Opinion: The big banks are already showing signs that they will use the rising interest rate environment to battle hard for market share

By David Hargreaves

Would-be home buyers, and those already with mortgages, should, in my view, be encouraged by the initial response of banks to the Reserve Bank's recent raising of official interest rates.

Now, that might seem to you like an odd thing to say. After all, bank lending rates have just gone up pretty much across the board. And the blow-by-blow description of how they've gone up, who did what and when, can be seen here.

But the point is, that it wasn't just a question of the Reserve Bank moving and all the banks immediately following, which I freely admit, I thought is what would happen.

This was the first time the RBNZ had raised interest rates since 2010. That's a long time between drinks and the banks could have been fully justified in all immediately pumping up their rates in response, from what have been extremely low levels.

Yes, the market's leader ANZ, which lays claim to financing over 30% of all home loans in this country, was greased lightning out of the starting gate less than two hours after the RNZ had raised rates, passing on the full 25 basis points rise into its floating mortgage rates.

However, some of the other banks were prepared to wait for a bit. In fact Westpac didn't move for a week and it raised its floating mortgage rate for high equity customers (those who have deposits in excess of 20% of the house value) by just 10 basis points.

Market positioning

Okay, so it might be argued that this was just market positioning. And I would actually agree.

But this is just the first of what's expected to be several rate hikes by the RBNZ this year. And if the banks are already, albeit in a fairly subtle way as yet, starting to apply marketing tactics, then it is reasonable to anticipate this activity will build as the year progresses. The more official rates are raised the more individual banks can differentiate themselves in the market by offering 10 basis points less here and 15 points less there.

For the current or would-be mortgage customer, that has to be encouraging. To me, it very much raises the possibility that the banks will become very tactical as the year goes on in order to try to build their market shares. And this can only be good for the customer.

The RBNZ is currently indicating that it is likely to raise official interest rates by 125 basis points this year. In layperson's terms this means the anticipation is that the RBNZ's Official Cash Rate is likely to be 3.75% by Christmas, compared with its present level of 2.75% and the 2.5% it started the year at.

Fully passed on

Bank economists have tended to talk as if that full 125 basis points would be passed on to mortgages rates during the year. If that did happen we could expect to see average floating mortgage rates around or just under 7% by the end of the year.

According to interest.co.nz's mortgage calculator, based on a starting point of the 'effective' floating mortgage rate of 5.65% (according to RBNZ statistics) prior to the rate rise, a full 125 basis point rise would add around $77 a month, per $100,000 borrowed, to a floating mortgage on a 25-year term. It would make a difference, though not terrifyingly so (unless someone's really borrowed too much). 

But nothing in life is that simple. Arguably the means of banks funding their activities have never been more complicated. The rise to prominence of fixed mortgage rates has only added to that. Individual banks will have individual funding needs, which means their marketing approaches at any given time might be quite different. So, one bank will be pumping two-year fixed rates for a couple of weeks, while another might be keen on getting more money lent out on floating rates, etc. It all depends on the balance of funding that individual banks want to achieve. So, they may well have different approaches in the market at different times.

What is clear is that the scramble for homeowners to fix their mortgage rates is now well and truly on - hence the kind of gimmicks the banks are already bringing out.

Different dynamics

The dynamics of the mortgage market are quite different now to what they were the last time the RBNZ was hiking rates in earnest during the housing boom of the mid-2000s.

Going back to December 2004 the dollar amount of mortgage money that was on floating rates made up 24.3% of the total loaned - with the rest on various fixed term rates. A year later the amount on floating had dropped to 17.6%, then 15.2% by 2006 and finally just 12.6% at the end of 2007.

Remember, at this stage the world was awash with cheap credit, so the banks could source plenty of cash overseas at much lower rates than prevailing here, which they could then loan out at reasonably favourable fixed rates in New Zealand.

This of course made it very difficult for the RBNZ to slow down a speeding economy that was generating inflation. The more the RBNZ squeezed interest rates up, the more the bank customers fled to the sanctuary of fixed rate loans, basically avoiding, or at least deferring, the impact of the RBNZ's moves.

Many changes

Much changed after the global financial crisis of 2008. The cheap money was no longer available overseas, but then interest rates here were in any case dropped like a brick in order to stabilise the economy.

And with interest rates staying down for a long time, more people gravitated back to floating mortgages. At the end of 2011, more than 60% of mortgages by value were floating.

As it became clearer in recent times that interest rates were going to rise again, then so there was a move back to fixed - but nothing like to the extent of that in the early 2000s. As of the end of 2013 the amount of mortgages on floating rates was 41.3%, dropping to 40.1% by January, the latest figures available.

Expect to see that figure plummet through this year.

Not fixed for as long

The other interesting statistic to look at though is within the fixed mortgages themselves. As at the end of 2006 the amount of mortgages fixed for two years and more made up 26.6% of the whole mortgage total. As of January this year, the comparable percentage was just 9.2%.

So, to swap that around, currently over 90% of mortgage money is financed on either floating rates or rates fixed for under two years - compared with something just a bit over 70% of it in 2006.

This means the RBNZ right now can wield considerably more influence through its rate rises than it could back in 2006 because most people even on fixed mortgages will find the RBNZ's rate rises affecting them relatively soon.

For how long though? The scramble to fix is on and, anecdotally, this includes people seeking to break shorter term fixed mortgages for longer contracts.

The hot deals are gone

The horse has to some extent already bolted though. Around a year ago fixed rates of under 6% for five years were available. Now most of the big banks are at over 7% for five-year terms. That's quite a big change given that the RBNZ has only shifted official rates by 25 basis points in that time and shows the extent to which the fixed rates and the swap rates that feed into them move ahead of anticipated rate changes.

So, to some extent this time around the RBNZ has had its job done for it by the market.

It also means that by moving up fixed rates in anticipation of higher rates the banks should have flexibility in the rates they offer customers, even though this time around there is not the same volume of 'easy money' washing around internationally that can be used to hold fixed rates down here.

Interest rate margins

In terms of the flexibility the banks have to offer deals, its worth looking at some interest rate differentials.

If we go back to December 2006 again we can see that the 'effective' floating mortgage rate for banks was 9.28% - yes  really, and it was set to go well over 10% within a year. The 'effective' fixed rate as again measured by the RBNZ was 7.73%.

Against this, the RBNZ's Official Cash Rate was 7.25%, while the 90-day bank bill rate was 7.66% and the effective six-month term deposit rate was 7.24% (yes, really, also!)

In terms of trying to get some sort of rudimentary handle on banks' cost of funds - and its very rudimentary - then it's worth looking at the gap between the mortgage rates and the OCR and 90-day bank bill rates.

As at December 2006 the floating mortgage rates were some 200 basis points more than the OCR and more than 150 basis points ahead of the 90-day bill rate. The 'effective' fixed rate was about 50 basis points above the OCR and barely 10 basis points above the 90-day rate.

Fast forward

If you fast forward to the RBNZ's latest available figures, for January this year, you can see that the effective floating rate (at 5.64%) and effective fixed rate (5.42%) compared with an OCR of 2.5%, a 90-day rate of 2.88% and a six-month deposit rate of 3.76%.

So the prevailing floating rate was some 300 basis points above the OCR, and slightly less than that above the 90-day rates, while the fixed rate was not too far short of 300 basis points above the OCR either.

Therefore, while the funding dynamics are different for the banks to how they were in 2006 with all that easy offshore money available then, what is clear is that the banks appear to have room to absorb at least some of the rate rises coming up from the RBNZ.

The extent to which they choose to do that will depend presumably on how their share of the market is going. But the banks are under great pressure to keep growing their mortgage books and share of the market.

An interesting wrinkle in all this is provided by the RBNZ's 'speed limits' on high loan-to-value lending. As we know, this has made it difficult for those with low equity (less than 20% of the house value) deposits to get a loan.

High-end success

Anecdotally though, the banks have enjoyed good success in targeting higher deposit customers - typically through offering sweeter mortgage rates.

But without the low deposit people - typically first-home buyers - coming into the market, the banks might struggle to keep growing their mortgage books in the manner they would like.

One argument could be then that unless the LVR limits come off at some point - and I suggested before Christmas that this might happen soon - then we might see the banks competing very vigorously - through discounted interest rates - in a mortgage market that is not growing as it would otherwise. How ironic then if the RBNZ were to see its interest rate rises not being passed on as quickly as could be the case because of the impact of its LVR policy.

Whatever happens though, the early signs are very positive that while, yes, mortgage rates will go up this year, the competition between banks - and the fact they are well placed to absorb some higher costs - will likely see nothing like the full extent of RBNZ rate rises passed on to mortgage customers this year.

Personally I would be surprised if we saw floating rates any higher than 6.5% by Christmas, while fixed rates might not go all that much higher at all. What the RBNZ might make of that is a moot point.

History shows though that our central bank almost always ends up pumping interest rates higher than it originally intended at the beginning of a rate hiking cycle. If it wants and needs mortgage rates of say 8% it will get them there eventually.