There can be few mortgage practitioners who have not been affected by the near daily withdrawal and re-pricing of fixed rate deals since mid-July when, with little warning, swap rates lengthened by approximately 50 basis points, but why has this happened, and why has it caused rates to fluctuate so much?
Whenever a lender decides to offer a fixed rate mortgage it runs the risk that the cost of money will rise. If this happens it may well have to uplift the rates on interest it pays to savers because if it does not they might withdraw their cash deposit. Given that the lender cannot increase the income it receives on fixed rate mortgages it is clear that it has a pricing risk to overcome. A lender may solve this by approaching other institutions for an interest rate ‘swap’. This is simply an agreement whereby the lender will pass to the institution or bank the fixed interest rate payments it receives from borrowers and will receive back floating rates similar to that which it pays depositors. In this way, even if interest rates change the interest receivable matches that payable. An in-depth understanding of how these markets work will allow brokers to be more nimble footed in the future.
A good example of how and why rates move occurred in July 2003. In this instance a series of events combined to drive up rates. The initial upward pressure on rates could be sourced to the US market where equity traders began to sell bonds as a result of long term fixed rate mortgages increasing by over 1%. At the same time, many UK and EU companies looking to raise finance were beginning to return to the equity markets by way of rights issues. Both of these developments kick-started a rise in swap rates which was boosted further in August by the Monetary Policy Committee’s (MPC) decision to keep the base rate at 3.5% due to buoyant retail sales in July and evidence that much of the housing market was in fact cooling.
All of which illustrates that the cost of fixed rate mortgages at any one time can be manipulated by a whole series of macro and micro-economic factors. The old adage about New York sneezing and London getting a head cold has never been truer. Global events and economic well-being really do matter, but closer to home there is also a raft of UK Plc financial indices which can affect the market including retail spending patterns, inflation management – a topical issue given the EU measures being prescribed – factory output statistics, and unemployment data.
Added to this are two very meaningful drivers of pricing. First, the actual demand and supply of money. As with any commodity an oversupply will depress values and in the present market the opposite applies. Second, there is the matter of confidence. The levels of confidence that lenders and borrowers operate with in the wholesale market are detailed later, but there are now conflicting opinions among leading economists as to what direction base rates move in over the remainder of this year, which will obviously affect confidence.
Getting back to the lenders, one of the greatest vagaries of the UK mortgage market is that there are hundreds of providers of mortgage products, and to Gordon Brown’s chagrin the vast majority of these will continue to place significant proportions of their products in the two to five year fixed rate market. Such a diverse lender population means that fixed rate products are resourced and costed in different ways. Tranche sizes range from £10m for the smaller mutual lenders up to parcels of debt in excess of £100m for the mainstream operators.
One example is GMAC RFC, which lent £3.3bn last year, and with a wealthy US parent is better placed than most to acquire funds at a competitive cost. Most of its fixed rate business is on two year products upon which many lenders still opt not to hedge, alternatively choosing to fund in relation to base rate rather than the swaps market. Peter Stimson, head of product development at GMAC, comments: “As we portfolio-sale our loans we have to price fixed rates in a loose relationship to the margins lenders would expect for these assets.”
Like many lenders, GMAC RFC will price its products with various factors in mind, including: annual lending targets and profitability targets, what the competition is doing (see below, the overall ‘mix’ or ‘blend’ of asset obtainable (crucial for portfolio sales), the swap rates applying at the time and the costs of processing and/or distribution.
One of GMAC’S most prominent competitors is BM Solutions whose emergence in non-prime classes is partly attributed to the way in which it funds its own fixed rate products.
Being part of the HBOS group means that it has a 26% market share which obviously helps in terms of funding but what is interesting is the role that its branches and postal accounts play in its ability to be competitive on price. Steve Sandiford, head of product strategy at BM Solutions, says: “The recent volatility in the wholesale markets affected most lenders although those who fund solely from the wholesale market were most vulnerable. BM Solutions funds through a combination of wholesale funds and savers’ deposits which allows for a healthy stream of funding but at rates which can not be inordinately influenced by the money markets.”
But what are the implications for intermediaries who have to maintain their own profitability on occasions such as July’s market movements, and explain to would-be borrowers why their Halifax or Nationwide five year rate is now ‘x’% more expensive?
Certain lenders have recently withdrawn products with less than 48 hours warning, with some notifications representing what could be termed ‘constructive closure’ – when the lender needs a fully packaged paper application or on-line submission at its head office by close of business that day. Thankfully most lenders who take intermediary business seriously will allow a window of at least three to five days during which time a ‘reservation list’ of applications can secure a tranche of mortgages. Portman Building Society, Mortgage Express and Bank of Ireland are time honoured subscribers to this code of practice.
As any broker will vouchsafe, having to switch a borrower to a substitute lender can be pretty painstaking. Not because of the renewed paperwork (which can be minimal in most cases) but because of the awkward explanations which have to be given to the client particularly if the replacement product is inferior. Therefore, in a market such as this it is recommended that conscientious brokers should adhere to the following best practices:
• Be mindful of your lender’s track record when leading products have been withdrawn in the past.
• If swap rates are volatile, tell your client that. We are not dealing with nuclear physics and if a layman’s outline of what drives pricing can be given it will ‘professionalise’ you in your client’s eyes.
• Make a point of checking swap prices each day in the Financial Times or on any one of various financial websites, which carry this information and record this on a board in the office, which will then profile the trend.
• Lastly, and at the risk of sounding puerile, use a courier service to ensure that the 24-hour notice product withdrawals are overcome. Clients really appreciate both excellent service and a rate which you can then tell them is no longer available in the market.
This way up
Looking at where interest rates are heading for the remainder of this year, it is interesting to note that even after the recent hiatus swap rates almost immediately made back 20 basis points of the 50 that were lost. So even sharp short-term movements can be partly reversed very quickly.
That said, of 32 economists recently polled by Bloomberg 72% felt that the next move would be up. And of the major investment banks that have predicted interest rate movements only Deutsche Bank have predicted a year end base rate at 3% with most forecasting that the base rate will be at 4% or higher by the end of 2004.
Moving into a period when statutory regulation costs will impact on lenders’ margins, it is ironic that if commentators are proved right their forecasts will hold some compensation for lenders because as rates rise, the returns they enjoy on their free reserves will do likewise. For the intermediary a base rate of 4% in a historical context still gives us plenty of room to make money in a £220bn marketplace.
Market sentiment and macro-economic factors can influence swap rates, exposing them to world events.
Changes in swap rates can very quickly lead to lenders ‘pulling’ products.
Keeping abreast of the money markets is a good way of second-guessing when a product may be withdrawn.