Lending against the London Inter-Bank Offered Rate (Libor) and especially mortgage lending linked to Libor, is often seen as the new kid on the block. As any new kid knows, that means facing questions about your behaviour, your appropriateness and how well you are going to fit in.
However, preconceived ideas have to be challenged when it comes to Libor. Libor has been around in its present form for more than 20 years, evolving in the early 1980s with the growth of syndicated lending and changes in derivatives markets. It now accounts for more than 20% of all international bank lending and more than 30% of all foreign exchange transactions in London.
Libor is also positively mature when compared with the Bank of England base rate. Many people remember Black Wednesday 10 years ago when Britain pulled out of the European Exchange Rate Mechanism, narrowly avoiding a planned rise in interest rates from 12% to 15% ‘ and who can forget the trouble lenders faced in those days?
But we often forget the Bank of England’s interest rate was then called the minimum lending rate. Before that, it was simply called the bank rate. It is safe to predict that Libor will still be around when the politicians have renamed and rebranded the base rate once again. Libor remains rock solid.
There is a misconception the public understands the Bank of England’s base rate but could never get to grips with something as complicated as Libor. This confusion can be easily cleared up by explaining to customers just what Libor is and how it works.
Of global importance
Libor is the rate at which members of the British Bankers Association agree to lend to each other. They decide this every morning and set the rate at 11am every day, releasing it to more than 300,000 screens in markets around the world just before noon. Libor is hugely important to the world economy.
Technically, a panel of at least eight main contributor banks set the rate by taking their own suggested lending prices, discard-ing the upper and lower quartiles and averaging the middle 50%.
Therefore Libor is, in effect, the view of Britain’s banking industry as a whole. It reflects what the banks’ own economists think is going to happen to the Bank of England base rate when the Monetary Policy Committee (MPC) next meets.
If banks believe the MPC will up the rate, they up the price they will lend to each other. If they think the MPC will lower the rate they will lend to each other more cheaply. In periods of stability, as we have seen for much of this year, Libor has closely or exactly matched the base rate, fluctuating less than 0.1 of 1% above or below the base rate. But if Libor gets 0.25% out of line, it is likely the MPC will be about to change the base rate by the same amount. The banks rarely get it wrong.
It is true Libor gets less publicity than the base rate. You won’t find it published in most newspapers. This is often cited as an excuse for shying away from Libor mortgages, but the reality is most borrowers wouldn’t be able to tell you the base rate on any given day either. They pay attention when it moves up or down and their mortgage rates change, but few imprint the base rate on their memory. Libor-linked mortgage customers are the same.
Libor-linked mortgages took off in the UK a decade ago when Kensington launching into the non-conforming market.
Mortgage lending linked to the rate that major banks would lend at was an idea that had worked for years in the US and was imported here at this time. With sub-prime lenders borrowing money to fund the mortgages at Libor, there was a comfortable logic in linking their lending rates to it too. The mortgage provider knew what profit it was going to make on the money it had borrowed.
From the lender’s perspective, linking the mortgage to Libor provides other benefits. Once a lender has lent the money it has borrowed, it may need to securitise its mortgages in order to free itself up to lend more. It is likely to securitise at a rate linked to Libor, so having its mortgages linked to Libor too means it can easily calculate its profit.
But the customer’s view is more important. We have seen a radical change to the mortgage market as a whole over recent years with consumer demand leading to more transparency in lending. We are also seeing a significant increase in tracker mortgages of one kind or another.
As an industry, customers are becoming more sophisticated and increasingly demanding. Many want to see what they are buying and how much money lenders are making from them. They are being guided in this by an increasingly knowledgeable and professional mortgage broking community.
At the moment, customers are confident that lending rates are not going to rise. Recent figures from the Council of Mortgage Lenders (CML) show variable rate mortgages outnumber fixed-rate mortgages by something like four to one.
As Libor indicates what the major banks think is going to happen to the Bank of England base rate, when rates are falling, Libor leads the field. Libor will fall first, base rates after and mortgages set at lenders’ standard variable rate (SVR) will follow that. A Libor-linked mortgage holder could benefit from that lead.
That does not mean Libor lenders have changed their target audience. The non-conforming customer is still a significant market for Libor-linked mortgages. People who might otherwise struggle to find a lender ‘ due to a rocky credit history in the past ‘ can usually find someone to help them buy their home ‘ at a price.
For low to medium-adverse risks, rates can be as low as Libor plus two percentage points, sometimes with a discount in the early months. But many specialist sub-prime lenders, such as Southern Pacific Mortgages Limited (SPML) or Mortgages plc, will lend to higher-risk customers and can run to Libor plus 4.5 percentage points.
But Libor lenders have made new friends. We are seeing a boom from customers in the buy-to-let market where the transparency offered by Libor-linked mortgages and the stability they provide are seen as vital. Here, rates can be just one percentage point above Libor.
One added attraction for this group of customers is that most Libor-linked mortgages only change rates quarterly, giving them a stability that helps them plan and manage their properties. Lenders have two reasons for working in this way.
Many are borrowing the money they lend on every three months, tying them to that rate. But even those with access to money on a monthly basis stick to quarterly adjustments to save costs. Those with the business acumen to successfully manage buy-to-let properties appreciate this sort of sensible approach.
There is still a bit of snobbery about Libor mortgages. But there are some double standards there. Some prime lenders will, in public, look down their noses at Libor-linked mortgages, refusing to countenance the notion of offering them to their customers.
Yet many of these prime lenders will buy portfolios of mortgages that include substantial chunks of Libor-linked products from other lenders.
The reality is that most of the major mortgage players are involved, either through sub-prime branded subsidiaries or through portfolios of mortgages they have bought from other lenders.
At the top end ‘ mortgages to housing associations and other registered social landlords ‘ Libor lending is common, giving it an ethical badge of approval too.
The future for Libor mortgages looks rosy. As borrowers and their advisers learn more about Libor-linked mortgages and some of the old prejudices die away, providers will develop an increasing range of Libor-linked products to meet most demands.
There is no reason why we cannot provide Libor-linked mortgages to sit alongside other types of products targeted at mainstream or specialist customers, such as the self-certification market. Libor-linked mortgages are as good an option as any other and have some specific advantages.
The reality is that Libor mortgages are firmly established as part of the portfolio of products advisers and brokers can recommend to their customers. They are transparent and open, cheap and stable. They may suit a range of customers and are especially suitable for non-conforming customers and people with special needs.
They are not bad boys. They live happily as neighbours with other mortgage products and they have a growing respect from householders who have bought with them. In short, if the Libor mortgage is a new kid on the block, it is is a new kid who is here to stay.
Gordon Jolly is manag- ing director of Amber Homeloans
Libor now accounts for more than 20% of all international bank lending.
There is a boom at the moment in the Libor-linked buy-to-let market as it offers stability.
When Libor moves, it usually means the base rate will follow and so will lenders’ SVR.