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mdman

How Are Mortgage Rates Set?

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I expect one of the main drivers of the economy going forward will be the cost of servicing debt. In a consumer-based economy such as ours, that means to a large extent mortgage debt. So I was wondering if any of the wise owls on HPC could answer this question.

How are mortgage rates set?

Specifically:

How are fixed-rate mortgages (of 1 year, 2 year, 5 year or 10 year vintage) set? Do they depend on LIBOR, swap rates, the gilt market, BoE base rate or something else?

And how is the SVR determined? Ie, at what rate does the bank borrow its funds, and what determines the spread between that rate and the rate it lends out at?

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They put their finger into the wind and pick a number. If it is less than their competitors they will get lots of trade, so much so that they may raise rates to put customers off. The rate they pick has nothing to do with anything. They don't borrow it from anyone, not even the Boe.

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Banks can borrow from the BOE (although they don't have to) so that is a threshold as it grounds the lending market. The market will form around the BOE rate, because the BOE is the lender of last resort and .'. cannot move much away from the BOE rate.

Generally the spread between the BOE base rate and the Lending rate (or the spread between the savings rate and the lending rate) is determined by risk. If more people go bankrupt, asset prices falling etc etc, then the spread needs to be bigger to cover the risk. If the spread is big enough, and the banks charge lots of fees they make a profit. If the spread is too small, and the banks are being chased by people on Money Saving Expert then the banks loose money and have to put up interest rates.

Techy details in here

http://www.bankofengland.co.uk/markets/mon...edbookjan08.pdf

Edited by moosetea

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They put their finger into the wind and pick a number. If it is less than their competitors they will get lots of trade, so much so that they may raise rates to put customers off. The rate they pick has nothing to do with anything. They don't borrow it from anyone, not even the Boe.

Cheers

So why don't we see more mortgages below BoE base rate (apart from a handful of lifetime trackers)? Is the market that uncompetitive? And why does everyone make a big deal about central bank base rates?

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Cheers

So why don't we see more mortgages below BoE base rate (apart from a handful of lifetime trackers)? Is the market that uncompetitive? And why does everyone make a big deal about central bank base rates?

It's a very generous spread for the banks, they will charge a higher rate if there is a high chance of individual default, or if the market is contracting like now. In either case they risk not getting their money back which is inconvenient since they need to go bust and start a new bank all over again. They tend to follow the Boe only for guidance, it is helpful for the banks to move together as in a herd so that they all make money on the way up and they can have the excuse that everyone else was doing just the same on the way down. This collective behavior is what accounts for the business cycle.

The Boe base rate is a mirage, it has almost no significance other than everyone talks about it.

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Doesn't the yield on gilts have an effect on mortgage rates? Presumably banks will always charge a higher rate to individuals then they can earn from the Government on the basis that the Government is a better credit risk (for now)?

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Banks choose a rate that they believe will optimise their return on investment.

They may have money obtained from depositors. Do they deposit that money with the boe and get base. Do they buy shortterm fixed rate investments paying 1 or 3 month libor? Etc

when anyone makes or takes a fixed term loan they are guessing what the average base rate will be for the period of the loan. The borrower may pay slightly more because of the convenience of a fixed monthly payment. The bank will want a higher rate because credit ratings may change, and because the may be a risk of base rates falling. The going rate for a particular fix on the wholesale Market is the swap rate.

The gilt rate is the rate at which investors are willing to lend, fixed rate to the govt. Normally this is virtually identical to the swap rate for equivalent duration- but QE has pushed this down by nearly 0.5% for some durations.

So, if the bank is going to offer a mortgage it needs to charge a rate, that after admin costs and risk has been taken into account is at least as good as the short term investments (libor), or for a fix. At least as good as the swap rate. If a bank borrows off the money markets at libor to lend (as was very common) then they have to beat libor after all costs and risk.

During massive HPI banks lost sight of risk and would often price loans at base + 1% or even less (I'm not counting loss leading short term offers, like base - 0.25%). similarly fixed were often priced at swap + 1%. with admin costs taken out, the banks were basically assuming that only 1 in 1000 borrowers, or less would default.

Now banks are taking a realistic view of default rates, with high risk of loss due to neg eq. Also, volumes are down and the pile 'em high sell, sell 'em cheap model doesn't work, so overheads are up, this means they have to charge a much higher premium over libor.

Again, libor has disconnected from base a bit, because lending to boe at base is guaranteed, but lending to another bank or major company at libor is at the lender's risk.

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Thanks ChumpusRex

So QE was introduced to reduce borrowing costs (one of the reasons). And the divergence between swap and gilt rates implies this has been a partial failure?

One of the effects of keeping borrowing costs low is that other things (eg wages) being equal, debt principal goes up. And the bigger the debts, the worse the impact of rising borrowing costs become when rates do go up. This looks like a debt accumulation trap every bit as vicious as the debt deflation trap.

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Thanks ChumpusRex

So QE was introduced to reduce borrowing costs (one of the reasons). And the divergence between swap and gilt rates implies this has been a partial failure?

One of the effects of keeping borrowing costs low is that other things (eg wages) being equal, debt principal goes up. And the bigger the debts, the worse the impact of rising borrowing costs become when rates do go up. This looks like a debt accumulation trap every bit as vicious as the debt deflation trap.

I don't think it means that QE has been a failure - it means that QE is working and keeping actual long-term interest rates down.

Interest rate swaps are derivatives (and the going 'rate' of the derivatives are the swap rates). E.g. A 2 year swap rate of 1% means that if I think IR's are, on average, going to be higher (or lower), that I can find someone else who would be prepared to take my bet. Let's say that I bet that rates are going to average higher than 1%, I can agree a £1million interest rate swap from a 3rd party; While base rate is less than 1%, I pay the difference to the seller on a monthly basis. While base is higher than 1%, the seller pays me the difference in interest rates. When base rate is 1%, we exchange handshakes rather than cheques.

IR swaps are the most popular derivatives. The reason is simple - fixed rate consumer loans are common, but it's cheaper for banks to borrow 1 month, or 3 months at a time. Many banks don't want to take the risk, so they use the IR swaps to 'hedge' their fixed rate loan - so that they win on the derivatives if IR's go up (compensating the fact that their fixed rate loan is now loss making because it's loaning money out for less than cost) and vice versa.

As a result, swap rates are the 'market's' 'best bet' for what IRs are going to do over that period. As gilts are risk free, just like depositing cash in the BoE, you would normally expect the gilt rate to be pretty close to the swap rate. What QE has done is push the gilt rate down below what investors expect base rates to do.

Part of what QE was meant for was to discourage investment in gilts, and encourage investment into more risky assets - e.g. commercial loans.

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