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Jargon buster: how do swaps work?

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Published: 30 July 2015 | Author: Sue Anderson

We see many glib references to swap rates "determining the price of fixed-rate mortgages" - but how many people really understand how these transactions work? In this article, designed to supplement Five things you need to know about mortgage rates and sit alongside our other jargon buster on the yield curve, we explain how swaps limit the interest rate risk of "borrowing short and lending long" (or vice versa).

So, for the non-expert, read on for everything you ever wanted to know about swaps but were too afraid to ask!

What's the risk lenders are trying to cover?

Imagine a lender is borrowing funds from savers at a cost of 1% at a variable rate, and lending on a fixed rate mortgage for 5 years at 3.5%.

In the short term, this is a deal that covers the lender's costs and generates a surplus. But what if, in a year's time, interest rates are higher and the lender finds that to attract savers or investors it now needs to pay 2%? And what if, a year after that, it is paying 3%?

Such uncertainty completely changes the level of return to the lender.

If a lender lends at fixed rates, it faces the risk of losing money if it is borrowing at variable ("floating") rates. The phrase "borrowing short and lending long" is shorthand for this potential mismatch.

In part, a lender will try to match its borrowing and lending terms reasonably well so that it does not face undue risk from this. But another way to hedge (protect) against this risk is to enter into an interest rate swap contract.

In its simplest form, a swap enables a lender in the position above to ensure that its variable cost of funds and its 3.5% fixed income on assets can be aligned to deliver a consistent return over five years, whichever way rates move. It does this by entering into an agreement with another institution (a "counterparty") which has the opposite need: to replace its fixed cost of funds with a variable one.

Stylised example of a swap contract

Please note that the illustrative rates we have chosen here are purely for simplicity and illustration and do not represent real conditions.

Lender A and Company B agree to enter into a five-year swap on £100 million of their own underlying funding with the following terms (we are using Bank rate as the reference rate for the purposes of intelligibility in this example - but, in reality, LIBOR would more often be used as the reference rate for swap contracts).

Lender A agrees that each year, for five years, it will pay Company B a sum equivalent to 2.5% of the £100 million.

Company B agrees that each year, for five years, it will pay Lender A an amount equivalent to Bank rate plus 1.5% on £100 million of funding.

Lender A still has its underlying variable funding costs (it will still have to pay its savers their variable rate), and Company B still has its fixed rate funding costs. But they have both found a way to align the cost of their funding liabilities to the income on their assets, whichever way rates move.

At outset, Bank rate at 0.5%, the structure of the deal looks like this. Lender A's funding costs are 1.5% (£1.5 million) composed of £1 million to savers, plus £0.5 million as the net cost of the swap:

At Outset

Now let's fast forward a year. In this fantasy scenario, let's imagine (purely for illustrative purposes; this is not a forecast!) that Bank rate has moved from its current level of 0.5% to 1%. The diagram below shows how Lender A's funding costs are still 1.5% (£1.5 million), composed of £1.5 million to savers and no net effect from the swap.

One year on

And, if we fast forward on one more year, let's imagine our fantasy Bank rate has moved up again to 1.5%. At this point, Lender A's funding costs are once again 1.5% (£1.5 million), composed of £2 million to savers offset by the net receipt of £0.5 million from the swap.

Two years on

Bearing in mind that Lender A's fixed rate mortgage lending is still bringing in income of 3.5% a year, and it is now having to pay its savers 2.0% a year, it is nevertheless still experiencing the same margin (ignoring other costs) as it did at the start when the lender first entered into the swap contract.

But, if Lender A had not swapped, it would now be having to pay significantly more for its own funding with no corresponding increase in income, so its margin would have been significantly eroded and it might be making a loss after costs.

Meanwhile, Company B - which is lending at variable rates, which have also risen - sees its funding costs rise, but also sees its income from its lending rise because the variable rates it charges have also gone up.

In reality, the example given above does not convey the true complexity of how lenders manage their balance sheets. Lenders are continuously managing numerous sets of cash flows across all their liabilities (all sources of funding) and all their assets (all lending).

There are many other factors that could affect the transaction above - the savers might drift away and the lender might need to pay more to retain them; the borrowers might default, or might redeem their mortgages early.

So it is actually very difficult to deconstruct any movement in swap rates into a direct correlation to a change in mortgage rates, since within every lender there will be a large number of variables and different contracts of varying lengths and maturities.

And, on every deal, there will be particular factors that affect the actual rate paid, reflecting features such as the overall level of market appetite to enter into swaps, and the relative financial stability of the particular counterparties involved in a transaction.

Swaps are certainly an influence on rates, but as we explain in Five things you need to know about mortgage rates, be cautious of attributing too much influence to any single factor - there are always a number at play.