I'm not sure exactly what month of the economic crisis we are in, but the refounding of capitalism seems to be taking its time. I haven't seen a single solid proposal yet that tells me that the same factors and agents that caused this crisis won't bring about another identical or worse one in a few years time. So to help the process along I think we can start identifying some targets for action so that at least those who have no responsibility for causing the crisis do not have to bear the full brunt of it.
Candidate number one is the Euribor, this curious rate of interest that is used to control the mortgage interest payments of those Spaniards who have managed to become property owners. The Euribor, as everyone is now finding to their cost, bears surprisingly little relationship to the real rate of interest. People used to think that their enemy was the European Central Bank, as the Eurozone attempted to keep interest rates high to try and cap inflation. Not so, now that interest rates have fallen fast and there is no reason to imagine they will rise in the near future, it turns out that the Euribor still comes close to doubling the interest payments that people have to give to the banks. It's similar to the way in which people still believe that it's OPEC controlling the price of oil, when in reality its the Let's Make Money Out Of Betting On Oil Prices Casino that runs the show.
The Euribor is supposed to be the interest rate at which banks lend to each other, quite how it became the rate which banks use to rip off their own customers is not clear. Now that banks don't trust each other or anyone else, this has the very convenient windfall effect of keeping the Euribor high and along with that the banks receive a windfall premium from those who are struggling to survive the same crisis that the same banks did so much to bring about! If you want to borrow money at the moment you can be sure it will be at Euribor + rates of interest, the "+" will probably be quite substantial. Deposits are not treated in the same way, they are often based on what the banks jokingly call the "cost of money". In other words, the Euribor bonus is for the banks only. So, what possible justification is there for banks to charge their own customers such a high rate of interest, apart from massively increasing profitability at every mortgage payer's expense. Let's get rid of it for bank loans to their own customers. It's a start, any other suggestions?
Candidate number one is the Euribor, this curious rate of interest that is used to control the mortgage interest payments of those Spaniards who have managed to become property owners. The Euribor, as everyone is now finding to their cost, bears surprisingly little relationship to the real rate of interest. People used to think that their enemy was the European Central Bank, as the Eurozone attempted to keep interest rates high to try and cap inflation. Not so, now that interest rates have fallen fast and there is no reason to imagine they will rise in the near future, it turns out that the Euribor still comes close to doubling the interest payments that people have to give to the banks. It's similar to the way in which people still believe that it's OPEC controlling the price of oil, when in reality its the Let's Make Money Out Of Betting On Oil Prices Casino that runs the show.
The Euribor is supposed to be the interest rate at which banks lend to each other, quite how it became the rate which banks use to rip off their own customers is not clear. Now that banks don't trust each other or anyone else, this has the very convenient windfall effect of keeping the Euribor high and along with that the banks receive a windfall premium from those who are struggling to survive the same crisis that the same banks did so much to bring about! If you want to borrow money at the moment you can be sure it will be at Euribor + rates of interest, the "+" will probably be quite substantial. Deposits are not treated in the same way, they are often based on what the banks jokingly call the "cost of money". In other words, the Euribor bonus is for the banks only. So, what possible justification is there for banks to charge their own customers such a high rate of interest, apart from massively increasing profitability at every mortgage payer's expense. Let's get rid of it for bank loans to their own customers. It's a start, any other suggestions?
2 comments:
Hi Graeme,
Nice post, I hope I will be able to provide some explanations about how the money markets work and alternatives to using Euribor.
One substantial difference between the Spanish and British mortgage markets is that British tracker mortgages (so far) are being referenced to the base rate set by the Bank of England, and not Libor.
The BBA are making noises about using Libor in the future but so far no institution has taken the move.
In Britain, the banks shoot themselves in the foot offering mortgages at a premium to base rate, their treasury desks assuming that their cost of funding would always be marginally above base rate, i.e libor.
For example, I have a tracker mortgage of base rate +0.24% in the house and another at base rate + 0.49% in the old flat. Amazingly, I got the former after the credit crunch had started. British banks risk models never accounted for the possibility that the libor spread (libor – base rate) would be more than a few basis points, at it was during the credit boom.
In my view, there are two key reasons why Spanish mortgages are priced to Euribor and not ECB base rate:
1) Spanish banks, being much more risk averse and still remembering the banking crisis in the 90s, priced their mortgages referenced to Euribor, which reflects their cost of external funding better. By adding a spread over euribor, their margins on the mortgage book are quite big. In a way, Spanish banks need wide margins since their capital requirements (set by the Bank of Spain) are counter-cyclical and higher than for British banks. Plus Spanish banks maintain a vast network of branches that is unique in Europe. I don’t know if using Euribor was the banks’ idea or the Bank of Spain’s or both. But from a banks’ perspective, it makes sense since they are more able to influence euribor than the base rate set by the ECB.
2) Spanish banks were not keen/efficient/operationally able/good to securitise their mortgage book as British banks, therefore being unable to package up their mortgages, sell them on as Mortgage-Backed Securities (MBS) via the investments banks and lock in a tiny but “safe” margin,. They decided to go for a floating rate that would reflect more closely their true cost of funding via the Eurobond market, which is priced using a spread over Libor.
As for solutions, I don’t think the regulators/politicians have the courage/energy/brains to do much about it.
An obvious one is to force banks to price their products (both savings and loans) referenced to ECB rates. After all, these rates are the rates at which banks can get funding from the BCE, which is secured. Euribor reflects the cost of unsecured lending between banks. Why a secured product (a mortgage secured on a house) should be priced referenced to an unsecured benchmark rate I don’t yet understand…
There is a bit of an operational problem though: the ECB actually uses 3 rates: deposit, refi and marginal. The one we hear about in the news is the refi rate, now 2.50% (20 Dec 2008). This is the rate at which the ECB will conduct auctions for money. In the past, this rate was the “minimum” rate at which banks could bid. The true rate would normally be higher. The main problem is that after the credit crunch these auctions are heavily subscribed, and the final rate after all the bids was super high. Additionally, not all the banks can access the refi facilitiy: you need to pledge appropriate collateral like government bonds, etc. So the ECB also has the marginal lending rate, at which any bank can borrow from the ECB. Historically, this rate has been 1.00% higher than the refi rate. The ECB also has the deposit rate, so if banks have spare money, they can deposit it with the ECB and get a return with no counterparty risk. This deposit rate was 1.00 lower than the central, refi rate.
Since the set up of the euro, these two rates has been 1.00% below/above than the main base rate. So for years, the spread between what the ECB charged for a marginal loan and what it paid for deposits was 200bps (2.00%). For example when the base rate was 4.00%, banks could borrow ad-hoc (away from the actions starting at 4.% minimum bid) from the ECB at 5% and deposit spare cash with the ECB and get a return of 3%.
This policy of keeping the ECB spreads so wide was “good” in the sense that it encouraged banks to lend to each other more, as the ECB was deemed expensive: it paid little for deposits and it charged a lot for borrowings. For a few years, while there was confidence in the markets, this encouraged liquidity which arguably was one of the contributing factors to the credit expansion and consequent credit contraction (it was also a contributing factor in the exponential growth in credit default swaps but that’s another story…).
But this all changed in October:
1) the ECB changed the mechanism of the auction. All bids would be accepted at the refi rate. In the past, a bank could bid for say €500m, at 4.19%, and only get €300m at 4.10%. Now, all bids are accepted at the set refi rate.
2) Since October, the differential between the main base rate (refi rate) and the deposit and marginal lending is only 50bps (0.50%). This is a knee-jerk reaction which is having unintended consequences. The ECB decided to tighten the spreads as liquidity in the money markets had dried up. By making borrowing from the ECB cheaper, the ECB hoped it will make banks more willing to lend to each other and, crucially, to customers and businesses. However, in my view the opposite is happening. Since it is so cheap to borrow from the ECB, all banks are doing so in a massive scale and not borrowing from each other, which is what is required.
Also, by getting paid in deposits just 0.50% below refi rate (instead of 1% below as in the past), this is discouraging banks to lend to other banks: if there is any spare cash in the treasury desks, it is safer to deposit it with the ECB at 2% than with another bank at 3.1%. In the past, all things equal, it would have been 1.5% for deposits at the ECB.
So as for solutions I propose: (letter to the CESR on its way…)
+ Regulatory action: price products referenced to refi rate.
+ Political action: a fixed percentage of borrowing from the ECB in current conditions must be “passed on” onto the real economy. At present, the banks are borrowing record amounts from the ECB just to keep their capital ratios afloat, a complete scandal.
+ Regulatory action: executive remuneration of the executive committee, and highest 10-25 paid employees must be fully disclosed in the annual accounts.
+ Political action: legislate against tax havens (all banks use them) and offshore centres.
+ Regulatory action: ban banks from having off-balance sheet investments vehicles. Everything must be in the balance sheet and at mark to market value, not models.
+ Regulatory action: banks must disclose their Euribor/Libor quotes. The BBA will oppose this on the basis it is the index rate calculated by a private organisation, but if Libor/Euribor are used for product literature and pricing full disclosure of quotes must be enforced by the regulator. Otherwise, all product literature must be banned from containing references to Euribor.
Thanks for such a detailed response Rab. It just seems so rich to hear banks worrying about problems of debt with their clients when they use a rate of interest that can only increase the difficulties that people have in paying.
The tax haven suggestion sounds like an excellent next step.
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