The Financial Regulator, Matthew Elderfield, received a clamour of popular support recently when he publicly objected to the Irish domestic banks planned decision not to decrease variable mortgage rates in response to the ECB cut in interest rates. The political establishment was warmly enthusiastic for Elderfield’s intervention. The government used its shareholding and political muscle to ensure that the banks’ decisions were reversed. The government also offered to provide the financial regulator with legislative power to determine banks’ mortgage rates. Wiser heads within the Central Bank prevailed, and the government was told by the Central Bank “thanks, but no thanks” for the offer of new legal power to set retail mortgage rates.
Despite the uniformly warm response to Elderfield’s intervention in the popular media, there was some unease expressed by columnists in the business press (e.g., Ronan Lyons in last week’s Sunday Business Post). I share Lyons’ view that Elderfield’s analysis was flawed. The instability of liquidity funding in the Euro currency system changes the nature of variable-rate mortgages. In the classical view, the fair price on a variable rate mortgage depends only upon the short-term funding cost of the bank:
Fair rate on a variable rate mortgage = short-term bank funding cost
where this cost is taken to include bank expenses and its cost of risk capital.
This classical model does not work in the Euro currency system, where liquidity shocks, real or rumoured, can cause massive liquidity drains from individual national economies, simultaneously affecting both the national banking sector and national sovereign. Paul DeGrauwe has a good discussion of the mechanism giving unstable liquidity flows within the Euro monetary system. Most economists now understand the basic instability of liquidity flows in the Eurozone, at least most economists outside the rarefied atmosphere of Frankfurt. Those who do not should read DeGrauwe’s clear and simple explication.
Irish banks, realizing that they are lending into a small vulnerable country within the Euro monetary system, need to rethink the risk modelling and pricing of variable rate mortgages. The classic view shown above requires guaranteed future access to short-term market funding. The Irish banks know that if there are future liquidity drains from Ireland, the Irish banks and their customers will be locked into existing variable rate mortgages. This means that a variable rate mortgage has a higher fair-value rate
Fair rate on a variable rate mortgage = short-term bank funding cost + cost of 30-year commitment to continued funding.
The ECB does provide “emergency liquidity” to banks, and accepts mortgage assets as collateral. However it has made clear that this is a short-term emergency measure, and subject to sudden withdrawal at its whim. So, for example, the ECB has made clear that if the Irish government does not stick with the agreed programme (such as by not paying back fully on private sector bank bonds) liquidity support for Irish banks will be withdrawn at short notice. So the Irish banks have plentiful ECB liquidity support over the immediate term, but it is a very risky and unreliable long-term funding source.
I suspect that the liquidity cost of variable rate mortgages in Ireland is so high that this market is now in a corner solution. The risk-adjusted profit maximizing supply of new variable rate mortgages in Ireland is zero. The observed number of new mortgages is just zero plus noise (using the loosey-goosey “noise” concept of Fisher Black). It is not clear if this will change next year, but perhaps it may not.