Mortgage fixing demand could become a stampede

Roger J Kerr warns that the rush to fix 'which always comes' as homeowners chase low rates, will unbalance the swap market and will raise rates across the curve. Your view?

29th Jan 13, 2:40pm by Roger J Kerr

By Roger J Kerr

The two risks of increasing interest rates that I have highlighted over the last several weeks, namely retail mortgage fixing and US 10-year Treasury Bond yields increasing are still very much to the fore.

Stronger US economic data, reduced US Fed consensus around continuing monetary stimulus and the absence of financial/investment market blow-ups in Europe has been behind the upward movements in USD long-term interest rates (US 10-year Treasury Bond yields now up to 2.00% from 1.60% before Xmas).

Comments from RBNZ Governor Wheeler at this Thursday’s OCR review are unlikely to be any different than previous RBNZ statements on the economy.

The OCR cannot be lifted unless the exchange rate depreciates substantially, which in turn causes inflation/growth risks to be elevated.

It is still hard to see what could occur to drive the NZ dollar currency value down on its own accord.

The “biological scare” with Fonterra’s milk contamination report last week hardly dented the Kiwi dollar.

It will take a stronger US dollar on global forex markets to cause any NZD weakness below 0.8000.

The US Fed’s FOMC meeting this week may shed more light on how far away increases in US short-term interest rates might be. The USD currency should strengthen well ahead of the eventual withdrawal of monetary stimulus and interest rate increases in the US sometime in 2014.

The Governor may well take the OCR review opportunity to remind all and sundry that the RBNZ now has other tools to manage inflation than just ramping up interest rates.

The macro-prudential measures of funding, LVR and capital ratios on the banks are either available or close to being available.

However, retail mortgage borrowers are not concerned with that, they always take the lowest available rate going no matter what the outlook for interest rates.

Right now the banks are offering two-year fixed rates at 5.25% to 5.45% against the 5.65% to 5.75% costs of variable rate mortgages.

The rush to fix may have only just started; however as we have seen in the past the stampede always comes and the banks are forced to swamp the wholesale swaps market with the one-sided “fixed paying” demand.

The net result is a gap upwards in two year swap interest rates that pulls other long term swap yields upwards.

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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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19 Comments

by bigblue | 29th Jan 13, 3:04pm 1359425078

There's no point continuing to quote banks published mortgage rates - most banks will do a deal at around 5% floating, or if you really want to fix then 2 years fixed at 4.95% is easily negotiated.

Mortgage rates are more likely to go down than up and as for the LVR issue - there is no chance of that happening under National.

by Roadhouse Blues | 29th Jan 13, 3:43pm 1359427414

Correct me if I'm wrong Roger - your a good sales person.

Banks can lend about $9:00 on every dollar deposited so over the course of a 20 year mortgage at 5% interest the bank returns $5:00 as profit - a 500% return on there deposit.

Logically, by way of maths to keep the system of fractional lending afloat there needs to be a 500% increase of money supply in the next 20 years to maintain the status quo ratios.

How can the reserve bank afford to put up interest rates as this would limit the amount of new money supply in the future and make banks insolvent?

Having used the tool of low interest rates to stimulate growth the reserve bank as I see it is stuck and will not be able to unwind.

by Chris_J | 29th Jan 13, 5:14pm 1359432841

Maths, spelling, economics ... all round confusion!

I will let some else do the correcting, or else my head may explode...

by Stephen Hulme | 29th Jan 13, 5:55pm 1359435347

It might be worthwhile reading Gareth Vaughan's recent article entitled :

"New Zealand banking system has highest loan-to-deposit ratio of 14 Asia-Pacific countries, Moody's says"

and my appended comment.

by Roadhouse Blues | 29th Jan 13, 9:55pm 1359449733

Hi Stephen, thank you for your constructive comments.

I’m still a little perplexed with the linked article it it describes - “A loan-to-deposit ratio can be used to assess a bank's liquidity by dividing its total loans by its total deposits”. And comes up with the result 140%.

To me this is a misleading representation because a ratio is almost always expressed similar to 3:1 or three dollars lent is backed by one dollar deposited. In this example to express the number as a % the formula would be 3/1*100=300%

Looking a wikipedia “Like all modern monetary systems, the monetary system in New Zealand is based on fiat and fractional reserve lending. In a fractional-reserve banking system, the largest portion of money created is not created by the Reserve Bank itself, 80% or more is created by private sector commercial banks.

In this example which is expressed as a % it is clear that just 80% of money in circulation is created by banks creating a ratio is about 8:2

Now the article by Gareth says that the current ratio is 140% this is not a ratio how-ever I would deduce he is saying that 140% of money in circulation is created by banks so every 14 dollars of debt is backed up by just one dollar of cash creating a ratio of 14:1

Do tell me if and where I’m going wrong, I want to understand this.

by scarfie | 29th Jan 13, 7:43pm 1359441822

Recently updated with part 4, but part 3 is the clincher.

by Roadhouse Blues | 29th Jan 13, 10:28pm 1359451709

Exactly Scarfie and that is why I don’t get Chris J’s high handiness.

As Stephen’s link suggests (in my opinion poorly), NZ has a debt ratio of 14:1 debt to cash ratio, so when I go to Bernards mortgage calculator and this time take a 14 dollar loan over 20 years at 5% interest the result is $22 is paid back to the bank comprising of the principle + $8:00 interest.

Thus creating a 8:1 return on the deposit for the bank. To me it looks like a 800% margin that they work with.

(This is where I think I am wrong), For the system of lending to continue it requires that in twenty years time that $22 be in existence for every $1 that is currently in existence. So $22 worth of cash tomorrow will by the same bag of pataoes as $1 buys today - how likely is this to happen over the next 20 years.

If the above is correct, my question is simple at this point - how is the current system of lending sustainable? And why would Roger Roger spend time writing about fixing Vrs floating when there are more important factors and issues which he could address.

by Chris_J | 29th Jan 13, 11:22pm 1359454923

I'm risking cranial explosion, so all in one breath only...

A bank's deposits and their capital are not the same thing... a 500% return over 20 years is 9.4%PA (unspectacular)... businesses charge margins - it's how they make a profit and pay their way...

...out of breath, but fortunately my head is still intact...

by Roadhouse Blues | 30th Jan 13, 12:39am 1359459556

I couldn’t find a decent graph Chris on the Average Wage over the previous 20 year period, how-ever, if you accept the above graph as an indicator of New Zealand salary trends then this shows the Minimum Wages have risen from about $9:00 to about $13:00 dollars per hour which is a total rise of about a 44% raise over a 20 year period so maybe 2.2% per annum.

Sure Average Wage growth will be more than this over the same period but surely you can see an issue when bank growth is 9.4% per annum (not sure how you reached this number Chris), and wage growth is just 2.2%.

It means more money is being taken away from our system than is being put in through income and this is I believe unsustainable.

In 1993 NZ had 143$b of debt across a population 3,576,000 people averaging debt per person at $40,200 today we have 433,000 more people and each man woman and child shoulders $103,480 to me this is a precarious situation for our country.

Um - Interest.co.nz doesn't accept graphs:-)

by Chris_J | 30th Jan 13, 3:23pm 1359512603

Now you're confusing inflation with a return on capital invested!!

I think I can safely make the assumption that you don't have a finance, mathematics or similar background, however being at risk of adding more confusion I will keep this simple and only say it once:

To calculate what a 500% gain after 20 years (6 times the original amount) is annually (say r) then:

(1+r)^20=6

Hence:

r=6^(.05)-1=9.4%PA

(I think that's 6th form level maths).

I'm not trying to be disagreeable but in 1993 we had just exited a period of high interest rates (over 20%PA 4 or 5 years earlier) and similarly high inflation (which had both limited debt growth and devalued the value of that debt). Today we have had low interest rates and low inflation for 20 years, which has allowed more borrowing (for the same cost) and not devalued debt as much.

Is it the end of the world? Probably not.

by Roadhouse Blues | 31st Jan 13, 2:58am 1359554295

Hi Chris, I try not to let education get in my way of learning and thank you for your input.

Of the subject at hand, there are many forms of intelligence and to define a persons perceived lack of maths skill while not taking into account other 'talents' in-order to make assumptions shows a lack of empathy or degree of ignorance. How socially intelligent do you see yourself as being?

In 1993 when you say interest rates were 20% for a 4 to 5 years people were also required to have a minimum of a 20% deposit on a mortgage loan, this in association with a bank reserve requirement of around 1:8 (deposit to loans ratio), meant people were limited not only in the amount they could borrow to purchase or invest in property but also the banks were limited in the amount of money that they could lend to be invested - I guess you would say Chris that the supply of available debt limited debt.

Supply Vrs Demand were therefore both slack (fifth from economics).

Today, this has changed - the reserve requirement is currently 1:14 (deposit to loan ratio), and with this increased supply of debt has come the double incentive for people to borrow at low interest rates of around 5%.

The difference between 1993 and today is not large. In 1993 at 20% interest rates with limited demand and a 8:1 (loan:deposit ratio), and over a period of 20 years creates the formula $1:00 deposit results in the bank lending $8:00 which over 20 years creates a return to the bank of $33 with $25 being the return on deposit. The Ratio is 1:25 deposit:return.

Today, with just a 5% interest rate and a 14:1 ratio, over a period of 20 year year period creates the formula $1:00 deposit results in the bank lending $14:00 which over a twenty years creates a return to the bank of $22:00 with $8:00 being the return on deposite. The ratio is 1:8 deposit:return.

You would think that a bank would rather have a return on lending of 1:25 than the current 1:8 how-ever this does not make a difference to a banks profit model because of supply and demand. Check the data in the link following referring to total overseas debt and notice that total indebtedness has increased over 300% over the last twenty years.

en.wikipedia.org/wiki/File:New_Zealand_overseas_debt_1993-2010.svg

So weather it’s 20% interest rates and few loans or 5% interest rates and allot of loans the bank is in a good position at every step and this again makes the discussion to fix or float a mute point.

Again and expressed differently again so you might understand Chris, interest rates have fallen from 20% to 5 % over the last 20 years under the current fractional reserve banking system to sustain the current levels of growth over the period. I presume you agree with me that interest rates can not become negative in the future.

The supply side of our money expansion is full or almost full, so from a monetary point of view Chris, where are we going to create demand and growth in the coming 20 years with the interest rate card almost burnt out?

by scarfie | 31st Jan 13, 9:09am 1359576598

Roadhouse do watch parts three and four of the videos I linked to above. Parts two describes the banking system as is taught in economics and is what you (and I at one stage) perceive it to be, part three dispels that myth. Part four talks about reserve ratios, also a bit of a myth.

Try my rework of the quantity theory of money to account for interest. From M.V=P.Q to (M.V)+i=P.Q

If you plug some numbers in it will become apparent that interest is simply a method for the redistribution of weath. It is also apparent that interest rates will decline over time as a greater percentage of the money supply is tied up in debt servicing. A raise in interest rates will collapse the system, although collaspe through hyperinflation or debt write off is inevitable as the money supply will eventually go hyperbolic. BTW it is possible for interest rates to go negative and in fact it has happened in Europe as people take a negative yield to keep their money secure.

by Chris_J | 31st Jan 13, 12:44pm 1359589440

Roadhouse, I think you have got more than a bit confused in all of this and will do a good deed and try to point out where you have gone wrong. (Apologies in advance if I appear terse!)

1. NZ Bank's only have capital requirements, they have no reserve requirements. Capital requirements depend on the risk weighting of assets (eg business loans are more risky than residential home loans). To keep an example simple assume that the bank requires 10% capital across its loan portfolio, then if it has $100m in capital, it can make no more than $1b in loans.

If you want to get technical check out the RBNZ site:

http://www.rbnz.govt.nz/finstab/banking/4436523.html

2. When the bank lends money it actually comes from somewhere! (ie NOT thin air!). For our bank example (above) in order to lend $1b with $100m of capital, assuming it leaves $100m in reserves it needs to have raised the $1b to lend from somewhere. In NZ at the moment most banks raise the largest part through customer deposits. The rest is through bond issuances or money market deposits (generally overseas funding). The bank also keeps an amount of reserves (invested in liquid assets).

Then look at an example balance sheet:

ASSETS:

Loan Advances to Customers: $1b

Cash/Bonds: $100m

Total Assets: $1.1b

LIABILITIES:

Customer Deposits: $714m (say)

Money Market Advances (eg Bonds Issued): $286m (say)

OWNER'S EQUITY:

Owners Equity: $100m

TOTAL LIABILITIES AND OWNER'S EQUITY: $1.1b

Now in this example, let's work out the ratio of customer loans to customer deposits:

Loans/Deposits = $1b/$714m = 140%

(Obviously I used those numbers those the ratio makes the average mentioned previously above).

NB: The ratio is NOT 1:14, that is just plain wrong! 140% is a ratio of 1:1.4

As you must now see those ratios you having been talking about are nothing to do with anything and frankly are just plain nonsense.

The amount of lending a bank can do HAS NOT CHANGED EVER! To lend a dollar they first need to have a dollar (despite what Scarfie et al might think about some irrelevent technicalities that conspiracy theorists like to dwell on!).

All the change in ratios tells us is that the source of money for lending has changed (less local depositers and more off shore funding).

To clarify: I said interest rates were 20%PA 4 or 5 years EARLIER than 1993 (ie 1988ish) I was making the point that the interest rate environment in 1993 had only recently changed. In 1993 mortgage interest rates had fallen to about 7.5%ish and the lowest since the early 70s.

By 1993 banks were routinely offering 95% on a home loan. My sister bought her first home in 1994 with a 95% home loan at the age of 24.

The banks profits can be measured by their interest rate margins, which in all honesty have remained fairly consistent for the last hundred or two years!

I suggest if you are REALLY interested in the topic, take a course in Economics or Finance at University, or just go to the library and read some relevant literature.

by Stephen Hulme | 31st Jan 13, 8:46am 1359575216

This online RBNZ inflation calculator includes a wage component.

by Wolly | 29th Jan 13, 4:15pm 1359429358

"It is still hard to see what could occur to drive the NZ dollar currency value down on its own accord."

Easier to see, when you ask, what event could destroy the agricultural export demand for Kiwi product.....and that's an easy one to answer!

by Grumpy | 30th Jan 13, 2:12pm 1359508340

This drought we are having could well be the catalyst for the KIWI $ to fall. Id rather this that the present issue the dairy industry is facing. Overall its been a tough season for alot of dairy regions - we wont see the flow on effects of this for another 2-3 months though......

by MortgageBelt | 29th Jan 13, 5:52pm 1359435126

Why bother fixing? - interest rates are still in free fall.

Interest rates are not going to rise.

Interest rates are never going to be hiked in NZ until we get something near an actual authentic recovery. No where in sight yet.

Bernie Lo of CNBC has a mortgage of .9% in Hong Kong. Yes, that's 0.9% less than 1%.

Don't be beguiled into thinking 5 or 6% is a 'low' interest rate - it is 2 or 3 times a global rate or the rate it should be. Mortgage holders in NZ are being completely gamed by the banks & RBNZ.

by SmoKey | 29th Jan 13, 8:04pm 1359443078

Quote :

What central banks have done is to buy time to allow governments to follow the policies that are more likely to lead to a resumption of “strong, sustainable and balanced” global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.

Read more: http://business.time.com/2013/01/28/the-great-central-banking-experiment-will-unlimited-cash-solve-problems-or-cause-them-2/#ixzz2JLUqXA8o

by boofta | 30th Jan 13, 11:28am 1359498534

Here we go again. The prtagonists say fix fix fix, when economically all the fanancial data indicates there will be no significant growth with-in the next two years, hence the dispartive 2 year interest rates offered by Banks to Fix as opposed to Float

Yes Roger in time there will be an "influx" of home owners moving from floating to fixing, but based on the "now" it wont be now

cha cha