending rates.  As the relative pressures on deposit-gathering and loan demand change, the margins on deposit rates and lending rates, relative to a benchmark rate such as the Bank rate, will also change.

Raising deposits 

The credit crunch has reduced the amount of wholesale and capital market funds available to mortgage lenders, and raised the price of these funds relative to the Bank rate. The average rate paid on deposits has fallen somewhat less than the fall in the Bank rate since December, making it relatively more expensive to fund existing mortgages. 

The spread between three-month interbank rate and the Bank rate widened to nearly 0.9% in April from a more normal range of between 0.15% and 0.2%. Interbank rates set the benchmark for the price at which lenders can raise wholesale money - typically at a rate with a margin somewhat over interbank rate.  Interbank rates simply did not fall in line with the cut in Bank rate last month.

Chart 2: Bank rate and three month interbank rate

Source: Bank of England 

Because of the shortage of wholesale money available in the money markets, lenders have started to compete more fiercely for available retail funds. Newspapers and bank and building society windows in the high street are full of eye-grabbing deposit rates, with some offering interest rates on ISAs of around 6.5% - some 1.5% above the Bank rate and 0.7% above average new business mortgage rates.

Other pressures 

In addition to higher funding costs, deposit-raising lenders are also facing pressure from the regulator to increase the proportion of liquid assets on their balance sheets.

Liquid assets earn a lower rate of return for lenders than mortgages and yet need to be funded with relatively more expensive funds.

Adjusting portfolios in line with regulatory guidance is resulting in a lower rate of return on a larger proportion of the portfolio. This is putting further upward pressure on mortgage rates relative to funding costs, as lenders seek to maintain adequate rates of return on their businesses overall.

Margins and mortgage pricing 

Lenders can only pass on the increased costs of funding and running their businesses to those borrowers over whom they have the discretion to change the mortgage rate. This rules out all existing borrowers on fixed rate and tracker rate mortgages - or around 75% of all customers - and means that the two million existing borrowers on SVRs and new borrowers are bearing the brunt. 

It is important that lenders have this flexibility and discretion. If they do not, it would be much more difficult for them to serve the interests of both depositors and lenders and operate in the wider economic interest. 

It is also important to note that, despite the current pressures on funding costs and availability, current mortgage interest margins on new products relative to conventionally used benchmarks are not unusually high in a longer-term historical context. In the case of typical base rate trackers with a maximum LTV of 75%, a margin in March of around 0.75% compared with a long run average of 0.9%. 

And margins on new two-year fixed-rate products relative to the Bank rate are currently in line with long run averages. The margin over two-year commercial bank liabilities is, however, historically high. But it was unsustainably low - in fact negative - in 2006 and the first half of 2007, reflecting intensely competitive pressures in this market.

What next? 

Over the next few months, it seems unlikely that pressures on lenders’ funding costs will diminish appreciably. This means that current higher marginal funding costs will increasingly be reflected in the average, pulling up the average cost of deposits relative to the Bank rate. 

Against this background, the pressure for mortgage margins to widen relative to conventional benchmarks will remain, and, in all likelihood, increase. We are looking at a process of adjustment. 

Over time, the higher level of mortgage rates relative to the Bank rate will start to reduce the demand for mortgages relative to the available supply of funds. At some stage, this will feed back into reduced pressure to compete for deposits and downward pressure on funding costs. 

This process will be assisted by the Bank of England’s special liquidity scheme, announced last month. The aim of this is to improve the liquidity of banks and lower the high current level of wholesale money rates relative to the Bank rate.