CML news & views

A press release last week compared average mortgage fixed rates with swap rates, claiming that the spread between the two had risen to an all-time high. A number of reports prompted by the release mistakenly interpreted reported swap rates as a proxy for the lenders’ cost of raising funds, and the margin between the reported mortgage and swap rates as a profit margin. Both are misleading interpretations.

The press release described swap rates as a “traditional barometer of fixed rates.” Essentially, however, a swap rate in this context is the cost of transforming variable funding costs on to a fixed rate basis. By doing this, lenders remove the uncertainty created by having fixed income stream for a period, while the cost of raising funds at market rates fluctuates over the same period.

Some reports assumed that a swap rate is a measure for the total cost of raising funds, but, as we reminded journalists in a press release in July last year, the real picture is more complex than that. The CML is disappointed that some press coverage of fixed-rate mortgage pricing continues to fail to reflect the wider range of influences on lenders’ pricing strategies.

CML data shows that the trend in the price of fixed-rate borrowing has been generally downwards over the last two years. According to our regulated mortgage survey, the average new fixed rate, which stood at 5.68% in December 2008, had declined to 4.88% by December 2009. And the most recent data (for June this year) shows the average new fixed rate has fallen further, to 4.45%.

This pattern was noted in the Bank of England’s most recent Trends in Lending report, published on the same day as last week’s press release comparing fixed mortgage and swap rates. The Bank reported that average fixed mortgage rates at 75% loan-to-value had fallen since the middle of 2008, although it noted that the fall for three- and five-year mortgages had been less than for two-year products.

The Bank said that swap rates had also fallen over the same period, and by more than advertised fixed mortgage rates so that spreads over swap rates for fixed-rate products had risen during this period.

Crucially, however, the Bank’s report also acknowledged a clear distinction between swap rates and funding costs. “Some major UK lenders reported that recent higher long-term funding costs had contributed to a rise in spreads on longer-term fixed-rate mortgage products,” its report said.

Mortgage pricing remains a sensitive issue, but is not fully understood by simply comparing fixed mortgage and swap rates. Since the financial crisis, regulation has reinforced a world in which risk attracts a higher premium than in the past, and more capital and liquidity are required by financial institutions.

• Funding, from savings and other sources, has re-priced upwards more quickly than outstanding mortgage business, much of was originated at fixed rates. Savers have been moving money to chase higher available rates, while borrowers often choose to remain on attractive low “back book” rates that lenders often have little discretion to vary.
• A portion of existing mortgage business is therefore operating at reduced – or even negative – margins, which has to be offset elsewhere.
• Anticipated credit losses and provisioning have increased in the light of wider economic factors.
• Lenders are experiencing lower returns on their own capital and reserves as a result of the low interest rate environment.
• The cost of strengthening liquidity – to hold higher quality, but lower yielding, assets – has a significant impact on operating costs in its own right, even before taking account of how funding costs have changed.

The credit crunch has meant dramatic changes in the funding environment for lenders, and this means that there is no longer a convenient single measure of lenders’ funding costs. Spreads on wholesale or retail funds, or against swap rates, are pieces of a complex jigsaw, but it is now highly misleading to use them as a proxy for lenders’ costs. It is similarly misleading to suggest that widening spreads characterise lenders’ desire to increase profitability.