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jacob

Duration Of Average New Mortgage

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Hello,

I was wondering if anyone on this site has tried to assess the impact of widening credit spreads on mortgage rates. Current mortgages are around 5.5% pa the spread is therefore around 100bps (5.5%-4.45% of the Gilt 3 months)

This seems quite high to me considering the possibility of collateralisation of the pool of mortgages, it is also similar to the spread of low quality non-investment grade debt.

If corporate profits start disappointing, the spread of below investment grade debt is likely to widen by anything between 50 to 100bps. How do you expect mortgage rates to behave?

A widening (increse in rate) of 50 bps would reduce the affordability of houses by 4%. A 100bps increase in the spread would require a drop in prices of 7.7% to keep the monthly repayments unchanged (assuming a 25 year repayment mortgage).

Is it possible that further reduction in interest rates will not be passed to home buyers because of higher credit spreads?

Also, is the currently very high duration of mortgages (low rates + IO) a potential cause of massive price reductions (and volatility) in house prices? (at current rates the duration of a 25-years mortgages is around 8 = an increase in interest rates of 1% should cause an 8% theoretical reduction of house prices)?

Any comment is welcomed....

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could you post the English version of this please?????

:blink:

bps - thats beats per second - are you a DJ?

BTW Welcome aboard! ;)

I apologise if this was a little bit technical.

The main idea is the following.

When a bank (or anybody else lending money) decides the interest rate they require to lend the money they have to consider two things.

1) how much is the state paying in interest (UK Gilt)

2) How much more should the bank charge a customer to take into account the fact that he might default (go bankrupt)

Currently the interest rate for a 3-month Gilt (State bond) is 4.45%. Mortgages are around 5.5%. This means that the amount the bank required to turn a profit and be remunerated for the risk that the customer will not pay is 5.5%-4.45%=approximately 1% (100 basis points bps) :)

The bank could also decide to lend the money to a corporate or invest it somewhere else. The fact that large low quality companies can also borrow at 5.5% in the current markets means that somehow the risk of the mortgage is expected to be similar to the risk of large but low quality company defaulting (not repaying).

If the economy goes into recession, the cost of borrowing for low quality company will increase substantially (so the company will have to pay 6.5% or 7.5% to borrow money even if interest rates are unchanged).

The same could happen for mortgages. Since the risk of somebody being fired or not paying back its mortgage in a recession is higher, the bank will charge higher interest rates even if the Bank of England doesn't increase interest rates.

We could therefore be in a situation where interest rates are lower but mortgage rates don't change or even increase.

The second part of my post refers to the fact that because a lot of mortgages are interest only and also because interest rate are low, the sensitivity of mortgage repayments to changes in interest rates is very high. As an example, an increase of 1% (from 5.5% to 6.5%) would push up the monthly repayment by almost 8%. This could be a cause of large price fluctuations in the coming months.

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Also, is the currently very high duration of mortgages (low rates + IO) a potential cause of massive price reductions (and volatility) in house prices? (at current rates the duration of a 25-years mortgages is around 8 = an increase in interest rates of 1% should cause an 8% theoretical reduction of house prices)?

It's been a long time since I heard the word "duration" used in this context!

Would the duration of a mortgage be relatively stable? Since if interest rates and therefore your discount factor were to change so would your cash flows (unlike a normal bond). (They probably wouldn't change proportionally by the same amount but then as you say the amount they do exactly change is ambiguous - not at all easy to calculate particularly if you remove the assumption of a flat term structure)

Continuing to think out loud...

The real interest rate is probably the best discount factor to use in which case the worse time to borrow is when inflation and nominal interest rates are low. And the worst thing to do is to borrow big and for a long period. Even worse to go IO. If the BoE is credible in its willingness to control inflation (therefore assume that inflation will not rise and make your discount factor harsher) then low but potentially rising nominal interest rates, long period and IO all increase your duration. Borrow big only has an effect when you consider an income constraint. So I think I'm agreeing with you, we currently have high DV01 and therefore mortgage costs are more sensitive to base rate moves.

My personal feeling is that house prices are a function of three variables: interest rates, wages and future expectations of the economy/ risk appetite. There are essentially two agents: Lenders - who will lend if interest rates allow borrowers to pay the interest out of their wages and if they expect them to continue to be able to do so and Borrowers - who will borrow if interest rates allow them to pay the interest out of their wages and continue to do so. The key difference is that borrowers only tend to look at nominal rather than real interest rates and lenders are only playing this game as an average of many borrowers.

Therefore with interest rates likely to rise to fight inflation, wages looking more fragile and the future expectations of the economy dicey, I would argue that prices are likely to fall but would stop short of saying that a 1% increase will cause an 8% drop.

Agree with your credit risk outlook. Just would add the thought that corporates are likely to have loan contracts where it is stated that the interest will vary with their credit grade whilst retail customers will not. This means that as the risk increases, banks are likely to increase the interest charged with MPC decisions (since they don't want to make a loss) but not significantly more than that (even though they should to reflect the worsening credit risk). Unlike with corporates, pricing according to risk greatly increases the risk of default and is also very unpopular with the public (kicking someone when they're down).

Of course the pricing on new mortgages is a whole different story... ...and that's where the bottom falls out of the market. In fact you could argue that banks will try and increase the rates on new mortgages by even more to cross subsidise the poorly planned lending they did during the credit boom.

BTW technical is fine - keep it coming - wouldn't the world be a better place if people were able to look beneath the headlines "house prices rise again" etc...

Final thoughts: Fully utilised income constraint on IO

Assume lenders and borrowers are able and willing to lend/ borrow a certain fixed percentage of their wage.

Assume that (interest rate * mortgage amount) is a good guide to the cost of a mortgage in its first year (i.e. no compounding etc...).

Assume a few more things such as wages constant, no fixed period, no discounting etc...

Then (old interest rate * old mortgage amount) = (new interest rate * new mortgage amount) i.e. keep the cost the same

Re-arrange (old interest rate/ new interest rate) = (new mortgage amount/ old mortgage amount)

If old interest rate = 5.5% and new interest rate = 6.5% then (new mortgage amount/ old mortgage amount) = 85%

I.e. prices fall by 15%.

Regards

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Also, is the currently very high duration of mortgages (low rates + IO) a potential cause of massive price reductions (and volatility) in house prices? (at current rates the duration of a 25-years mortgages is around 8 = an increase in interest rates of 1% should cause an 8% theoretical reduction of house prices)?

Any comment is welcomed....

Could you clarify:

duration (in this bond analogy context) and how you calculate it

where you get 8% from

Nice to see some thought on here.

JY

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Continuing to think out loud...

The real interest rate is probably the best discount factor to use in which case the worse time to borrow is when inflation and nominal interest rates are low. And the worst thing to do is to borrow big and for a long period. Even worse to go IO.

Absolutely. Only borrow big if you've got big cash flow (then it might make sense) and pay it down ASAP - after which your big cash flow is still in place and you have yourself a new asset to boot (which will have changed in value, up or down).

BTW, where you say inflation, you really mean wage inflation, no?

My personal feeling is that house prices are a function of three variables: interest rates, wages and future expectations of the economy/ risk appetite. There are essentially two agents: Lenders - who will lend if interest rates allow borrowers to pay the interest out of their wages and if they expect them to continue to be able to do so and Borrowers - who will borrow if interest rates allow them to pay the interest out of their wages and continue to do so. The key difference is that borrowers only tend to look at nominal rather than real interest rates and lenders are only playing this game as an average of many borrowers.

As you point out, the risk profile of the lender and borrower are very different - especially when the borrower has to pay a significant premium. The key difference I'd say is that the lender understands the risk and the borrower often has no clue how much risk he is taking on.

On your three variables - they hold in rational times, but go haywire when there is a bubble:

IF bubble, price++

Therefore with interest rates likely to rise to fight inflation, wages looking more fragile and the future expectations of the economy dicey, I would argue that prices are likely to fall but would stop short of saying that a 1% increase will cause an 8% drop.

I reckon it could be more like 9%.

e.g.

25 year mortgage, wage constrained borrower can afford MAXIMUM £1000 per month:

At 5.5% he can borrow £162,843

At 6.5% he can borrow £148,103

That's a 9% reduction in borrowing for a 1% increase in lending rate AND he pays £14,740 more in interest over the life of the loan (he pays £300K in total over 25 years in both scenarios).

JY

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Is it possible that further reduction in interest rates will not be passed to home buyers because of higher credit spreads?

Of course, in fact I believe that the last reduction was not passed in full.

Also, is the currently very high duration of mortgages (low rates + IO) a potential cause of massive price reductions (and volatility) in house prices? (at current rates the duration of a 25-years mortgages is around 8 = an increase in interest rates of 1% should cause an 8% theoretical reduction of house prices)?

Any comment is welcomed....

Time to buy a straddle? :)

Cheers

Edited by LazyDay

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  • 301 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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