The correlation between mortgage rates and the repo rate has decreased due to the higher funding costs banks have faced since the 2008 international financial crisis. Tighter new regulations, which Swedbank has welcomed, further increase the cost of a mortgage for both the bank and for customers.
A debate is under way in the media on how banks set their lending rates and how large their margins are on mortgages, for example. A lot of attention has been drawn to the fact that the interest rates customers pay on their mortgages are not always lowered when the Riksbank cuts its repo rate. It has also been said that mortgage rates generally seem higher in relation to both the repo rate and the interbank rate (STIBOR) now than before the financial crisis.
Banks’ total funding costs have increased more than the repo rate
The diagram, see link in the margin, shows that the three-month Stockholm Interbank Offered Rate (STIBOR), the rate at which a well-managed bank can obtain short-term deposits from other banks in the interbank market, was slightly above the Riksbank’s repo rate, which is a day-to-day rate, until mid-2007. After that the difference between the repo rate and STIBOR rose due to growing suspicions between banks in connection with the subprime crisis in the US and widened during the 2008 global financial crisis. A bank can never fund its lending in the Riksbank and in the long run not in the interbank market either. On the other hand, until the financial crisis in 2008 it could issue bonds – covered or unsecured – at interest rates largely corresponding to STIBOR. But after STIBOR gradually climbed above the repo rate, the cost of market funding – a bank’s actual funding cost – rose faster than the repo rate until the financial crisis culminated in autumn 2008.
Swedbank funds its lending primarily through covered bonds
Since 2009 the large percentage of mortgages granted by the banks must be funded by issuing covered bonds. They are in themselves a beneficial and efficient form of refinancing for banks that can use them, since they give the banks’ own lenders access to the collateral that the banks receive from mortgage borrowers. As evident in the diagram, this has not prevented the cost of covered bonds to remain at a higher rate than STIBOR since the financial crisis in 2008. As a consequence, the banks’ funding costs fell significantly less in 2009 than interest rates in general and have since remained above STIBOR. This also means that a change in the repo rate has only a limited effect on the banks’ funding cost and hence on the mortgage rates they charge.
One reason for this is that covered bond investors require the banks to post collateral for their funding in excess of the loan amount (so-called over-collateralisation). This protects them against the risk that the collateral will be insufficient if housing prices fall substantially.
In its report, the Riksbank confirms that the banks are not funding their lending at a cost that corresponds to the repo rate
The diagram, see link in the margin, is similar to the one published twice a year in the Riksbank’s Financial Stability Report. In its autumn 2011 report, the Riksbank states: “A common misconception is that the banks borrow money at a cost equivalent to the repo rate. The chart shows, however, that additional costs arise when the banks acquire funding. To fund mortgages, the banks usually issue covered bonds at a fixed rate and with a maturity of up to five years. This led to an increase in the cost of funding a mortgage compared to the interbank rate. The red, yellow and grey fields have thus together contributed to an increase in the banks’ total funding costs.”
Deposits help to keep mortgage rates down
The blue field in the diagram shows the bank’s gross margin
The upper blue field in the diagram represents Swedbank’s gross margin on mortgages. This field shows the difference between the average interest rate on three-month mortgages that the bank charges borrowers and its funding cost based on covered bonds, deposits and senior unsecured funding. The diagram shows how the margin, which was well over one per cent in the early 2000s, gradually decreased until the financial crisis. The gross margin was nearly nil during the financial crisis, but has increased again since they bank has been able to normalise its funding terms. From summer 2009 to summer 2011, when the funding markets were generally working normally, the average gross margin fluctuated between approximately 0.3 and 0.5 per cent.
Tighter new regulations are increasing costs for banks and for customers
In recent years a number of tighter regulations have been discussed and introduced for banks, which we welcomed and feel are a prerequisite for creating a more stable financial sector in the future. The biggest effect on costs is expected to come from the new liquidity rules. They require a bank to ensure that it can continuously fund a long-term mortgage portfolio even if its ability to raise new refinancing loans is closed for shorter or longer periods, as was the case during the financial crisis. This cost of liquidity protection can at times amount to 0.5 per cent, but in normal market conditions is closer to 0.2–0.3 per cent. This cost must be covered by the bank’s gross margin on mortgages. The bank must also expect that some borrowers, despite careful credit checks, cannot fully pay the interest and principal on their mortgages.
The bank must also expect that some borrowers, despite careful credit checks, cannot fully pay the interest and principal on their mortgages. The bank estimates that credit impairments over time will amount to three hundreds of a per cent (3 bp). According to current capital adequacy rules, the bank must at the same time maintain risk-bearing capital, mainly shareholders’ equity, as protection against unforeseen credit impairments. Given the lowest required return on shareholders’ equity and these increasingly tighter rules, this capital adequacy cost has risen from approximately 3 bp before 2008 to 13 bp at present. These credit impairments and capital adequacy costs, totalling approximately 16 bp, must be covered by the bank’s gross margin on mortgages.
Lastly, we expect our expenses to manage a mortgage portfolio of well over SEK 700bn “from start to finish” at approximately SEK 2.2bn (including a portion of the Treasury department’s costs to manage funding operations). This corresponds to approximately 30 bp or approximatetely 20 per cent of the total expenses of the Swedish retail operations. These expenses must also be covered by the bank’s gross margin on mortgages.
Our calculations show that the gross margin on a normal mortgage – calculated as the difference between the bank’s actual funding cost and the lending rate charged to the customer – must be at least 0.65 per cent to cover the bank’s costs for the mortgage operations and at least 0.75 per cent to also cover our shareholders’ return on the bank’s equity. As a product, mortgages have not been profitable for Swedish banks for long periods of time. This is because the net margin has been negative after factoring in expenses for liquidity, credit impairments, administration and costs related to our shareholders’ required return. Mortgages have instead been used as a door opener to other types of business with the customer.