What drives banks fixed mortgage rates?

Discussion in 'The Switchers' Forum' started by Chimchimney, 1 Jun 2018.

  1. Chimchimney

    Chimchimney Registered User

    How do banks set their fixed rates?

    There were reports in the media this week of Irish bank bond yields rising due to contagion from Italian political issues. I think this is because the spread of the banks bond yields above the risk-free rate has risen. Could a rise in irish bank bond yields lead to banks hiking their fixed rates?

    I know the breakage fees can be calculated by reference to cost of funds i.e. inter-bank swap rates as discussed on a bunch of threads on askaboutmoney. I understand that where a bank has a good credit rating the bid-offer spread around interbank rates (euribor) should be small. I'm not sure if this means that pure interbank swap rates are the key driver of fixed rates and irish bank spreads are a red herring.

    Apologies if this has been discussed in the past. I searched but didn't find anything.
  2. RedOnion

    RedOnion Frequent Poster

    Competition. Pure and simple.
    Sarenco likes this.
  3. moneymakeover

    moneymakeover Frequent Poster

    As well as competition presuming the banks can borrow at 0.5% over 5 years
    They can comfortably offer 5 year fixed of 3%
    I also presume banks all borrow from same place ie ECB
  4. Brendan Burgess

    Brendan Burgess Founder

    Last edited: 3 Jun 2018
    Hi Chim

    A very good question.

    The lack of competition means that Irish banks can charge rates much higher than they should be charging.

    In theory, banks should set all their mortgage rates based on the cost of funds and other costs.

    The cost of 10 year money is much higher than demand money, so fixed rates should be much higher than variable rates.

    But look at Bank of Ireland for 90% mortgages:
    1 to 5 year: 3%
    10 years 3.5%
    Variable: 4.5%

    1 to 5 year fixed any LTV - 3.2% to 3.3%
    7 year fixed any LTV : 3.5%
    Variable <90%: 3.15%
    Variable< 50%: 2.75%

    So AIB's fixed rates are higher than the variable, as I think they should be.
    BoI's are lower which makes no sense to me, except that they can.

    Why does AIB charge different LTV rates for variable rate mortgages, but the same fixed rates for all LTVs?

    Why do they charge existing customers higher fixed rates than new customers?

    There are other such anomalies elsewhere.

    So the banks set the rates at what they can get away with.

    If there were proper competition, I think that the normal relationship between fixed rates and variable rates would return.

    Do banks actually fix their cost of funding?

    If Bank of Ireland issues €1b in 10 year mortgages fixed at 3.5%, so they actually do interest rate swaps to lock in the profit?

    I suspect that they don't. One banker explained to me that, in effect, all the banks have a source of almost free funding fixed at 0%, i.e. current accounts.

    Last edited: 3 Jun 2018
  5. RedOnion

    RedOnion Frequent Poster

    Last edited: 3 Jun 2018
    The banks all hedge their fixed rates. So they either borrow fixed, or enter a fixed rate swap. They'll have notes in the annual reports about derivatives and hedge accounting if you ever need material to help you sleep...

    The banks don't hedge each individual mortgage, but will do it in tranches. A very obvious one is UB. Their 4 year fixed is always for a little more than 4 years. They estimate how much they expect to fix, then lock in their rate up front for 80 or 90% of estimate. The mortgages will draw down / fix over a period of 4 or 5 months, and then UB will do a balancing hedge to fix the remainder, and roll out their next tranche.
    Last edited: 3 Jun 2018
  6. Brendan Burgess

    Brendan Burgess Founder

    Does that explain any of the bizarre pricing in the market at the moment?

    If BoI fixed €1 billion for 10 years and lends €1 billion for 10 years.

    What happens if the borrowers break out early and pay no penalty because fixed mortgage rates have fallen?

    BoI is stuck with its fixed funding. But as long as it still is charging a huge margin, it will still make big profits.

  7. RedOnion

    RedOnion Frequent Poster

    No. It's purely competition that drives pricing. Cost of funds determines minimum pricing, but competition, or lack of, allows margins to be higher.
    There is a small element of dysfunction at play in that a lot of funds are being borrowed at 0%, when the market rate is minus 0.4 for overnight money. So technically banks can fund 2 year for the same price as variable.

    The changed pricing in this case would be BoU having a lower profit on their new lending. So they are just getting a lower profit on the mortgage the customer refixes.

    If there's no break fee to customer, it's because BoI can break the swap with no fee. Banks regularly do adjust swaps to be more closely aligned to the assets. If not, they can account for them as hedges and they are effectively running positions in the market.
  8. Jim2007

    Jim2007 Frequent Poster

    And that is the reason I would never ever invest in an Irish bank - their inability to correctly structure a mortgage product. They got hammered the last time around for failing to match long term borrowing with long term funds and they learned nothing from it.
    cremeegg likes this.