Will they or won’t they? This question dominates financial press headlines as economists study the runes and seek to interpret the utterances of central bank governors to divine the direction and degree of interest rate movements.
It’s a pressing question in particular for the UK’s strained economy, and one that hits hard the many mortgage borrowers across the land. The UK’s excessive exposure to a floating rate cost of borrowing is once again taking its toll.
This old routine is very much part of life in the City, although most people had almost forgotten the rules of this headline-grabbing guessing game following a prolonged period of almost zero interest rates. We were all lulled into a false sense of security. But what is a puzzle to City pundits is a drama for many borrowers.
Why has the UK economy, with all its supposed financial acumen, not managed to engineer a change in mortgage practices?
The rediscovery of inflation and associated rising interest rates are a worry, adding another aspect to the cost-of-living crisis. The average UK mortgage holder is very exposed to the upward trajectory in interest rates through floating levels of mortgage interest. This is a long-standing structural issue in the UK economy, an enduring feature of Britain’s historically inflation-prone economy where mortgage borrowers remain wedded to floating mortgage rates.
Some of us remember rates rising to the mid-teens in the 1980s, making the digits of today seem distinctly modest. Yet, as the UK struggles with today’s rising rates, borrowers in other jurisdictions appear better protected, with the ability to have locked-in, low and fixed rates. Why on earth has the UK economy, with all its supposed financial acumen and City expertise, not managed to engineer a change in mortgage practices?
Having been involved in the wholesale mortgage funding markets from the late 1980s (indeed working on early securitisation and later the evolving market for covered bonds), it is clear to me that banks have become far more adept at funding their mortgage books and innovating on this side of the balance sheet than on the lending side, particularly in the UK.
Decades of developments, including advances in securitisation, risk transfer and on-balance sheet covered bond secured funding, helped bring down costs for lenders and increase funding availability. Moreover, banks benefit from capital and liquidity relief in respect of their mortgage portfolios relative to other forms of lending, something recognised in global capital and liquidity directives.
There were inevitably problems along the way, with over-reliance on wholesale markets, rising default levels, and squeezed margins in earlier cycles (the failure of Northern Rock, or earlier centralised lenders of the 1980s). But little has significantly changed in the fundamental nature of the UK mortgage market besides a better provision of mortgage lending availability. Back in the 1970s and ‘80s, lenders had to ration their mortgage lending to established clients in a queue system.
So, is mortgage lending a good business? Today, it remains a generally profitable activity for lenders, benefiting from a low default rate along with a reasonable margin due to low deposit rates and a conservative pricing mechanism (the standard variable rate). But as rates rise, borrowers face increasing levels of discomfort.
It is true that, in recent years, borrowers have been able to fix the rate of interest for short periods, although doing this entails potentially extra interest cost, not to mention hefty break costs. However, elsewhere in the world, there are jurisdictions where the mortgage moves with the borrower and/or attaches to the property, giving greater flexibility. In the US, homeowners are able to borrow very flexibly at long-term fixed rates with little in the way of penalties or break clauses.
Drawing on years of experience in the sort of liability-side, funding innovation in the banking industry’s wholesale markets, one former banker, Arjan Verbeek, has resolved to tackle the issue through some innovation on the lending side. He is the founder of a new company, Perenna Bank, established to lend medium- to long-term mortgage money at fixed rates with flexible break clauses.
Applying lessons from the wholesale markets, and with an eye to past mistakes, Mr Verbeek’s Perenna Bank, whose marketing blurb states that it was set up to ‘create a nation of happy homeowners’, offers fixed-rate loans of up to 30 years. This is something that would have been unthinkable in past cycles. Does this potentially point to the future, or is it an innovation set to be fast forgotten?
Perhaps unsurprisingly, Mr Verbeek is a fellow former debt capital markets banker and one-time rating agency professional. In setting up Perenna, he has made the most of his many years of experience structuring the funding side of banks and their mortgage books. To be fair, he has already managed to obtain a banking licence, itself no mean feat in today’s UK. Good luck to him and others attempting to bring about change.
Perhaps the British public can now get a chance to fix their borrowing costs and break the habit of several lifetimes. In the meantime, while Perenna Bank takes its tottering baby steps, the British public joins the City economists and other luminaries in the perennial game of ‘spot the next interest rate’.
Maybe the future will become more predictable for borrowers in the UK, as it is elsewhere, but that might just be either wishful thinking, or perhaps good financial engineering.
Tim Skeet is a career banker in the City with over four decades of experience. He previously worked in the debt capital markets, specialising in wholesale mortgage finance and meeting bank capital and funding needs.
