Tuesday, December 02, 2008

Have we seen the end of cheap mortgages?

HSBC became the latest bank in Hong Kong to raise its interest rates for new mortgage loans. The new rates will be between 1% and 1.5% below HSBC's prime lending rate. This represents an increase of about 75 basis points. New borrowers will be paying between 3.5% and 4.0% on their home loans.

The stated reason for the increase is to reflect the higher risk premium of lending to home buyers. HSBC is not alone as other banks have also raised their lending rates for much the same reason.

I find this a very odd explanation for the interest rate increase and a very odd method of reducing the risks which banks face in advancing mortgage loans:

1. the banks have already adopted lower valuations (generally below market) as a risk management measure. This has the effect of requiring a higher deposit from borrowers;

2. for luxury properties banks have reduced the maximum loan to value ratio that they will accept. Again, this requires a higher deposit which reduces the banks' risk;

3. in a market where borrowers are competing for funding, higher risk borrowers would have to pay more for their loans - in effect a risk premium. The mortgage market is not such a market as (i) bank deposits are still rising faster than banks can lend money out (ii) generally speaking banks are not charging higher risks premiums for different customers (except at the extreme ends of the lending spectrum - preferred customers and those who need mortgage insurance). The argument that banks need to charge a higher risk premium to home buyers simply does not stand up to the facts;

4. higher interest costs actually increase the risk of default by borrowers. While this is largely irrelevant to the risk premium argument, it is still a true statement;

5. inter bank rates in Hong Kong have fallen over the last few months. Three month HIBOR currently stands at around 2.04%. Deposit rates remain close to zero for small short term deposits. This makes the decision to increase lending rates odd;

6. there is no regulatory pressure on Hong Kong banks to increase the capital needed to support mortgage lending.

A more likely explanation is that the banks are simply attempting to increase their lending margins. In a free and competitive market there is nothing wrong with this - if supply side competition kicks in the increases will not last long. If supply side pressure does not push interest rates back down, then the increases are no more than a reflection of supply and demand for mortgage loans.

On the latter point, the build up of bank deposits and the multi-year fall in the loan to deposit ratios have been cited as reasons why mortgage rates have been pushed as low as they went in the the last few years. The latest data from the HKMA may suggest that this trend is reversing. The rate of increase in HK$ and US$ deposits has been slowing for about a year now and the HK$ deposit level fell in absolute terms in September. US$ deposits and deposits in other currencies (mainly RMB) continue to rise (at a slower rate) but the net effect is that the decline in the loan to deposit ratio has reversed its trend and has been rising steadily during 2008. If this trend continues it may be some time before we again see the relatively cheap mortgages that we have enjoyed for the last few years.

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