Of Swaps & Spreads: What are the Drivers of UK Mortgage Spreads (Margins)?
Understanding the intricacies and drivers of mortgage pricing is crucial for mortgage advisors. Fixed rate mortgages make up the majority of mortgage lending in the UK and the headline rate comprises two elements, the swap rate at the relevant maturity (e.g. the 2 or 5 year SONIA rate) and the “spread” (the margin) over this swap rate, set by the lender.
Headline fixed rate = Swap rate + Spread
This blog series explores the relevance of swap rates for banks, their driving factors, and the determinants of spreads. This article focuses on what drives mortgage spreads. See our other article on why swap rates matters for mortgage rates.
Spreads are set by individual lenders, in the context of the competitive dynamics of the wider market. In theory, spreads are the plug to solve the return on equity (profitability) puzzle for banks but the reality is more complicated, with competitive dynamics and uncertainty playing a large role in spreads.
Target Return on Equity (Profitability)
Return on equity, a key metric for bank valuation, reflects the profit generated from the bank's equity capital. Banks target a return on equity in their mortgage business, which can be used for dividends to investors or to fuel growth in the wider business.
Banks (in theory) choose spreads on their mortgage lending to make this overall return on equity equation roughly work, as other variables are not as actively “chosen” by lenders themselves.
Interest Expense Paid for Funding
Banks need to fund mortgages with liabilities, and the primary source of funding, particularly for large banks, is deposits. Other lenders may utilise wholesale funding, such as securitisations or unsecured bonds.
Deposit funding is cheaper than other forms of funding and current account deposits are particularly “sticky” (e.g. people do not move their current account for small differences in interest rates). Larger banks usually have an advantage in attracting and maintaining cheap deposit funding.
This access to cheap deposit funding gives larger banks an advantage in mortgage lending. They can price at a lower spread to competitors, and capture a higher market share or the same spread and capture higher profits. Mortgage lenders reliant on expensive deposits or wholesale funding either have to charge higher spreads to borrowers, or accept a lower return on equity.
Operating Expenses
Operating expenses, such as staff and marketing costs, directly influence the spread lenders set for new mortgages. More efficient lenders (those able to process higher mortgage volumes with lower costs) will be able to charge a lower spread, or make a higher return on equity. UK lenders in recent years have undergone major restructuring programmes to reduce their cost base in a competitive mortgage market.
Impairment Costs (Defaults)
Banks consider potential mortgage defaults when setting spreads. Impairments (the cost of defaults) can be split into two separate drivers:
Impairments = Probability of Default * Expected Loss Given Default
The probability of default is largely driven by individual characteristics. For example, borrowers with a poor credit history will have a higher probability of default than borrows with a clear credit history. This is why certain mortgage products may have stricter criteria, to manage the appropriate probability of default for their product.
The expected loss given default is the loss the lender takes if a borrower defaults and they have to go through the process of taking a property over and selling it (typically via auction).
This is why higher LTV products have higher spreads than lower LTV products, the lender has a higher expected loss given default on higher LTV products.
In times of high uncertainty, for example the start of the Covid pandemic, lenders may not feel they can price this credit risk appropriately, and withdraw from the market completely. For example, HSBC was the only lender offering high LTV mortgages in June 2020 at the onset of the Covid pandemic, as other lenders had withdrawn their products.
Equity Requirements
Equity requirements, as set by the PRA (Prudential Regulation Authority), dictate the capital banks must reserve for mortgages, based on the risk associated with the assets.
Higher risk lending has higher capital requirements, so banks would be expected to hold higher equity against assets where historically there have been higher loss rates (e.g. higher probability of default or higher loss given default).
Competitive Dynamics
In the above, we assumed that lenders simply set their spread and then received new business at this rate. However, borrowers, particularly those advised by independent mortgage brokers, are extremely price sensitive and will go for the cheapest deal available to them.
Lenders may use their spread as a tool to target a desired market share, knowing that if they are cheaper than competitors then they will increase their new business volume. HSBC and NatWest in particular have targeted a desired market share in recent years.
What then happens to other lenders in the market? Those with excess deposits (e.g. more deposits than loans) and fully staffed mortgage departments make no profits at all from not lending, so it’s rational to undercut the market leaders on at least some products to maintain reasonable new business volumes.
This dynamic has led to the UK mortgage market being extremely competitive in recent years, particularly amongst the large lenders. Ring-fencing of banks UK operations as part of post crisis reforms has led to banks’ having excess liquidity which they can only use on UK lending.
Competitive pressures can disrupt banks' targeted returns, which in turn can mean they don’t meet their cost of equity and trade below their book value in the stock market.
Have any questions or want to discuss the above? Drop us an email at info@keychain.co.uk.
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