Ronan Lyons "Ban Variable Rate Mortgages"

Ronan Lyons has made a number of suggestions on the housing market, but I want to focus on just one of them which doesn't seem to have been challenged. It's an interesting idea but it needs to be teased out.

Ban variable rate mortgages

My final suggestion is more controversial. It’s that we should ban variable rate mortgages. Much as it may surprise Irish readers, used to variable rate mortgages because Ireland had no idea what its inflation rate would be from one year to the next, many countries in the world have mortgages where the interest rate is fixed for the lifetime of the mortgage. In the US, the very concept of an “adjustable rate mortgage” was an early-2000s financial innovation that is now viewed in the same light as sub-prime mortgages and CDOs.


Having variable rate mortgages exposes the borrower, obviously, to the risk of higher interest rates and thus to the risk of cashflow problems. A fixed rate mortgage has the substantial benefit of providing certainty of expenditure to the borrower. It also focuses the lender’s mind at the outset about its own costs of borrowing. And there is also a wider economic justification. Ireland no longer sets its own interest rate. As a result, when the country needs stimulus, the rate can be too high, prolonging recession.


Banning variable-rate mortgages closes down one channel through which interest rates set in Frankfurt can bring about recession in Ireland, as households would no longer face cashflow constraints when ECB rates rise.
Again, by bringing in this change in the middle of the “post-storm eerie calm”, the Government can help the market find its new floor. If I know that not only do I have to save up a 10% deposit but also that I must allow for a 7% interest rate on my mortgage, my house purchase and monthly budgets are suddenly an awful lot clearer. Conversely, trying to do this after a new equilibrium has emerged in the property market would be very tricky, as it would almost certainly push house prices down further.

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Presumably there is some theoretical or comparative basis for this? I think that Germany and France does long-term fixed rate mortgages. How do they work in practice? I remember trying to find out some years ago why German long-term rates seemed very cheap compared to Irish fixed rates, but I never managed to find out why.

In general, I don't like fixed rate mortgages.

As a point of principle, I am opposed to long-term inflexible financial arrangements between financial institutions and consumers. Most people can't plan their lives 3 years ahead, never mind 30 years ahead. Circumstances change. People want to pay off their mortgage quicker. People can't afford their repayments and need to reschedule. People want to move house.

Long-term fixed interest rates tend to be higher than short-term rates. So this proposal would mean that most borrowers would end up paying more. If the government thinks that it's a good idea for borrowers to pay more to keep house prices stable, then this could be achieved by charging a tax on mortgage interest. (I am not proposing this but it would be better than paying the increased cost to the lender).

30 year interest rates are less volatile than standard variable rates. But they do still rise and fall. What happens if I am a first time buyer when the 30 year interest rate is at its high point? Am I committed to paying a very high rate for best part of my life? I won't mind if I am buying when long-term rates are low.

I find it very hard to see how long-term fixed rates would work in practice. The average duration of a mortgage used to be 7 years. Before the 30 years was up, people would have traded up, switched or repaid their mortgages.

I suppose we could deal with trading up easily enough. If a person has a 30 year fixed rate mortgage, they would have to be allowed to transfer the mortgage to the new property.

Switching would be a problem. If someone fixed when long-term fixed rates were high, would they be allowed to switch at no penalty to a cheaper mortgage? How could the lender plan for this? They would have to up the rates to allow for it. I just don't see how it works.

Early repayment would face the same problem. There would have to be a penalty for paying off an expensive fixed rate mortgage early.

There is nothing to stop an Irish lender offering 30 year fixed rates at the moment, except that there is no demand for them. Some lenders have offered 10 year fixed rates, but there has been very little take-up of them either.

So would fixed rates help moderate the volatility in property prices?

A number of factors contributed to the house price bubble
The low interest rates
The high loan to salary ratios
The high loan to value ratios

It seems that the loan to salary and loan to value ratios are much easier to restrict (and relax) and would have a much greater impact on house prices.

The Central Bank could increase the stress testing during a time of low interest rates which would achieve some of the intended objective of long term fixed rates.

Interest rates are used to stimulate and cool down the economy and inflation.

If we are stuck in a high long term interest rate environment, the housing market might be dead for a long time. This might not be a problem now in that we have a massive overhang of housing stock. But at some later stage, we may need to start building again.

Kathleen Barrington describes a variant of this in the [broken link removed]

The system is based on the so called Principle of Balance.

This means that when the borrower obtains a mortgage loan, the mortgage credit institution issues the corresponding number of bonds in an open bond series. These mortgage bonds are attractive to investors such as pension funds as there has never been a default.

The borrower can refinance the loan at par (face value) if rates fall.

But if rates rise, the borrower can buy the bonds corresponding to his or her loan at a discount, and present them to the credit institution to repay the mortgage.

This feature has several important benefits. It allows an automatic reduction in the size of loans when interest rates rise and reduces the probability of negative equity, Lea argues.

Lea points out that Danish borrowers exercised this option in significant numbers in 2006 and 2007 when interest rates were rising, which may have reduced the likelihood of negative equity when house prices fell in 2008 and 2009.

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This seems to be creating a relationship between house prices and interest rates. I don't fully understand how this works: "The borrower can refinance the loan at par (face value) if rates fall."

If interest rates fall, I can switch. And if interest rates rise, I can repay a lower amount by switching to a higher rate loan.

I wouldn't like to buy a bond at a fixed rate if I knew that the issuer could simply cancel it if interest rates fell.

There must be something missing from this description.

More on the Danish Model here.

I'm aware that the Danish model is based on matching investors and borrowers in a quasi bond arrangement.

I'm not sure how the borrower can refinance at par though. If a bond investor is getting 4% on a 25 year €300,000 bond, how can the borrower redeem the bond and how does that investor keep getting his 4% (and if he or she doesn't then why would they bother investing in the first place)?

It seems to be the holy grail though - No bubbles and mimimal defaults.

One downside though is that forbearance appears to go out the window. A deliquent borrower seemingly has to be turfed out promptly for the system to work.

There are several issues apart from the structural/operational 'matching borrowers with bond finance' ones mentioned by Gekko (btw: pleased to see ya here Gekko!).

The way that Irish banks offer fixed rates is often via a swap, that is why they are able to penalize you if you break it - because their swap obligation remains in place; so they close it out with their counterparty via the penalty.

Fixed rates offer good one way protection - when rates are moving up, but personally, I think that there are many households who would be in arrears right now if it were not for the downward movement in rates that came in 2008. Otherwise the increased level of taxes and wage cuts would have made their debt servicing impossible, that isn't to say it won't happen now if rates go into a strong upward trend.

One argument that Ronan put forward on The Last Word (I didn't get a recording of it unfortunately), was that people are not able to deal with complexity in the mortgage market, personally I don't accept this at all.

My counter suggestion would be that banks should have whatever rates they want, but split the risk appropriately and let them price for it.

If you have a 90,000 loan on a 100,000 purchase then just make it that the first 75,000 is at a premier rate, and that over 75% (75k in this example) you have to finance it via a 2nd lien which can't be held against the person, only the asset.

The 2nd would charge a higher rate, but at the same time it protects the person in case of default with negative equity to a small degree, their equity is wiped out first (10%) then the 2nd lien (15%).

That would be a more appropriate alignment of incentives and pricing, mandatory fixed rates don't change the structure or manner of financing, they only give a set price for the future, which as mentioned earlier isn't a general solution

New York Fed also wrote an interesting paper 'why aren't more people on adjustable rate mortgages' - well worth a read. The lower default in people with fixed rates isn't just a factor of the rate it seems.

there are many households who would be in arrears right now if it were not for the downward movement in rates that came in 2008.

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Given the high level of unemployment and the high level of borrowing, the arrears level in Ireland is surprisingly low. The reason is the very low margins at the peak of the market combined with a very low ECB rate.

However, the counterargument would be that if rates had been higher in 2006 and 2007, the bubble would have been less pronounced so borrowings would now be a lot lower.

Do you have a link to that New York Fed paper? I have looked for it but can't find it on their website.

If the government thinks that it's a good idea for borrowers to pay more to keep house prices stable, then this could be achieved by charging a tax on mortgage interest. (I am not proposing this but it would be better than paying the increased cost to the lender).

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Just revisiting this idea. The proposal seems to be that higher interest rates are good for us because they prevent a housing bubble.

But we are doing the opposite in Ireland by giving tax relief to borrowers. Maybe the government should have a much more flexible approach. When the housing market is overheated, abolish TRS and charge a tax on mortgage interest. When the housing market needs a boost reintroduce TRS to effectively lower mortgage rates.

In recent years the Department of Finance advised the government to operate a counter-cyclical economic policy but the government ignored this advice. A government would find it very difficult to tax mortgage interest even if it was for the long-term good.

sorry, I got the name of the paper wrong!

http://www.newyorkfed.org/research/current_issues/ci16-8.pdf

As an aside, having fixed rates doesn't prevent bubbles, what happens often is that areas with high levels of development potential attracting new buyers who want property (in the US think California, Florida, Las Vegas) are often bought up by buyers that cannot afford the more established (think New England/ east coast) prices, and they tend to use whatever method of financing is cheapest - so you get the sub-prime & ARM mix.

The biggest chunk of ARM in the USA was (as a percentage of loans) in the early 90's so it wasn't some 'new invention' of the last decade, perhaps it was more 're-invented'.

New York has predominantly fixed rate mortgages and their prices tanked, the dynamics of booms and busts have more to do with land/development rather than being a product of finance prices alone - finance does have a role but it is not the genesis alone.

Thanks Karl

I scanned that and the main thing seems to be that borrowers take out fixed rate mortgages when the rates are low and variable rate mortgages when the rates are high.

What I don't understand is that if the borrower has a right to surrender a fixed rate mortgage without penalty, how do the lenders price that?

If you asked me to lend you €100k at a variable rate or at a fixed rate of x% I would charge a huge premium on the fixed rate to compensate me for the fact that you have a right to surrender the mortgage. It would seem to me that the variable rate would have to be cheaper every time. If rates rise, you will keep your cheap fixed rate mortgage and I lose out through higher funding costs. If rates fall, you will remortgage, but I will probably have prefunded it at the higher rates.

Unless the fixed rate mortgages are funded by the state in some way and the state takes the risk that interest rates will change.

Brendan

My sense (I could be wrong) is that the fixed rate products available in other countries are very different to those currently offered in Ireland. Would I be correct in saying that they apply a fixed percentage interest rate to the outstanding balance on the mortgage, regardless of what that balance is i.e. there are no early repayment penalties, premiums etc. ?

So if you want to move house, you can pay off the balance of your mortgage without penalty. If your rate is too high and you want to refinance, you find another lender who'll give you a fixed rate mortgage at a lower interest rate and simply discharge the old mortgage with the borrowings from the new lender. With this type of loan, you will probably find that most people would refinance every few years as they could probably get better rates as their LTV improves (as less risk for bank).

The problem with fixed rates in Ireland is that the rates are way too high - banks fleece people - and they are too inflexibile i.e. repayment penalties. (In normal times when solvent) Banks do have the ability to raise money on the markets at a fixed rate with no early repayment penalties, so it is possible for them to develop these products without early repayment obligations.

Does this guy have an idea of who mortgages work from the lenders point of view??? The big problem with mortgages done Irish/UK/ and even many in the USA, is how they are financed - long term financial commitments are being financed from short terms deposits, meaning that banks would end up needing new bail outs if deposit rates were to shift in the wrong direction!

It is true that many countries within the Euro zone do offer long term fixed rates, but the model is different - long term is being matched with long term, most often in the form of pension funds. Having predictable long term cash flows is very important to many European funds as they are now heavily into the pay out phase.

There is also the Swiss model to consider, where when I enquired about a pay back schedule I was told: "Our Mortgages are not designed to be paid back"! Here they split the loan into two parts, the part you intend to pay back (about 35%) and the part you don't (about 65%). From the bank's point of view the part which will be paid back is financed by short term deposits and the part not being paid back is financed by pension funds and the like. Again this only works because long term requirements are being matched with long term requirements.

Jim.

I got this suggestion by email which I thought interesting:



On a practical level borrowers could make payments at a nominal say 6 % rate as a matter of practice – overpay –but most expect the benefit of lower rates and the protection against higher rates –sort of jam on both sides.


Set the repayments at a 30 year loan with a 6% interest rate. So if the interest rate is actually lower, then the borrower is paying off more capital. If the interest rate exceeds 6%, then less capital would be paid off. But the underlying interest charged would be the standard variable rate.

It would be a good replacement for the stress tests - telling people what their actual repayment in cash would be each month.

I don't think that this could be introduced now but it's an interesting idea worth considering when the markets return to normal.

Brendan

Hi all,

Thanks for the discussion here - the idea was suggested on my blog to stimulate discussion and I'm glad it has. (Apologies also that I haven't been able to respond before now.) I won't go through everything point by point but I'll try and explain in some greater detail what I was proposing, taking in along the way hopefully a few of the key points made.

What I was suggesting was a way of changing the default mortgage product offered in Ireland from (what I regard as economically and financially dangerous) variable rate products to fixed rate products. The thought experiment is this: suppose we could choose only between a system with flexible rates and a system with fixed rates, which one would we choose if we were the Minister for Finance? When we were a small country with its own currency, we had very little choice but to have high and volatile interest rates, because our banks couldn't do what good banks should and finance long-term lending with long-term debt.

Now, however, we are a small region within a large economy, effectively like a state within the US. Our circumstances have completely changed and - for unfortunate reasons - we have the opportunity to design whatever banking system we want. I strongly believe we should be aiming to learn from countries like Denmark and have covered mortgage bonds, rather than recreate Celtic Tiger Ireland's mortgage market, with high variable rates when we need them low and low variable rates when we need them high.

Effectively, there are advantages to the State, to borrowers, and principally to lenders from a system where the typical mortgage is fixed not variable:

From the State's point of view, it no longer has to worry about two things. The first is inappropriate interest rates in the eurozone, choking off consumption and economic growth when impetus is needed, and fuelling the economy when it needs to be cooled down. The second is the household debt burden channel, which amplifies this effect when families have variable rate mortgages.

From the point of view of borrowers, fixed rates for the length of the mortgage offer security of household expenditure. This is a more dirigiste argument, which I'm generally against. However, surveys show astonishing financial illiteracy, so we certainly are not in a position to assume that individual households can make optimal decisions. As Brendan said himself, "Most people can't plan their lives 3 years ahead, never mind 30 years ahead." If you accept that point of view, then it's very hard to then make the case that people should be allowed try and outguess financial markets by going variable when times are good in the belief that they'll be able to fix when times are bad.

Lastly, and most importantly from the point of view of the lenders (and the Irish taxpayer), fully covered bonds don't just encourage responsible lending, they effectively require it. For example, Danish banks, if they want to lend €200m in 30-year mortgages this year, have to go off on to the financial markets and issue a 30-year bond for €200m, which has a fixed interest rate (regardless of who sells it on later for how much). This rate determines the rate on the mortgage, meaning banks are not speculators, they are intermediaries linking consumers to sustainable mortgage finance. Clearly, as was pointed out, banks will be expecting the typical household to move once or twice over the course of the mortgage. The simple solution - which is actually already done by banks, who have to price in repayments - is to price this in, which is reflected in a capped margin between bond market and mortgage-holder rates and means there can be no case for banks to argue that they require large penalty fees.

Such a system has proven extremely resilient in Denmark and means Ireland's taxpayers would rest easy knowing that they never ever have to bail out their banks again, while also guaranteeing security of outgoings but preserving the obvious flexibility required by modern households.

The principal other arguments in this thread appear to be around how Irish banks do business now. We need to change the system anyway (no-one is arguing that the current state of the banks is healthy, presumably) and we control almost all the banks operating in the State, so they are certainly criticisms of how such a system may have worked 2000-2010 but I would hope they will become obsolete in the next year or two.

I should make clear that I am not claiming this would be a panacea preventing future housing bubbles. Denmark has had its house price up and downs over the two centuries it has operated this system... but it has never had a systemic collapse in its banks. However, with a few other relatively straightforward policy decisions, this would definitely minimise the chance that Ireland ever again faces anything like the lunacy that we've had in the property and mortgage markets over the past decade.

Effectively, there are advantages to the State, to borrowers, and principally to lenders from a system where the typical mortgage is fixed not variable:

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Surely there are disadvantages as well as advantages? This is a problem I have with a lot of proposals. The advantages are listed, but the disadvantages are not dealt with in any detail. At the end of the day, whether long term fixed rates are suitable for borrowers will be a balanced decision after weighing up the pros and cons

There is no restriction at all on lenders to offer these products in Ireland, so I assume that there is no advantage to them in doing so. In particular, if a borrower could exit a fixed rate without penalty, it could not be to the advantage of lenders.

"Most people can't plan their lives 3 years ahead, never mind 30 years ahead." If you accept that point of view, then it's very hard to then make the case that people should be allowed try and outguess financial markets by going variable when times are good in the belief that they'll be able to fix when times are bad.

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I don’t think that anyone is making that argument?

fully covered bonds don't just encourage responsible lending, they effectively require it.

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Surely we can impose responsible lending in other ways through a maximum LTV of 80% and a maximum salary multiple of 3?

You seem to be suggesting that if we charge people higher mortgage rates, they won’t go mad and create a bubble. Wouldn’t it be easier to impose a substantial tax on mortgage interest to achieve the same effect and a huge stream of income for the government? When rates rise, the tax could be lowered. And when they get very high, they could be subsidised.

Clearly, as was pointed out, banks will be expecting the typical household to move once or twice over the course of the mortgage. The simple solution - which is actually already done by banks, who have to price in repayments - is to price this in, which is reflected in a capped margin between bond market and mortgage-holder rates and means there can be no case for banks to argue that they require large penalty fees.

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I don’t really understand this. I am suspicious of financial wizardry that allows a borrower to fix their rate but yet switch the mortgage if rates fall, at no apparent cost to anyone. OK, the banks may not benefit or lose if they are simply intermediaries, but then the bondholders will suffer. Why would I use my cash to buy a bond at a fixed rate of 4% if I knew that the seller of the bond, the mortgage holder, could exit it at any time if rates went against him?

Such a system has proven extremely resilient in Denmark and means Ireland's taxpayers would rest easy knowing that they never ever have to bail out their banks again, while also guaranteeing security of outgoings but preserving the obvious flexibility required by modern households.

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The state is not bailing out the banks due to mortgage defaults? Mortgage defaults are going to be a very small part of the overall cost. We are bailing out the banks due to losses on residential and commercial property development. Wasn’t most of the housing boom caused by an oversupply of credit, rather than cheap interest rates? The rates during the property boom were much higher than now and probably at around what you would expect the long term fixed interest rate to be.

Overall, I think a simpler solution to achieve what Ronan is trying to achieve is to tell borrowers that their repayments must equaly 7% of the loan each year.

Brendan Burgess said:

Overall, I think a simpler solution to achieve what Ronan is trying to achieve is to tell borrowers that their repayments must equaly 7% of the loan each year.

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So that would imply that there is a way to go before house prices came down sufficiently for affordabity tests to meet that kind of payment.

Also how does one arbitrate between financial institutions as to what the "7%" is in each institution and how they can compete with each other if they are all at 7%?