Explaining the gap between mortgage rates and the Libor rate

Article by Trevor Williams in FT Advisor

Lend me your ears...

Why is there such a widespread gap between mortgage rates and the Libor rate?

Stresses in financial markets in the developed economies are still apparent, nine months after the start of the 'credit crisis'.

Credit spreads remain wide, bond yields are at five to seven year highs, the difference between short-term benchmark government lending rates remains at historically wide levels and equity markets, though recovering, are still mainly lower than a year earlier. Even though in the US and UK and Canada, but not in the eurozone, short term interest rates have been cut.

A period of very low price inflation in the second half of the 1990s and 2000s had allowed the US Federal Reserve in 2001 to stave off most of the nasty deflationary economic effects of the bursting of the dot.com boom by cutting short-term interest rates sharply.

Other countries followed suit, and interest rates were kept below the long run average real rate for many years. For instance, the key short term US Fed funds was cut in early 2001 from 6.5 per cent and continued to be cut aggressively down to 1 per cent in early 2003, where it then stayed for a year before starting to rise in 2004. Fed funds were only slowly raised by Alan Greenspan and did not reach 5 per cent until 2006.

The effects of the loss of confidence in credit derivatives and related instruments by buyers - insurance companies, pension companies and life assurance funds - has also seriously impacted credit markets unrelated to mortgage-backed securities, making it harder for loans to be securitised and sold and so for the issuance of asset-backed commercial paper to fund normal commercial operations.

What led to the increased demand in financial markets for these types of instruments? One reason was product innovation at a time of increased liquidity and more sophisticated investors - or so it seemed at the time. But the main reason was a search for higher returns in an environment where low interest rates had led to low returns from conventional short term assets and so longer term, higher yielding assets were created. This has often been described as a 'search for yield'.

Volatility in credit markets is still likely for some time yet, as not all of the news about potential losses and exposure to more complex securities has been fully disclosed and so credit markets remain open to further shocks as new information emerges. But the cost of buying protection against credit risk from holding securities has fallen quite sharply in since the forced sale of Bear Stearns by the US Fed to JPMorgan Chase in March.

The impact of the credit crisis on the mortgage market is perhaps clearer than for many other sectors. Losses and downgrades on mortgage-backed securities in the US were the catalyst for the credit crisis, as they were used more than any other asset class to be wrapped into CDOs and CLOs. These, in turn, were used to borrow against, creating leverage in some cases - such as Bear Stearns - of up to 35 times the underlying assets.

Surveys by central banks in the US, UK and eurozone all show that banks are tightening credit standards or planning to do so, which will raise borrowing costs and lower the supply of credit. The reason they give for doing this is that slower economic growth, combined with the credit squeeze and higher oil and commodity prices will raise defaults rates. As a result, banks plan to raise, and have raised, the cost of borrowing and have cut back on risk exposure through reducing the availability of credit.

In this regard, the latest UK credit conditions survey for the first quarter from the Bank of England, was no surprise, but nonetheless made grim reading. It suggested that credit conditions will tighten even further for UK households and companies in the next three months, after a pronounced tightening in the three months to March 2008, which itself was more than was expected at the end of 2007. At the same time, the survey reported that lenders also intended to widen spreads, effectively raising the cost of borrowing to households and companies. So it was no surprise that the report also showed that a greater number of lenders expected default rates on loans in the UK to rise, after being higher than expected in the previous three month period.

What does the evidence suggest? It is certainly the case that UK mortgage arrears are rising – individual insolvencies were up by 1.6 per cent in the first quarter, but were actually down by 13.2 per cent in the year to the end of the first quarter, partly because the rise was strong last year. But the quarterly rise still suggests that individual defaults will rise in 2008, or at least the segment that is related to mortgage loans.

Forecasts for mortgage arrears show that the expected rise, to about 0.45 per cent of loans outstanding, although up from its low of some 0.25 per cent in 2006 this is well below the ratios that occurred in the last housing market crash in the early 1990s. This forecast takes account of slower economic growth in the UK - our projection is for about 1.