Saturday, March 12, 2011

Keeping the mortgages

Several banks have started talking up the rates they are offering on mortgages. The latest being Bank of China (Hong Kong) Limited which has raised the spread on its HIBOR linked mortgage product to HIBOR + 0.9 - 1.2%. At current interest rates that works out at 1.1- 1.4% pa and compares with the old rates of HIBOR + 0.8% (1.0% pa). While still extremely cheap, its another sign that the banks are trying to exert some upward pressure on rates and expand their NIM (net interest margin). The new rates apply to new mortgages and do not affect existing mortgages.

While I can understand the banks' motivation, given that the demand for mortgage loans has fallen due to higher deposit requirements and a fall in transaction volumes (courtesy of the HK government's punitive stamp duty on short term resales), it seems unrealistic for a supplier of a good (mortgage loans) to increase price (interest rates) while experiencing falling demand (less money being borrowed). As far as I am aware the supply of money (deposits) has not dried up and Hong Kong banks still have very healthy loan to deposit ratios. Also, there has been no noticeable increase in either deposit rates or bond yields. I have to wonder what I am missing here?

As far as my own position is concerned, the case for not making early repayments has got even stronger in recent months:

1. all my mortgages currently cost less than 1% pa;

2. CPI measured inflation is currently running at 3.6% pa (for the year to January 2011);

3. yields on equities and real estate are well above the cost of funds;

4. there is no risk of being called (absent default);

5. based on current bank valuations, my weighted average gearing on the Hong Kong properties is less than 31% (range 7-45%);

6. historically, banks have not called mortgages unless there is an actual failure to make payments due;

7. I will make either a full or a partial repayment of the mortgage on our home when I retire and get back my capital contribution (and, yes, I feel like a complete wimp for doing this).

In effect, my position is that negative real interest rates and low nominal rates mean that keeping the mortgages for as long as possible is a meaningful way of adding value to the portfolio through generation of positive carry (yield differential) and inflationary erosion of principal.

The major risk is that the floating interest rates (HIBOR) move above the yields on investments and/or that we revert to an deflationary environment. While I do expect interest rates to move up at some stage (but can only guess and when this will happen and by how much), I consider the downside to be limited (especially compared to the risk of holding volatile assets like equities and real estate). Given that I will cease working in the near future, this is an important point because I will have to service the loans from rental income without the security blanket of job related income.

I also have to accept that rising interest rates have the potential to cause property prices to fall. This is a very real and not immaterial risk to my portfolio. Given my gearing and cash flow position I have a high degree of confidence that I can ride out any downturn. Hopefully this will not turn out to be a case of famous last words.

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