Variable-rate Mortgages, Liquidity Funding, and the Euro

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.

24 thoughts on “Variable-rate Mortgages, Liquidity Funding, and the Euro”

  1. @Gregory Connor

    “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.”

    What would be the consequences of that? Can the ECB really live with those consequences or is it just a bluff?

  2. @PR Guy – It may be a bluff but from the perspective of an Irish bank management team, it is still a risk factor of considerable import. If Noonan gets into a spat with the ECB, the ECB can literally close down the Irish banks by shutting off their liquidity support on a whim. Yes it is a bluff but difficult to ignore from the perspective of an individual bank’s risk management.

  3. If the Irish banks got off their asses, and produced extra info on their loan books – funding costs would be more realistic. Funders are still unsure as to whether banks have liquidity or solvency issues – and quality information is key.

    Detailed breakdown of remaining LTV (with valuation info) per ‘book’ is needed.

    Yes this means something akin to the effort required for securitization, but this is needed. No longer can we have amorphous opaque banks….information is key, and yes it will cost tens of millions to produce, but without it everyone will pay dearly for the confusion. MIS within Irish banks remains wholly inadequate, and the day of ‘seat of the pants’ ‘thumb in the air’ decisions should be long since past….however it is not…and there’s a (substantial) risk premium attached to mere liquidity.

  4. so if its a bluff hen its a bluff. if its a risk factor, then what % likelihood
    “the ECB can literally close down the Irish banks by shutting off their liquidity support on a whim. ”
    I wasnt aware General Westmoreland was in charge of the ECB…”to save the euro banking system we had to destroy it”

  5. This seems to me to be an effort to model a deeply dysfunctional and highly politicised issue and, as such, is flawed.

    The fact of the matter is that if the ECB stop doing their job of providing liquidity to Irish banks, for purely political reasons, then, at the very least, the Irish banking system would collapse. This would probably precipitate a run on the whole European banking system and its ultimate collapse (can you imagine UBI or Spanish cajas being able to survive the collapse of the Irish banking system?).

    Should Irish mortgage customers be required to pay for this political uncertainty? No doubt many economists, reasonable people that they are, would say yes. It is for this reason that I think that economists (e.g. P. Honohan) should be kept far away from the negotiating table.

  6. @Gregory Connor

    If the Irish mortgage customer really needs to pay for the risk of a withdrawal of ELA, they must also have to pay for the risk that the Euro breaks up or that the Irish sovereign defaults.

    To price such risks into mortage lending is clearly ridiculous. Banks must be able to rely on the presence of a central bank, otherwise what is the point of having a central bank?

    If we really cannot rely on the ECB in this way, then we should pre-emptively leave the Euro immediately.

  7. Greg,

    Thanks for another excellent post. While I am basically in agreement, it does seem that standard variable holders are quite vulnerable in a situation where they are in negative equity (and so can’t refinance) and the banks are not competing (via rates) for new business. Do they need some degree of protection?

  8. @Bazza

    Where you are wrong is in assuming that the central bank (ECB, Fed, Bank of England) should ever be required as a source of continuous, ongoing liquidity support of banks in its jurisdiction. That type of support should be in exceptional circumstances, not as a permanent funding source. So even without the dark hints from the ECB about cutting liquidity off, emergency liquidity funding by the ECB is not an appropriate source of long-term mortgage funding in Ireland. I agree though that the Euro monetary system is dysfunctional and needs some deep design changes. Not sure however that the ECB should be looked upon as a source of mortgage funding. LIBOR markets, yes, but the ECB not usually.

  9. @John McHale

    I actually was not trying to take a position in terms of what the variable rate should be. As Bazza says, the current system is dysfunctional. I guess that my only point is that the banks are not making excess risk-adjusted profits on the variable-rate mortgage market. The banks would prefer to shrink rather than grow their outstanding book of mortgages at existing rates, or even at somewhat higher rates. But these mortgages are long-term relationships now, not market-price-dictated contracts, and both the banks and existing customers are locked in. So the banks have to suffer along with their existing customers, holding too-risky mortgage books which they would like to shrink. I am not sure what are the policy implications and I did not mean to imply any, except that Elderfield’s intervention was insufficiently nuanced.

  10. @Gregory

    You say “That type of support should be in exceptional circumstances”, but as long as the Interbank market is dysfunctional we are dealing with exceptional circumstances and it should be possible for Irish banks to rely on the ECB.

    The root cause of a lot of interbank uncertainty is that the ECB failed to push for realistic EZ bank stress tests for too long and also because they have refused to put a floor under sovereign debt, thus fueling risk on the banks’ books. Should Irish mortgage holders be required to pay for that?

    In any case, some banks refusal to pass on rate cuts is not due to the risk of a withdrawal of ELA. It is an effort to recoup losses on other sections of its book and is facilitated by a lack of competition.

  11. “So the banks have to suffer along with their existing customers, holding too-risky mortgage books which they would like to shrink. I am not sure what are the policy implications and I did not mean to imply any, except that Elderfield’s intervention was insufficiently nuanced.”

    But if everything turns out grand it will be grand. The whole situation is incredibly fragile. The banks can’t finance themselves in the market. The banks have been stuffed with money the state doesn’t have as the state is broke. The state cannot pump any more money into the banks. The government is running a massive budget deficit and was stuffed for Anglo and INBS. The banks want to deleverage but nobody wants to buy their assets. And the property market is in freefall with only diligent mortgage customers between the banks and total meltdown.

    What can Elderfield do other than the sorrowful mysteries the rosary ?

  12. @gregory

    Slightly tangentially..

    “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.”

    I have seen that assertion repeated several times. Specifically I have read that “European partners were opposed [to doing otherwise]”.

    I once carried out a very careful study of an organisation in which a guy with a very successful sales background ran part of a financial firm. He wasn’t very good at it because the trait that caused him to be good at sales – trying to charm, leaving people thinking they had got what they were after and not confronting people but preferring a behind their backs approach – was the same trait that resulted in him failing to do the appropriate thing at the appropriate time.

    Figuring out what people want and giving it to them can be a successful strategy but it is not always appropriate. There seems to have been too much of an element of this in Irish policy making and I for one would like to see some actual evidence that will allow an objective assessment of this.

    It is generally true that if you make an error of judgement it is convenient to insist that you had no choice. It seems unlikely that a specific, credible threat could have been made but without a trace of persuasive evidence. If a threat of the type we are talking about were made then it would not be credible if the person making it were challenged to make it in a form that left evidence and that person wimped out. If they were not challenged to do so then that really was a bit remiss. They might not have really meant it.

  13. @grumpy and others

    Many commentators are making the decision-problem that I described, from the perspective of Irish bank management, seem more difficult and complex than it is. Take the perspective of senior management at one of the three remaining Irish banks. The bank can issue new variable rate mortgages at 5%. It knows that these will be funded for the foreseeable future via ECB-provided liquidity support. It knows that the ECB wants to lower its enormous exposure to Irish bank assets. The Irish bank sees no near-term horizon for removing its dependence on this ECB funding support. From the perspective of Irish bank management, does issuing any such mortgages seem a sensible strategy? The bank would need an unattainable premium, one that is not possible due to the constraints from the needs of existing customers. So the optimal solution is zero new mortgages at existing variable rates. Seems a clear and simple best decision.

  14. Excellent post. I think the views of Matthew Elderfield on variable rate mortgages are useful. He raised the issue in a speech delivered in UCC on the 14th of October. Here is the relevant extract.

    The thinking behind the prohibition on charging penalty interest is that banks’ actions should not exacerbate the financial problems of customers in distress. There is something to be said for looking at the treatment of standard variable rate customers from a similar perspective.

    Traditionally, SVRs were understood to adjust in line with competitive market conditions. Current conditions are unusual in several respects. When the interest rate on so much of their mortgage portfolio is fixed at a very modest (tracker) spread over the ECB’s policy rate, some banks have found that even the performing part of their mortgage book as a whole may be unprofitable given their increasing cost of funds in the market.

    The increases in SVRs implemented by some banks may thus be going beyond the traditional passing-through of the cost of funds, instead seeking to make-up for what has proved to be an inadequate spread on trackers.

    The Central Bank does not have the power to set standard variable rates or other interest rates – nor does the government (although as shareholder in many of the domestic banks it does have the opportunity to influence management actions.) However, it may be that these actions are, on balance, self-defeating if they push more customers into arrears, adding to the mortgage arrears problem and ultimately costing more in terms of capital.

    We are looking closely at this issue, and we do have a statutory responsibility so far as it concerns the soundness of banks. Accordingly we have decided to require any bank that has received government capital support to provide an impact analysis of any proposed standard variable rate increase in terms of the implications for its arrears position and future capital requirements, and that the bank’s Board of Directors be required to review and approve this analysis to ensure that proper attention is given to the costs of such actions.

    We informed lenders in February of this year to allow at least 30 days notice to be given in advance of any SVR mortgage rate increases and we are now introducing this as part of the revised Consumer Protection Code. These are admittedly limited actions in light of the absence of direct powers by a public authority concerning rate setting. If the banks continue to act in a way which is so damaging to customers and which appears to take advantage of the current dysfunctional competitive environment, it seems they are courting the risk of a public policy response involving powers to impose direct restrictions on their rate setting capacity by the competition or financial regulatory authorities.

  15. 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.

    Was the motive for the central bank decision one of wiser heads or a well dressed up refusal to take responsibility.

    To my mind there are a number of issues in your post.
    1. Who should set mortgage interest rates and if it is the banks should there be any constraint on them when setting those rates in a normal banking environment and in an abnormal banking environment?
    2. What kind of margin should be expected in a normal banking environment (which we do have at present).
    3. Should the abnormality of current banking environment be used as a basis for setting mortgage margins in the medium term or long term.

    I would argue that
    1. The central bank is shirking its responsibility in not taking some degree of control over mortgage rate setting in what is shaping up to be a duopoly. The central bank of course would come under pressure. Taking decisions under pressure is well reflected in the remuneration of the ICB.
    2. Whereas your argument for better mortgage margins is reasonable at present that is because the banking model is completely broken. No pricing model can work in an environment where a supranational body continues to threaten at every opportunity that it will implode the banking system. You are correct that under such a threat of implosion no mortgages should be issued.

    But this leads to the most important issue. No country should accept such a threat. The ECB should be told to take a hike. There would be huge fall-out but from a balance sheet perspective a new banking system could be easily funded from the assets of the existing banks.
    The losers would have to be all bondholders including the ECB itself. That should be well over €200 biliion.
    And the full cost of the ECB imposed ‘no bondholder left behind’ could be deducted from the final account paid to the ECB at the end of the resolution procedure. Just like is being done at Lehmans.

    Even without such a radical approach, banking will have to be returned to a deposit based banking system not reliant on ephemeral short term deposit and short term bond flows.

  16. @Seamus Coffey

    Thanks for the valuable excerpt by Matthew Elderfield. Reading it carefully, I still believe, with respect, that he is wrong in terms of his analysis of the Irish variable rate mortgage market. The VRM market is at a zero-supply corner solution due to their poor value whereas Elderfield makes it appear that the banks are using the VRM market to makes excess risk-adjusted profits to cover other business segments. That is not consistent with reasonable risk analysis of their overall positions – these VRM assets are net drains on precious liquidity, not a source of excess risk-adjusted profits.

  17. @Gregory Connor
    “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.”
    Like others I am struck by this bit – the banks get cheap funding because the government as committed to paying their debts for them. As effective ‘owner’ of the banking system, the government is not only funding it, it is providing cheap liquidity to it (by holding its nose and repaying bondholders).

    The government both for political and economic (budgetary, aggregate spending=taxation) and no doubt social reasons does not want mortgage distress to increase beyond an inevitable level (inevitable because we are having one of the largest and costliest housing busts the world has seen in recent times). As the paymaster of last resort, the government has to balance the gain of lower mortgages with future losses the banks might incurr.

    Meanwhile, in the realm of game theory, keeping the banks on an ECB lifeline ensures that any ejection of Ireland from the euro will be a costly affair.

    On the “Who’s on first base” side, the ECB is responsible for capital flows between ESCB countries and between the ESCB as a whole and other countries. It is failing to provide a level flow of capital to Ireland, having failed previously to halt excessive flows in. (It is not within the means or powers of an NCB to regulate exteral flows within the ESCB). Having failed to provide a stable flow of capital to Ireland (and not just Ireland), twice now, is it unreasonable to expect that the ECB should step up to the mark and make up the shortfall at the rates it determines to be appropriate?

    If the private market is not supplying short-term liquidity at or near ECB reference rates, then the ECB must supply that liquidity otherwise it has lost control of short-term rates. This must hold true for individual nations as it does for the eurozone as a whole. No?

  18. @ hogannmayhew

    You are assuming that the PTB regard Ireland as a ‘normal’ parft of the EZ, and not as a ‘default zone’, or failed economic entity where limiting of losses is the real policy goal.

  19. @gregory

    By tangential I meant taking aim at the assertion and its probable use by government, NCB etc to function as a go-with-the-flow (of peers) enabler.

    So far as the banks themselves are concerned, I think bank ‘ management’ are now just functionaries and it is really the shareholders’ interests and opinion that matters.

    If you separate them from the state as a whole then they cannot sensibly price variable mortgages since they cannot do more than guess what funding will be and the CB would be a bit of a mug to volunteer to do that job for them.

  20. So we the people pay the debts or the liquidity stops, meanwhile the banks seeing that there’s a chance of the liquidity stopping would rather, if at all possible, not extend it to the people.

    If this craic goes on for another couple of years one could imagine bigger problems for the property market and by extension the banks. A market where cash will be some kind of God as opposed to merely a king.

  21. @ Gregory

    “So the optimal solution is zero new mortgages at existing variable rates. Seems a clear and simple best decision.”

    The problem seems to be that nobody is in charge. Zero new mortgages means no support in the market for existing price levels. Which translates into price falls which means more punters with debt problems which ultimately come back to the banks. In theory the Government controls the banks. But there is no coherence.

    I asked a friend of mine who is thinking of buying in Dublin what prices are like. He has been looking since March at a particular development. 3 identical houses have come onto the market.

    House 1 March  – asking price 535k
    House 2 July – asking price 465k
    House 3 October – sold  for 435k

    He’s waiting for the price to get to 350K. Shouldn’t have to wait that long.

  22. @paul quigley
    What is happening in Italy (to name but one) is a similar failure of the ECB to provide a liquid money market. The ECB, it appears, is staying at the aggregate eurozone level and saying that everything is fine while allowing individual components to go to hell in a handbag.

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